Cost of Capital 2 - L Flashcards
(21 cards)
Introduction
What is capital structure?
What are the general costs associated with equity and debt? (2)
What is the ultimate goal of managing capital structure?
Why is WACC important?
What should be remembered about return on investment?
What is capital structure?
- The mix of capital sources used by a business, considering costs, risks, and rewards.
What are the general costs associated with equity and debt?
- Equity: Higher risk, requiring higher returns.
- Debt: Lower risk, thus lower cost and cheaper to acquire.
What is the ultimate goal of managing capital structure?
- Optimize the overall Cost of Capital, specifically Weighted Average Cost of Capital (WACC), for the company’s benefit.
Why is WACC important?
- It serves as a basis for determining a hurdle rate for investment appraisal, impacting current operations and future investments.
What should be remembered about return on investment?
- If the return on investment is lower than WACC, the company is not creating value.
Concept of an Optimal Capital Structure
The WACC calculation suggests a possible optimal structure, Since _______ is a ________ _______ than __________ it would seem to suggest that you just take on ________ ________.
Why is debt generally cheaper? (4)
The WACC calculation suggests a possible optimal structure, Since Debt is a lower cost than Equity it would seem to suggest that you just take on more debt.
Why is debt generally cheaper?
- Lenders require a lower rate of return than ordinary shareholders in exchange for security or collateral.
- ( K_d < K_e ) (Cost of debt is lower than the cost of equity).
- Debt interest can be deducted from pre-tax profits, reducing the corporation tax bill.
- Issuing and transaction costs for debt are generally lower than for ordinary shares.
The overall cost of financing the company should reduce: (2)
- Gearing level
- Overall Cost of Finance (If the returns to equity are constant or do not rise much with gearing)
Risk of the company becoming Financially distressed
Corporate Financial Distress Costs
What is financial distress?
What are some indirect examples of financial distress costs? (6)
What are some direct examples of financial distress costs? (2)
What is financial distress?
- Financial distress occurs when a company struggles to meet obligations to creditors.
What are some indirect examples of financial distress costs?
- Uncertainty among customers and suppliers.
- Quick asset sales at low prices.
- Legal and financial reorganization interfering with management.
- Management prioritizing short-term liquidity.
- Selling profitable business units out of necessity.
- Decline in staff morale and difficulty in recruiting.
What are some direct examples of financial distress costs?
- Legal, accounting, and court fees.
- Management time spent handling financial issues.
What happens when the gearing level increases?
Does increasing gearing come without risk?
How does financial distress risk change at different gearing levels?
What happens when the gearing level increases?
- The overall cost of financing the company should decrease.
Does increasing gearing come without risk?
- It raises the risk of financial distress.
How does financial distress risk change at different gearing levels?
- At low levels of debt, financial distress risks are minimal.
- At higher levels, financial distress costs become significant.
Modigliani and Millar (1958) Paper
What did the Modigliani and Millar (1958) Paper argue about companies’ capital structure? (2)
What did the Modigliani and Millar (1958) Paper argue about a company’s value?
What is M&M Proposition I?
What are the theoretical assumptions of the Modigliani and Millar (1958) Paper? (5)
What did the Modigliani and Millar (1958) Paper argue about companies’ capital structure?
- Has NO impact on the Weighted Average Cost of Capital (WACC).
- Therefore, no optimal capital structure exists.
What did the Modigliani and Millar (1958) Paper argue about a company’s value?
- A company’s value depends purely on business risk.
What is M&M Proposition I?
- The total market value (market capitalization) of any company is independent of its capital structure.
What are the theoretical assumptions of the Modigliani and Millar (1958) Paper?
- There is no taxation.
- Perfect capital markets exist with perfect information available to all economic agents and no transaction costs.
- There are no costs of financial distress or liquidation.
- Firms can be classified into distinct risk classes—purely business risk.
- Individuals can borrow as cheaply as corporations.
Modigliani and Millar (1963) – Implication of taxes
What is the implication of taxes according to Modigliani and Millar (1963)?
What is the major benefit of debt according to Modigliani and Millar (1963)?
How does increasing gearing/debt financing affect WACC and the overall value of the company? (2)
What is the implication of taxes according to Modigliani and Millar (1963)?
- In 1963, Modigliani and Millar revised their paper to take tax into account. They were heavily criticized for ignoring tax in their 1958 paper, as taxation has a measurable benefit on using debt in particular to finance an entity.
What is the major benefit of debt according to Modigliani and Millar (1963)?
- Debt has the major benefit of being a tax-deductible expense which can be offset against profit. Thus, by changing the assumptions to now take tax into account, Modigliani and Millar’s theory dramatically changed. So, where before Hoteliers Plc borrowed at 10%, effectively in a world with 30% tax, they borrow at 7% (1 - Tax rate).
How does increasing gearing/debt financing affect WACC and the overall value of the company?
- As you increase the gearing/debt financing, you will reduce the WACC due to the tax benefit of debt.
- Which will in turn increase the overall value of the company.
Business Application: Private Equity and M&M (1963)
What are Private Equity groups seen as?
What do Private Equity groups do with the shares of a company? (3)
Why do Private Equity groups control the Cost of Equity?
How do Private Equity groups leverage the company? (2)
What are Private Equity groups seen as?
- Classically, Private Equity groups are seen as the main practical utilizer of the thoughts behind M&M (1963).
What do Private Equity groups do with the shares of a company?
- Private Equity groups buy all the shares of a company and “take them private” and off the publicly traded exchanges.
- This is usually done for radical restructuring and/or financial re-engineering before selling back to the open market or another buyer.
- Most Private Equity deals aim for a 7-10 year exit horizon.
Why do Private Equity groups control the Cost of Equity?
- Because they have bought all the shares of the company out of the public domain and, by definition, therefore control completely the Cost of Equity.
How do Private Equity groups leverage the company?
- They can leverage the company to levels that would be unacceptable to shareholders if it were publicly owned.
- 70%+ debt is common for some of the largest deals.
Capital Structure
What are the four main models/theoretical development areas mentioned? (2,2,3,2)
What are the four main models/theoretical development areas mentioned?
- Trade-off Models (Kraus & Litzenberger, 1973)
- Pecking Order Models
- Signalling Models
- Agency Cost Models
What is the key idea of the Trade-off Models?
- Assumes that each firm has a value-maximising optimal capital structure that minimises its overall weighted average cost of capital (WACC).
- Optimal capital structure is a balance — enough debt to benefit from tax savings, but not so much that it becomes risky or costly.
What is the key idea of the Pecking Order Models?
- Asserts that when managers possess valuable insider information, they should have a preference for internal over external capital because the market is unlikely to underprice internal equity.
- Issuing equity might signal that the shares are overvalued and might hurt the share price.
What is the key idea of the Signalling Models?
- Similar to the pecking-order models in that they invoke information asymmetries; their motivation, however, differs dramatically.
- In signalling models, potential investors grow accustomed to management presenting news about the company’s prospects in the most flattering light.
- As a consequence, investors discount every management report, even when it is truthful, which in turn raises the firm’s cost of capital above what it otherwise would be.
What is the key idea of the Agency Cost Models?
- Assume that agency costs are widespread in non-owner-managed firms.
- These costs arise because management has an incentive to invest in perks, such as a Learjet or expensive office decorations, which benefit management without increasing shareholder wealth.
Trade-Off Models
What is the theory?
What is the optimal level of debt according to trade off models?
What are the key financial metrics highlighted? (4)
Trade off models theory
- The taxation of corporate profits and the existence of bankruptcy penalties are market imperfections that are central to a positive theory (observed behaviour of firms in real world) of the effect of leverage on the firm’s market value.
What is the optimal level of debt according to trade off models?
- The optimal level of debt maximizes the value of the firm, where the marginal benefit of debt (tax shield) equals the marginal cost of debt (bankruptcy costs).
What are the key financial metrics highlighted?
- EPS
- Share Price
- Market Value
- WACC
Minsky and the importance of credit market sentiment
What is credit market sentiment and why is it important? (2)
What is Minsky’s theory on financial stability? (3)
How does overconfidence affect financial markets? (2)
What is credit market sentiment and why is it important?
- Credit market sentiment, as studied by theorists like Hyman Minsky, influences economic fluctuations.
- Investor confidence in credit markets can drive financial cycles, leading to economic booms or downturns.
What is Minsky’s theory on financial stability?
- Minsky stated that “Stability leads to instability.”
- High aggregate demand and profits boost confidence, increasing risk-taking.
- Extended periods of economic growth and rising asset prices heighten the risk of a sudden market collapse, known as a “Minsky Moment.”
How does overconfidence affect financial markets?
- Overconfidence leads to higher risk-taking behavior.
- Increased speculative activity results in crashes and corrections.
Capital Structure in Practice: Why such a theory-practice gap?
Millar (1977) on the Theory-Practice Gap:
Millar (1977) on the Theory-Practice Gap:
- Financial teams lack sufficient reliable information on future prices to prove that financial strategies truly maximize firm value.
Capital Structure in Practice: Why such a theory-practice gap? 2
Why do rational behavior models often explain how markets and economies work? (2)
What are examples of heuristic behavior? (3)
(Baker et al. 2010)
Why do rational behavior models often explain how markets and economies work?
- These models complement intuitive decision-making in businesses.
- Heuristic behaviors tend to endure because they function effectively within market dynamics, despite appearing irrational when examined individually.
What are examples of heuristic behavior?
- Buying the cheapest option.
- Following the herd.
- Investing in projects with quick payback.
“…theories are designed to suggest how managers should behave and not to describe how they actually behave.”
(Baker et al. 2010)
Capital Structure: A Summary (picture)
Gearing in Practice
Why is balancing equity and debt important in a company’s capital structure? (2)
What compromise do managers need to reach? (2)
What factors influence the debt/equity ratio? (3)
Why is balancing equity and debt important in a company’s capital structure?
- Extreme positions tend to be avoided:
- All Equity – Loses the benefit of low-cost debt.
- Highly Geared – Increases financial risk, raising cost of equity (Ke) and cost of debt (Kd).
What compromise do managers need to reach?
- A company can borrow up to a “reasonable” level, but defining “reasonable” is difficult.
- Market sentiment influences how equity shareholders react to debt levels.
What factors influence the debt/equity ratio?
- Lower Cost of Debt – Tax relief on debt makes borrowing attractive.
- Financial Distress & Agency Costs – Too much debt increases bankruptcy risk.
- Weighted Average Cost of Capital (WACC) – Helps determine the optimal balance between debt and equity.
Trade-offs Models - IMPACT ON SHAREHOLDER WEALTH
What does the Trade-Off Model indicate about gearing and shareholder wealth?
What happens beyond the optimal point of gearing?
What is the impact of the increase in Ke compared to the impact of extra debt?
What happens to the WACC and share price when Ke exceeds the impact of extra debt? (2)
What can be attained by understanding the Trade-Off Model?
What does the Trade-Off Model indicate about gearing and shareholder wealth?
- The Trade-Off Model suggests that gearing increases shareholder wealth up to a point, as the cost of debt (Kd) is lower than the cost of equity (Ke).
What happens beyond the optimal point of gearing?
- Beyond the optimal point, gearing becomes too risky.
What is the impact of the increase in Ke compared to the impact of extra debt?
- The increase in Ke starts to outweigh the benefits of additional debt.
What happens to the WACC and share price when Ke exceeds the impact of extra debt?
- The weighted average cost of capital (WACC) rises.
- Share price and shareholder wealth decline.
What can be attained by understanding the Trade-Off Model?
- It helps determine the optimal capital structure.
What is Ke (Cost of Equity)?
What is Kd (Cost of Debt After Tax)?
What is WACC (Weighted Average Cost of Capital)?
What does the dotted line represent? (2)
What does the solid line represent? (2)
What is the optimal gearing level?
What does the vertical distance between curves represent?
What is Ke (Cost of Equity)?
- Increases with higher debt levels because equity becomes riskier due to increased financial leverage.
What is Kd (Cost of Debt After Tax)?
- Relatively constant or slowly increasing; reflects tax-deductibility of interest.
What is WACC (Weighted Average Cost of Capital)?
- Initially decreases with more debt (due to tax shield on interest) but eventually rises again due to higher financial distress risk and rising Ke.
What does the dotted line represent?
- Value of geared firm with tax effect only considered.
- Assumes firm value increases linearly with more debt because of tax shield benefits.
What does the solid line represent?
- Value considering taxes and financial distress.
- Shows realistic firm value: initially rises due to tax benefits, but declines past a certain point due to financial distress costs (bankruptcy risk, agency costs, etc.).
What is the optimal gearing level?
- Point where firm value is maximized, balancing tax benefits vs. distress costs.
What does the vertical distance between curves represent?
- Represents the costs of financial distress—the value lost due to excessive debt.
3
Therefore, Shareholder Wealth is affected by market reactions to gearing both through:
a. Share price movements
b. And, WACC changes.
In conclusion:
- Increasing Debt has a twofold impact on WACC and Shareholder wealth.
- It decreases WACC as a Cheaper source of finance
- But, it increases the Cost of Equity as shareholders demand more returns for the risks they are taking.
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