ACCA paper f9 financial management study materials F9FM session11 d08

SESSION 11 – WEIGHTED AVERAGE COST OF CAPITAL AND GEARING OVERVIEW Objective To understand the weighted average cost of capital (WACC) of a company and how it is estimated To understand the effect of gearing on the WACC of a company To discuss the theories of Modigliani and Miller WEIGHTED AVERAGE COST OF CAPITAL AND GEARING WEIGHTED AVERAGE COST OF CAPITAL Calculation of WACC Limitations of WACC GEARING The effects of gearing Traditional view of capital structure Modigliani and Miller’s theories 1101 SESSION 11 – WEIGHTED AVERAGE COST OF CAPITAL AND GEARING WEIGHTED AVERAGE COST OF CAPITAL 1.1 Calculation of WACC Companies are usually financed by both debt and equity, i.e they use some degree of financial/capital gearing We must therefore calculate a weighted average cost of capital (WACC) which represents a company’s average cost of long-term finance This will give us a potential discount rate for project appraisal using NPV In the previous session we saw how to estimate the cost of equity and the cost of various types of debt We weight the various costs of debt and equity using their respective market values WACC = KegE + Kd1D1 + Kd2D2 + + E + D1 + D2 + + Written as WACC = KegE + KdD E+ D OR WACC = Keg E D + Kd E+D E+D Where: E = Total market value of equity D = Total market value of debt Keg= Cost of equity of a geared company Kd = Cost of debt to the company (i.e the post tax cost of debt) In the exam the formula is given as follows:  Vd   Ve  ke +  kd(1 − T ) WACC =    Ve + Vd   Ve + Vd  Where: Ve = Total market value of equity Vd = Total market value of debt Ke = Cost of equity geared Kd = Pre-tax cost of debt T = corporation tax rate Note that the post tax cost of debt = Kd (1 – T) for irredeemable debentures or bank loans If you are given a redeemable bond then you should calculate the IRR of its post-tax cash flows which directly gives you the post-tax cost of debt 1102 SESSION 11 – WEIGHTED AVERAGE COST OF CAPITAL AND GEARING A company’s current WACC is used as the discount rate only if Proportion of debt to equity does not change Project is financed by existing pool of funds Project has same business risk as existing operations i.e a company’s existing WACC can only be used as the discount rate for a potential project if that project does not change the company’s: Gearing level i.e Financial Risk Business Risk More detail on the important concepts of Financial Risk and Business Risk is found in the next section Example A company has in issue: 45 million $1 ordinary shares 10% irredeemable loan stock with a book value of $55million The loan stock is trading at par Share price $1.50 Dividend 15c (just paid) Dividend growth 5% pa Corporation tax 33% Estimate the WACC Solution 1103 SESSION 11 – WEIGHTED AVERAGE COST OF CAPITAL AND GEARING 1.2 Limitations of WACC LIMITATIONS PRACTICAL THEORETICAL Assumes perfect capital market Assumes − market value of shares = present value of dividend stream − market value of debt = present value of interest/principal Current WACC can only be used to assess projects which − have similar operating risk to that of the company − are financed by the company’s pool of funds, ie have same financial risk CALCULATION OF Ke Estimation of “g” − historical data used to estimate future growth rates − Gordon’s model assumes all growth is financed by retained earnings Share price may not be in equilibrium Ignores impact of personal taxation A h CALCULATION OF Kd Assumes constant tax rates Bond price may not be in equilibrium Difficulty in incorporating all forms of long term finance, eg BANK OVERDRAFT Current liability but often has permanent core Must be aplit between fixed and variable element Put fixed element in calculation CONVERTIBLE LOAN STOCK Final cash flow is uncertain Investor has option of (i) taking the redemption value, or (ii) converting into shares Assume it will be redeemed unless data is available to suggest conversion 1104 FOREIGN LOANS Exchange rates will affect the value of the loans to be included and interest payments SESSION 11 – WEIGHTED AVERAGE COST OF CAPITAL AND GEARING These problems are particularly difficult for unquoted companies which have no share price available and possibly irregular dividend payments In this case it may be advisable to estimate the WACC of a quoted company in the same industry and with similar gearing and then add a (subjective) premium to reflect the (perceived) higher risk and lower marketability of unquoted shares THE EFFECTS OF GEARING The current WACC reflects the current risk profile of the company: both Business risk – The variability in the operating earnings of the company i.e the volatility of EBIT due to the nature of the industry and Financial risk – The additional variability in the return to equity as a result of introducing debt i.e using financial gearing Interest on debt is a committed fixed cost which creates more volatile bottom line profits for shareholders As a company gears up two things happen WACC = Ke E + Kd E+D D Ke increases due to the increased financial risk All else equal, this pushes up the value of WACC The proportion of debt relative to equity in the capital structure increases Since Kd < Ke this pushes the value of WACC down, all else equal The effect of increased gearing on the WACC depends on the relative sizes of these two opposing effects There are two main schools of thought Traditional view Modigliani and Miller’s theories 1105 SESSION 11 – WEIGHTED AVERAGE COST OF CAPITAL AND GEARING TRADITIONAL VIEW OF CAPITAL STRUCTURE 3.1 Reasoning The traditional view has no theoretical foundation – often described as the “intuitive approach” It is based upon the trade-off caused by gearing i.e using more (relatively cheap) debt results in a rising cost of equity The model can also be referred to as the “static trade-off model” It is believed that Ke rises only slowly at low levels of gearing and therefore the benefit of using lower cost debt finance outweighs the rising Ke At higher levels of gearing the increased financial risk outweighs this benefit and WACC rises Cost of capital Ke WACC Kd D/E Optimal gearing Note that at very high levels of gearing the cost of debt rises This is due to the risk of default on debt payments i.e credit risk This is referred to as financial distress risk – not to be confused with financial risk which occurs even at relatively safe levels of debt 3.2 Conclusions There is an optimal gearing level (minimum WACC) However there is no straightforward method of calculating Ke or WACC or indeed the optimal capital structure The latter can only be found by trial and error 1106 SESSION 11 – WEIGHTED AVERAGE COST OF CAPITAL AND GEARING 3.3 Project finance — implications If the company is optimally geared Raise finance so as to maintain the existing gearing ratio If the company is sub-optimally geared Raise debt finance so as to increase the gearing ratio towards the optimal If the company is supra-optimally geared Raise equity finance so as to reduce the gearing ratio back to the optimal 3.4 Approach Appraise the project at the existing WACC If the NPV of the project is positive the project is worthwhile Appraise the finance If marginal cost of the finance > WACC the finance is not appropriate and should be rejected If this was the case the company could raise finance in the existing gearing ratio and the WACC would not rise 1107 SESSION 11 – WEIGHTED AVERAGE COST OF CAPITAL AND GEARING MODIGLIANI AND MILLER’S THEORIES 4.1 Introduction Modigliani and Miller (MM) constructed a mathematical model to provide a basis for company managers to make financing decisions Mathematical models predict outcomes that would occur based on simplifying assumptions Comparison of the model’s conclusions to real world observations then allows researchers to understand the impact of the simplifying assumptions By relaxing these assumptions the model can be moved towards real life MM’s assumptions include: Rational investors Perfect capital market No tax (either corporate or personal) – although they later relaxed the assumption of no corporate tax Investors are indifferent between personal and corporate borrowing No financial distress risk i.e no risk of default even at very high levels of debt There is a single risk-free rate of borrowing Corporate debt is irredeemable 4.2 Theory without tax MM expressed their theory as two propositions MM considered two companies - both with the same size and with the same level of business risk One company was ungeared − Co U One company was geared − Co G MM’s basic theory was that in the absence of corporation tax the market values (V) and WACC’s of these two companies would be the same (proposition 1) Vg = Vu WACCg = WACCu 1108 SESSION 11 – WEIGHTED AVERAGE COST OF CAPITAL AND GEARING MM argued that the costs of capital would change as gearing changed in the following manner: kd would remain constant whatever the level of gearing ke would increase at a constant rate as gearing increased due to the perceived increased financial risk (proposition 2) the rising ke would exactly offset the benefit of the additional cheaper debt in order for the WACC to remain constant This can be shown as a graph: Cost of capital Ke WACC Kd D/E Conclusion There is no optimal gearing level; The value of the company is independent of the financing decision Only investment decisions affect the value of the company This is not true in practice because the assumptions are too simplistic There are differences between the real world and the model Note that MM never claimed that gearing does not matter in the real world They said that it would not matter in a world where their assumptions hold They were then in a position to relax the assumptions to see how the model’s predictions would change The first assumption they relaxed was the no corporate tax assumption 4.3 Theory with tax When MM considered corporation tax then their conclusions regarding capital structure were altered This is due to the tax relief available on debt interest – the “tax shield” 1109 SESSION 11 – WEIGHTED AVERAGE COST OF CAPITAL AND GEARING Illustration Consider two companies, one ungeared, Co U, and one geared, Co G, both of the same size and level of business risk EBIT Interest Co U $m 100 − Co G $m 100 20 100 35 80 28 PBT Tax @ 35% Dividends Returns to the investors: Equity Debt 65 52 65 − 52 20 65 72 The investors in G receive in total each year $7m more than the investors in U This is due to the tax relief on debt interest and is known as the tax shield Tax shield where kd D t = = = = kd × D × t pre-tax cost of debt current market value of the debt tax rate MM assume that the tax shield will be in place each year to perpetuity and therefore has a present value, which can be found by discounting at the rate applicable to the debt, kd PV of tax shield = = Kd × D × t kd D×t The difference in market value between G and U should therefore be that G has a higher market value due to the tax shield and this extra value is made up of the present value of the tax shield MM expressed this as: MVg 1110 = MVu + Dt SESSION 11 – WEIGHTED AVERAGE COST OF CAPITAL AND GEARING When corporation tax is introduced MM argue that the costs of capital will change as follows: Kd (the required return of the debt holders) remains constant at all levels of gearing Ke increases as gearing levels increase to reflect additional perceived financial risk WACC falls as gearing increases due to the additional tax relief on the debt interest Ke Cost of capital WACC Kd D/E The relationship between the WACC of a geared company, according to MM, and the WACC (Ke) of an ungeared company is: WACCg where = Keu D E t Dt   Keu  −  E+D  = cost of equity in an ungeared company = market value of debt in the geared company = market value of equity in the geared company = corporate tax rate The formula for the cost of equity is: Keg = Keu + (1 – T) (Keu – kd) D E 1111 SESSION 11 – WEIGHTED AVERAGE COST OF CAPITAL AND GEARING Illustration — continued Returning to the previous illustration these MM formulae can now be illustrated Suppose that the business risk of the two companies requires a return of 10% and the return required by the debt holders in Co G is 5% Co U Market value of Co U will be the market value of the equity This will be the dividend capitalised at the equity holders’ required rate of return MVu Keu risk) 65 = $650m = 10% i.e required rate of return for business risk (U has no financial = Co G Market value of the equity of Co G is determined by the equity shareholders’ analysis of their net operating income into its constituent parts and the capitalisation of those elements at appropriate rates: MVe = EBIT Tax @ 35%  Interest tax relief @ 35%  − − −  0.1 0.1 0.05  0.05  = 100 35   20 − − −  0.1 0.1  0.05 0.05  = 1,000 − 350 − (400 - 140) = $390m Market value of debt is determined by the debt holders capitalising their interest at their required rate of return: MVd = 20 0.05 = $400m ∴ Total market value of Co G = MVg = $390m + $400m = $790m The MM formula that describes the relationship between the market values of equivalent companies at various gearing levels can be illustrated here: MVg = MVu + Dt $790m = $650m + ($400m×35%) 1112 SESSION 11 – WEIGHTED AVERAGE COST OF CAPITAL AND GEARING MM’s WACC relationship can also be illustrated Firstly, WACC by the usual approach: Keg = Dividend Market value = 52 390 = 13.33% (assumes no growth in dividends) Kd = WACC = 5% × (1 − 35%) 13.33% × = 390 400 + 3.25% × 790 790 Then by using MM/s formula: WACC Keu = 3.25% = 8.23% = Keu (1− Dt ) E+D = 10% (1− 10% = 400 × 35% ) 390 + 400 8.23% MM’s equation for the cost of equity can also be checked Keg = Keu + (1 – T) (Keu – kd) = 10 + (1-0.35)(10-5) D E 400 390 = 13.33%, (as per the dividend valuation model above) 1113 SESSION 11 – WEIGHTED AVERAGE COST OF CAPITAL AND GEARING Conclusion The logical conclusions to be drawn from MM’s theory with tax is that there is an optimal gearing level and that this is at 99.9% debt in the capital structure This implies that the financing decision for a company is vital to its overall market value and that companies should gear up as far as possible This is not true in practice; companies not gear up to 99.9% Why not? In practice there are obviously many other factors that will limit this conclusion These factors include the risk of financial distress; the existence of not only corporate tax but also personal taxes; Thus in practice there are a series of factors that a company will need to consider in deciding how to raise finance 4.4 Practical considerations in choosing a gearing level These will include: business risk of the project; existing level of financial gearing: level of operational gearing – the proportion of fixed to variable operating costs If this is high then the company may not wish to use debt as this increases the level of fixed costs even further; type and quality of the assets; expected growth; personal tax position of the shareholders and debt holders internal and external limits to debt availability; tax exhaustion (not enough profit to fully utilise the tax shield) agency costs (increasingly restrictive debt covenants e.g restricting dividends) issue costs asymmetry of information – potential providers of finance may over-estimate the risk of the company and refuse to provide capital at reasonable cost Therefore the managers may have a preference for using internal finance i.e retained earnings, limiting the level of gearing; market sentiment 1114 SESSION 11 – WEIGHTED AVERAGE COST OF CAPITAL AND GEARING Key points WACC estimates the company’s average cost of long-term finance It is therefore a potential discount rate to use for the calculation of the NPV of possible projects However the existing WACC should only be used if the project would not change the company’s business risk or level of gearing i.e financial risk There are various, and conflicting, models of how financial gearing affects the WACC – traditional trade-off theory, Modigliani and Miller without tax and MM with corporate tax Each model has useful elements even if the conclusions of such models lack practical relevance FOCUS You should now be able to: understand the weighted average cost of capital, how it is estimated and when it should be used; discuss the theories of Modigliani and Miller, their assumptions, implications and limitations; evaluate the impact of varying capital structures on the cost of capital 1115 SESSION 11 – WEIGHTED AVERAGE COST OF CAPITAL AND GEARING EXAMPLE SOLUTION Solution Ke Kd = Do(1 + g) +g Po = 0.15 × 1.05 + 0.05 = 1.50 15.5% = 10% × (1 − 0.33) = 6.67% WACC = 1116 15.5% × 45 × 1.50 55 + 6.67% × ( 45 × 1.50) + 55 ( 45 × 1.50) + 55 = 11.54% ... that project does not change the company’s: Gearing level i.e Financial Risk Business Risk More detail on the important concepts of Financial Risk and Business Risk is found in the next section... EBIT due to the nature of the industry and Financial risk – The additional variability in the return to equity as a result of introducing debt i.e using financial gearing Interest on debt is a committed... risk of default on debt payments i.e credit risk This is referred to as financial distress risk – not to be confused with financial risk which occurs even at relatively safe levels of debt 3.2