WACC and Capital Structure Policy

Question 1

What is cost of capital?

Answer 1

• Projects have to earn at least a benchmark rate of return (minimum acceptable hurdle rate) to be accepted
• The benchmark return should be higher for riskier projects than for safer ones
• From investors’ viewpoint: required rate of return or market-determined opportunity cost
• From the firm (issuer)’s viewpoint: cost of capital

Question 2

WACC

Answer 2

WACC puts weights on cost of debt and cost of equity
Interpretations
• The overall return the firm must earn on its existing assets to maintain the value of its securities or
• The required return on any investments by the firm that essentially have the same risks as existing operations

Question 3

Each Component in WACC -Kd(cost of debt)

Answer 3

• Market interest rate that the firm has to pay on its long term borrowing today
• 𝑘𝑑 = risk-free rate + default spread
• If the firm is rated, use the rating and a typical default spread on bonds with that rating
• If not rated, use the interest rate on a bank loan or estimate a proper default spread based on a synthetic rating (how?)
• Estimating a synthetic rating
• Can be estimated by using one or a collection of financial ratios • A simple, common ratio that seems to work best is: Interest coverage ratio = EBIT/Interest Expenses

Question 4

Each Component in WACC -te: effective company tax rate

Answer 4

• (1 − 𝑡𝑒)𝑘𝑑 reflects tax savings associated with debt
• Under a imputation tax system corporate tax is reimbursed to resident shareholders as tax credits attached to dividends (so-called franking credits)
• Thus, the effective corporate tax rate can be lower than the statutory corporate tax rate (𝑡𝑐 = 30%):
𝑡𝑒=𝑡𝑐 (1−𝜆)
where λ is the proportion of corporate tax claimed by shareholders
• λ=0, a classical tax system; λ=1, a pure imputation tax system
• λ depends on a proportion of overseas shareholders and whether to distribute profits as fully franked dividends or not

Question 5

Each Component in WACC -Ke- cost of equity

Answer 5

• Two methods to calculate 𝑘𝑒
(1) Capital asset pricing model (CAPM)
• Beta reflects how the underlying stock moves with the market (correlation or diversification measure)
• Stocks contributing more risk (high beta) require a higher expected rate of return for an investor who holds the overall stock market (a diversified portfolio)
(2) DCF approach (Gordon Growth model)
where 𝐷 = current period dividend per share

Question 6

Each Component in WACC - Weights

Answer 6

• Weights should be calculated using market values rather than book values
• Ideally, use the firm’s target (or optimal) capital structure
• The firm’s current capital structure can be used if it’s optimally chosen and will not change following the acceptance of the project

Question 7

Single WACC for Diversified Firm

Answer 7

• What could be the problem of using the companywide WACC?
1. Likely to accept negative NPV projects
2. Likely to have a natural bias towards riskier projects
• The company cost of capital should only be used as a benchmark rate of return for a new project if
• The project has the same basic risk as the rest of the company
• If not, the company needs to find publicly-traded companies in the same industry as the project and obtain their average info.

Question 8

optimal capital structure

Answer 8

• Common measure of a firm’s capital structure Debt to Capital Ratio (or leverage ratio) = Debt / (Debt + Equity)• Firm value will be maximized when the cost of capital is minimized! – “cost of capital approach”based on DCF method

Question 9

Cost of capital approach

Answer 9

• Let’s see what will happen to the WACC as debt ratio increases
1. What will happen to the cost of debt (𝑘𝑑)?
• Will increase with leverage because default risk will go up and bond ratings will go down, requiring a higher default spread
2. What will happen to the cost of equity (𝑘𝑒)? • Will also increase with leverage. Why?
• Two types of risks shareholders of a leveraged firm need to bear: Business risk and Financial risk
• Stock beta (so, 𝑘𝑒) captures both types of risks
𝛽(L) : levered beta (stock beta of a firm with leverage)
𝛽(U) : unlevered beta (or asset beta) only reflecting business risk
Levered beta is a function of unlevered beta and D/E ratio

Question 10

Steps for cost of capital approach

Answer 10

1. Estimate the cost of equity (𝑘𝑒) at different levels of debt • D/E increases → Beta will increase → 𝑘𝑒 will increase
   • Estimation requires levered beta calculation
2. Estimate the cost of debt (𝑘𝑑) at different levels of debt
   • Default risk will go up and bond ratings will go down as debt goes up
   → 𝑘𝑑 will increase
   • Estimation requires estimation of bond ratings
3. Calculate the cost of capital at different levels of debt and choose the optimal level
4. Calculate the effect on firm value and stock price

Question 11

Modigliani-Miller “Irrelevance” Theorem

Answer 11

• Assume “perfect” markets:
• No transaction or bankruptcy costs; no agency costs
• No taxes and no asymmetric information
• Market efficiency and perfect market competition (no arbitrage opportunity)
Then
• The value of the firm is independent of its capital
structure (𝑉 = 𝑉 ) 𝐿𝑈
• Financing decisions do not matter!

Question 12

M-M Theorem Proof(pie theory)

Answer 12

• The value a firm is that of the cash flows generated by its operating assets (e.g., plant and inventories)
• The firm’s financial policy divides up this cash flow “pie” among different claimants (debtholders and shareholders)
• But the size (i.e., value) of the pie is independent of how the pie is divided up

Question 13

Limitation of M-M Theorem

Answer 13

• M-M Theorem was initially meant for capital structure
• But it applies to all aspects of financial policy under perfect markets assumptions:
• capital structure is irrelevant
• long-term vs. short-term debt is irrelevant
• dividend policy is irrelevant
• risk management is irrelevant

Question 14

Capital Structure Theory 1: trade- off theory

Answer 14

• The optimal target capital structure is determined by balancing taxes and expected costs of financial distress
• These two ingredients can change the size of the pie that goes to the firm’s claimholders (firm value) in the opposite directions
• Trading off the two gives an “optimal” capital structure (but, this theory does not aim at providing a precise target but rather a range)

Question 15

Capital Structure Theory 1: trade- off theory

Debt Tax Shields

Answer 15

• Debt increases firm value by reducing the tax burden
• Size of the pie = Value of before-tax cash flows
• Government gets a slice too
• Because interest payments are tax-deductible, the PV of the government’ slice can be reduced by using debt rather than equity

Question 16

Capital Structure Theory 1: trade- off theory

Debt Tax Shields Value implications

Answer 16

• With corporate taxes (but no other imperfections), the value of a levered firm equals:
𝑉L =𝑉U +𝑃𝑉(𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑡𝑎𝑥 𝑠h𝑖𝑒𝑙𝑑𝑠)
• If the firm is a going concern and debt is a perpetuity, • Leverage and firm value: 𝑉L = 𝑉U + 𝑡e𝐷
• This suggests that having enough debt financing is optimal so as to reduce the tax bill (realistic?)
• Imputation tax neutralises tax benefit of debt (e.g., the PV of tax-shields, 𝑡𝑒D, is zero in pure imputation system), implying lower leverage

Question 17

Capital Structure Theory 1: trade- off theory

Debt Tax Shields Value implications

Answer 17

• If taxes were the only issue, companies would be 100% debt financed
• Common sense suggests otherwise
• If debt burden is too high, the company will have trouble
• The result: “financial distress” ⇒ bankruptcy (court supervision) in some cases
• Now, the pie is divided like equity+ debt+ taxes+ destroyed in financial distress

Question 18

Capital Structure Theory 1: trade- off theory- Exp cost of financial distress- Probability of Financial Distress

Answer 18

Expected costs of financial distress
=(Probability of distress) * (Costs if actually in distress)
• Probability of distress
1. “Cash flow volatility” (or business risk)
• Is industry risky? Is the firm’s strategy risky?
• Is there a risk of technological change?
2. As debt increases, the probability of financial distress also increases

Question 19

Capital Structure Theory 1: trade- off theory- Exp cost of financial distress- Cost of Financial Distress

Answer 19

1. Direct costs (tend to be small)
   • Legal expenses, court costs, advisory fees…
2. Indirect costs (tend to be larger, but hard to measure)
   • Opportunity costs (e.g., management distraction)
   • Scare off customers and suppliers (damage to reputation)
   • Debt overhang (underinvestment: passing up +NPV projects, agency costs of debt)
   • Excessive risk-taking behavior (asset substitution: gambling for salvation, agency cost)

Question 20

Capital Structure Theory 1: trade- off theory- Exp cost of financial distress- Cost of Financial Distress- agency costs of debt

Answer 20

• In the MM world, investment policy is fixed
• In reality this is not true and potentially “agency costs of
debt” arise
1) Debt overhang (underinvestment) problem
• When a firm is in financial distress, shareholders may prefer to pay out cash to shareholders than fund projects (even positive NPV projects) because most of the benefits would go to the firm’s existing creditors
2) Excessive risk-taking (asset substitution) problem
• Shareholders have unlimited upside potential but bounded losses
• When a firm faces financial distress, shareholders are tempted to gain by gambling (negative NPV projects) at the expense of debt holders

Question 21

Capital Structure Theory 1: trade- off theory- Exp cost of financial distress

Answer 21

• Expected costs of financial distress increases sharply with leverage (both probability and actual costs increase)
• Shareholders bear expected distress costs in the form of more expensive debt (higher interest rates, more covenants)
• Companies with high expected distress costs should be more conservative in using debt

Question 22

Trade-off theory: optimal leverage

Answer 22

• The value of a levered firm is now
𝑉 = 𝑉 + 𝑡 𝐷 − 𝑃𝑉(𝑒𝑥𝑝. 𝑑𝑖𝑠𝑡𝑟𝑒𝑠𝑠 𝑐𝑜𝑠𝑡𝑠)
• As leverage increases, firm value first increases, then decreases. The highest point is the optimal structure.

Question 23

Firm and industry characteristics

Answer 23

1. Young, R&D intensive firms have low leverage because:
   • Risky cash flows – high probability of financial distress
   • High human capital – large loss in case of financial distress
   • Easy to increase risk of business strategy – danger of asset substitution problem
   • Many positive NPV investment opportunities – debt overhang problem
2. Low-growth, mature, capital intensive firms have high leverage because:
   • Stable cash flows – low probability of financial distress
   • Tangible assets – lower costs of financial distress
   • Few investment opportunities – debt overhang problem is unlikely

Question 24

Capital Structure Theory 1: trade- off theory: implications

Answer 24

1. Firms should:
   • Issue equity when leverage rises above the target level
   • Buy back stock when leverage falls below the target capital structure
2. Stock market should:
   • React positively (or neutrally) to announcements of securities issues

Question 25

Capital Structure Theory II: Pecking Order-PerspectiveWhat Really Happens?

Answer 25

• Stock prices drop (on average) at the announcements of equity issues
• Companies are reluctant to issue equity
• They follow a “pecking order” in which they finance investments:
• first with internally generated funds
• then with debt
• then with hybrids and finally with equity
• Willingness to issue equity fluctuates over time
So, Something is missing from the “target-leverage” view

Question 26

Capital Structure Theory II: Pecking Order Perspective-How to Incorporate These Concerns?

Answer 26

1. So far, we assumed
   • No distinction between existing and new shareholders • No conflicts between managers and shareholders
   • No costs of financial transactions
2. Departing from that can explain a pecking-order preference
   (1) Asymmetric information: managers have more information than
   outside investors
   (2) Agency costs of equity (or free cash flow problem): managers may not act in the interest of shareholders
   (3) Different flotation costs: issuing equity is more expensive than issuing debt (direct underwriting fees and legal/registration fees)

Question 27

Capital Structure Theory II: Pecking Order Perspective-Agency Costs of Equity

Answer 27

1. Free Cash Flow (FCF)
   • Cash flow in excess of that needed to fund all positive NPV projects
2. Managers may be reluctant to pay out FCF to shareholders
   • Empire building through unprofitable acquisitions
   • Pet projects, prestige investments, perks
3. This problem is more severe for “cash cows”
   • Firms with lots of cash (i.e., profitable firms)
   • And few good investment opportunities
   • Can leverage reduce FCF problem?
   • Debt = commitment to distribute cash flows in the future. Thus, debt reduces FCF available to managers
   • Less opportunities for managers to waste cash
   • This FCF theory also explains the negative stock price response to equity issues and why cash cow firms tend to have a higher leverage

Question 28

Capital Structure Theory II: Pecking Order Perspective-Pecking Order and Capital Structure

Answer 28

• If Pecking Order holds, a company’s leverage ratio reflects:
• Not an attempt to approach a target ratio;
• But its cumulative requirements for external finance
• High cash-flow ⇒ no need to raise debt & can repay debt ⇒
leverage ratio decreases
• Low cash-flow ⇒ need to raise capital (but issuing debt rather than equity) ⇒ leverage ratio increases

Question 29

An Integrative Approach－What Should We Do with These Theories

Answer 29

1. Each theory makes a statement about what is first order issue:
   • TO: Tax shield and Distress costs
   • PO: Information (market response), managerial agency costs,
   issuing costs
2. These theories need not be incompatible:
   • Use each when you think they emphasize the right issues
   • When getting far away from target, TO type issues dominate
   • When reasonably close to target, PO type issues dominate

Question 30

An Integrative Approach－Capital Structure: Checklist

Answer 30

1. Taxes
   • Does the company benefit from debt tax shield?
2. Expected distress costs
   • What is the probability of distress? (Cash flow volatility; business risk)
   • What are the costs of distress?
   • Competitive threat if pinched for cash, customers care about distress, assets difficult to redeploy?, agency costs of debt
3. Information problems
   • Do outside investors understand the funding needs of the firm?
   • Would an equity issue be perceived as bad news by the market?
4. Managerial agency problems
   • Does the firm have a free cash flow problem?
5. Issuing Costs

Question 31

An Integrative Approach

Answer 31

1. Establish long-run “target” capital structure
2. Evaluate the true economic costs of issuing equity rather than debt
   • Real cost of price hit and issuance costs vs. foregone investment or increase in expected cost of distress
3. If still reluctant to issue equity:
   • Are there ways to reduce the cost? (e.g., give more information) • Will the cost be lower if you issue later?
   • Can you use hybrids?