Part 4. The cost of capital and capital structure. 12. The cost of capital and capital structure Flashcards
What is meant by highly geared company?
A highly geared company has a high ratio of long-term debt to shareholders’ funds. A high level of gearing implies a higher obligation for the business in paying interest when using debt financing. It has a higher risk of insolvency than equity financing. While dividends on ordinary share capital need only be paid when there are sufficient distributable profits, the interest on debt is payable regardless of the operating profit of a company.
A review of the gearing ratio is key in the funding decisions made by financial managers and investors. It affects risk, returns and controls associated with equity capital. Investors may require a higher return to compensate for the higher risk associated with the higher gearing. According to the control principle, debt may also be preferred over equity to minimise possible risk of loss of control.
When might investors and other stakeholders prefer gearing and
why?
Other stakeholders who have an interest in the profitability and stability of the company, including employees, customers and particularly creditors, will also be interested in the level of gearing. Since debt capital is cheaper than equity capital, debt financing should minimise the cost of capital and maximise the earnings per share. The interest on debt is deductible for income tax purposes, making debt capital cheaper, whereas no such deductions are allowed for dividends. Debt should be used to the extent that it does not threaten the solvency of the firm.
What are the problems around high gearing?
The problems of high gearing include:
bankruptcy risk increases with increased gearing;
agency costs and restrictive conditions imposed in the loan agreements
constrain management’s freedom of action, such as restrictions on dividend levels or on the company’s ability to borrow;
after a certain level of gearing, companies will have no tax liability left
against which to offset interest charges (tax exhaustion);
companies may run out of suitable assets to offer as security against loans with high gearing;
gearing increases the cost of borrowing; and
directors have a natural tendency to be cautious about borrowing and
related solvency issues.
Outline the Modigliani and Miller theory of capital structure.
The Modigliani–Miller theory states that capital structure is irrelevant and efforts to reduce the cost of capital using gearing will not succeed.
The first proposition states that the value of the geared firm equals the value of the ungeared firm (earnings before interest ÷ WACC). The value of WACC is constant at all levels of gearing.
The second proposition states that savings from debt being cheaper than equity are equal to the increase in the cost of equity due to increased risk arising from gearing. The cost of equity in geared company Kg equals the cost of ungeared company Ku, plus a premium for financial risk.
Later developments in the theory with the introduction of tax state that debt interest is tax-deductible, whereas ordinary share dividends are not.
The conclusions are that debt is, in fact, cheaper than equity. Tax relief on debt interest reduces the WACC. Therefore, gearing up reduces the WACC and increases the market value of the company. The optimal capital structure is 99.9% gearing. This means higher the debt, the lower the WACC and the higher the market value. The company should use as much debt as possible.
What are the basic decision-making factors to consider when
making a choice between two or more projects using payback
period?
A few factors need to be considered in deciding whether to accept this project:
a project is acceptable if it pays back within the target period when choosing between two or more projects, the project(s) with the fastest payback is chosen.
- How do depreciation and sunk costs affect the decision-making
process in project appraisal?
Sunk costs and depreciation are non-relevant factors for project appraisal. Sunk costs are past expenditure that cannot be recovered and hence cannot influence the current decision. Depreciation is a non-cash item and does not affect future cash flows.
The importance of the cost of capital
A company’s cost of capital is the rate of return required by the providers of
capital for making an investment in the company. While equity investors receive
their returns in the form of dividends and capital growth from increases in the
share price, debt providers (normally in the form of a bond) receive fixed interest
payments and normally a date is set for when the debt will be redeemed or
repaid.
The cost of capital is an important concept in financial decision making. It
represents the investor’s opportunity cost of taking on the risk by making aspecific investment. In other words, it is the rate of return that could have been
earned by putting the same money elsewhere.
The financial manager uses cost of capital when:
designing a balanced and optimal capital structure
evaluating new project or investment options
The use of discounted cash flows (DCF) is an important approach to investment
appraisal. Companies calculate their weighted average cost of capital (WACC)
and use it as a discount rate to determine the present value of future cash flows
of its investment
What are the two methods of determining the cost of equity?
the capital asset pricing model
the dividend valuation model
The cost of equity is the return investors expect to achieve on their shares in a company. The rate of return an investor requires is based on the level of risk associated with the investment. Equity shareholders are the last investors to be paid out of company profits, as well as the last to be paid on the winding up of a company.
Equity investors face the greatest risk of all investors and therefore demand a higher rate of return to justify the risk taken.
The capital asset pricing model
CAPM is a means to measure the cost of equity.
The model studies
and establishes an equilibrium relationship between the expected returns from
each security and its associated risks. It can be used to assess risk in individual
company shares or a portfolio of securities. The cost of equity capital obtained under CAPM is called the risk-adjusted
discount rate (RADR).
Once the market portfolio has been established, the required rate of return for any security can be calculated using this model provided the beta factor is known
Risk-adjusted discount rate
The risk inherent in a project depends on the type of activity involved. Higher risk does not necessarily make a project unattractive. The RADR is the rate used to discount a risky asset or investment such as real estate. It represents the required periodical returns by investors to compensate for the higher risk involved. The higher the risk involved in the project, the higher the discount rate. The cash flows from riskier assets will be discounted at a higher rate. This adjusted discount rate is typically referred to as expected rate of return. It forms the basis for CAPM.
The RADR is based on the risk-free rate (RFR) (such as a short-term interest rate from government securities or a fixed deposit rate) and a risk premium for the riskier assets.
RADR = RFR + risk premium
Where:
RADR = Risk-adjusted discount rate
RFR = Risk-free rate
Unsystematic and systematic risk
Unsystematic risks are risk factors specific to a particular company or industry which can be eliminated or diversified away in a large portfolio of shares. These risks are not impacted by political and economic factors. Examples include weak labour relations, adverse press reports and strikes.
Systematic risk (or market risk) relates to the markets and the economy. It is largely caused by macroeconomic factors and affects all the shares in themarket. It is unavoidable and cannot be diversified. An example may be an economic recession affecting both the markets and the economy of the country.
Assumptions and criticisms of CAPM
Assumptions
Investors are rational and possess full knowledge about the market.
Investors expect greater returns for taking greater risks.
It is possible for an investor to diversify the unsystematic risk by actively
managing the portfolio.
Borrowing and lending rates are equal.
There are no transaction costs.
Markets are perfect and market imperfections tend to correct themselves in
the long run.
The RFR is the same as the returns on the government bonds.
There is no taxation and no inflation.
Criticisms
Research has shown that the linearity of the SML has been lost with
changes of gradient at different levels of ß during some periods.
Apart from changes in ß, there are also other reasons (such as company
size or market value) for the shares to give excess returns. These are not
considered by CAPM.
There are practical difficulties in deriving the systematic risk and the ß
of any company as trading on the stock market is subject to numerous
factors.
Companies with more than one division and company channel might have
different systematic risks for each division – yet ß is derived on the basis of
a single share price.
The CAPM is a one-year model and is relevant for a year only.
Cost of equity using the dividend valuation model
The dividend valuation model (or dividend growth model) states that the value
of the company/share is the present value of the expected future dividends
discounted at the shareholders’ required rate of return.
Assuming a constant growth rate in dividends:
P = D0(1 + g) ÷ (Ke – g)
Where:
P = current share price
D0 = current level of dividend
g = estimated growth rate in dividends
If we need to derive Ke, the formula can be rearranged to:
Ke = [D0 (1 + g) ÷ P0] + g
D0 (1 + g) is the dividend at the end of the year (D1).
The dividend valuation model is covered in detail in Chapter 15
WACC
The weighted average cost of capital
The weighted average cost of capital (WACC), commonly referred to as
the company’s cost of capital, represents the minimum return that a company
must earn on its existing assets. It reflects the weighted average rate of return
a company is expected to pay to all the providers of long-term finance. The
weights are the fraction of each financing source in the company’s total capital.
WACC is influenced by the external market.
The WACC is derived by averaging a company’s cost of equity and cost of
debt according to the market value of each source of finance. The appropriate
weights are the target capital structure weights expressed in market value terms.
WACC = Ke ×E/E + D+ Kd (1–t) ×D/E + D
Where:
WACC = Weighted average cost of capital
E = Total market value of equity
D = Total market value of debt
t = Corporate tax rate
Capital structure
After determining the finance required for an investment or project, a company
must consider the use of various sources of finance. Capital structure refers to the mix of equity and debt financing that shows how the company, or its overall operation, is financed. It is concerned with the balance between equity (shares and retained earnings) and non-current liabilities (loans, debentures or fixed return capital). The sources and the mix of capital are decided on the basis of need of the company and the cost of capital.
The key objective of a company is to maximise the value of the company.
This should be considered when deciding upon the optimal capital structure.
Decisions need to be made about:
the sources (form of capital)
their quantity (amount to be funded)
the use of their relative proportions in total capitalisation
The value of the company can be measured using the following two formulae.
EBIT ÷ overall cost of capital or (WACC)
Market value (MV) = future cash flows ÷ WACC
For example, if a project generates future cash flows of £100,000 at 10% WACC:
MV = £100 ÷ 10% = £1,000
Capital investment refers to funds invested by a company for furthering its objectives such as replacement of a non-current asset, expansion of its production capacity or diversification to a new product line. Capital structure decisions are involved whenever funds are to be raised for financing a capital investment. Raising funds generates a new capital structure in terms of its quantity, mix and forms of capital:
