WACC #
Concept #
Use: Benchmark rate of return Keypoint
- Calculate the cost of debt on after-tax basis
- WACC is the overall return a 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 - Existing operations determines the WACC, and since the investment does not change the overall capital structure of the firm, the investment should have the same risk as existing operations
- The cost of debt $k_d =$ Risk free rate + default spread - excess premium a firm has to pay to compensate on its investors
Calculation of components #
Cost of debt #
Estimating cost of debt
- If a firm is rated, use the rating and a typical default spread on bonds with that rating
- If not, estimate a default spread based on a synthetic rating - could be using Interest coverage ratio(EBIT/Interest Expenses)
Effective corporate tax - Imputation tax system
- Under the imputation tax system, in principle, investors are reimbursed by franking credits for corporate taxes.
- However, oversea/non-resident shareholders do not receive franking credits
- Hence, the effective tax rate is determined by the proportion of the overseas/non-resident shareholders, given by
$$
t_e = t_c(1-\lambda)
$$
where $\lambda$ is the proportion of corporate tax claimed by shareholders
- $\lambda = 0$: Classical tax system; $\lambda = 1$: Pure imputation tax system
- $\lambda$ depends on a proportion of overseas operations/shareholders and on the decision to distribute profits as fully franked dividends or not
Cost of equity #
CAPM: Risk-free rate, beta and market risk premium(MRP) DCF Approach(Gorden growth model derived):
$$P_0 = \frac{D_1}{k_e - g} \implies k_e = \frac{D_0(1+g)}{P_0} + g$$Keypoints
- Beta is calculated via regression (in practice)
Other components and keypoints #
Weights
- Need to be calculated using market values rather than book values
- Ideally, use the firm’s target(or optimal) capital structure
Keypoint
- The firm’s current capital structure can be used if the acceptance of the project will not change the capital structure of the firm and optimally chosen
WACC of a diversified firm #
Keypoints
- We cannot use company-wise WACC to accept/reject firms as it will bias towards riskier projects, and bias away from less risky projects
- Assume there are two projects, one mining(riskier) and one retail(less risky), and mining generate more(as it is riskier) and retail generate less(as it is less risky)
- However, we are using the same WACC to estimate their NPVs, and thus we will accept the mining project for higher NPV, however, if this continues, our firm will become riskier and riskier
- We use publicly traded companies in the same industry to estimate the riskiness of the new project and the expected return
- The company’s cost of capital can only be used as a benchmark if the new project has the same basic risk as the rest of the company
Optimal capital structure #
Keypoint
- Without the change of cashflows, optimum capital structure is obtained by minimizing the cost of capital(WACC), as it maximizes the value of the firm
- As the debt ratio increases, the cost of debt increases, as the default risk will go up as the firm’s leverage goes up, and investors seek higher spread for compensation
- As the debt ratio increases, the cost of equity also increases
Levered beta - Beta that incorporates financial risk
- The firm’s overall systematic risk is determined by the systematic risk of its financing component - the beta for the firm is the weighted average of the beta of its equity component and its debt component
- That is to say$$\beta_A = \frac{E\beta_E}{D + E} + \frac{D\beta_D}{D + E}$$Deduce a little bit, then we have$$\beta_E = \beta_A + (\beta_A - \beta_D)\frac{D}{E}$$Since the cash flow of the debt is steady (that is, risk-free, yet still an assumption), then we have$$\beta_E = \beta_A(1+\frac{D}{E})$$ For unlevered firms, we know $\beta_E = \beta_{A_0}$, where $\beta_{A_0}$ is the initial beta captured in the market, or denoted $\beta_U$ and that we know $$\beta_L = \beta_E' = \beta_U(1 + \frac{D}{E})$$By incorporating taxes, we have $$\beta_L = \beta_U(1 + (1-t_e)\frac{D}{E})$$where $t_e$ is the effective corporate tax rate
Interpretion of the formula
- $\beta_U$ is interpreted business risk
- $\beta_U(1-t_e)\frac{D}{E}$ is interpreted as financial risk (which only kicks in when $\frac{D}{E} > 0$)
M-M’s irrelevance theorem #
Theory
- Assume perfect markets, the value of the firm is independent from its capital structure, and that financing decisions does not matter
- Proved by pie theory - No matter how you cut the pie, the pie is of the same size
Trade-off theory #
Takeaway: The optimum target capital structure is determined by balancing taxes and expected costs of financial distress - the two ingredients can change the size of the pie that goes to the firm’s claimholders (firm value) in the opposite direction
Explanation: Government get a slice too(taxes) in the pie. However, increasing the proportion of debt in the pie, the proportion that gives to the government is reduced, and hence the allotable pie size is greater
Keypoints
- No other imperfections are involved except for taxes
- The firm may consider the debt as a perpetuity (on average, as they do not change the proportion of the debt in capital structure), leading to the pie to the government be valued as $t_eD$
- (This method) suggest that having enough debt financing is optimal so as to reduce the tax bill
- Imputation tax system neutralizes the tax benefit of debt, implying low leverage
- There may be a tax-induced reason to issue equity rather than debt where shareholders generate their returns via capital gains in imputation system
- Expected costs of financial distress must be taken into account as it also takes a pie, and that indirect costs is greater than direct cost, including opportunity costs and scare off customers and suppliers (damage to reputations)
- Expected costs of financial distress increases sharply with leverage (both probability and actual costs increase)
- The overall formula is $V_L = V_U +t_eD - PV(\text{Expected Distress Cost})$
- This is incomplete as firms should always keep an optimum capital structure and stock market should react neutrally to the announcement of new security issues - yet it is not the case
Pecking Order Perspective: Infomation asymmetry #
Logic: Management has more information on a firm -> The market is aware of this and will look for a signal by management about their prospects when the firm raises capital -> Management are reluctunt to issue equity as it dilutes the control - sending a negative signal about current value
Sequence to equity: Internal equity -> Debt -> Hybrids -> External equity
Keypoints
- Pecking order does not lead to optimal capital structure
- It reflects that capital structure is a reflection of the firms’ need for external finance
- Firms in same industry may have different debt levels due to their profitability
- (Empirical evidence) Managers choose the level of debt due to financial flexibility, volatility of earnings and cashflows and credit rating
Non-tax impacts on capital structure #
Asset type
- Investors prefer general use assets over firm specific assets (e.g. lands over planes) - easier to realize
- Investors prefer tangible assets over intangible assets - easier to realize
Free cash flow
- Cash flow in excess of that needed to fund all positive NPV projects
- Debt reduces the FCF available to managers and reduce the FCF problem - may explain cash cow firms have higher leverage
Firm age and characeristics
- Young, R&D(research and development) firms: low leverage - risky cashflows, high human capital, and few tangible assets
- Low-growth, mature, capital intensive firms: high leverage - stable cashflows, tangible assets and few investment opportunities
An integrative approach #
Takeaways
- Focus on each of the aspects - trade-off theory and pecking order and evaluate
- Establish long-run target capital structure
- Evaluate the true economic cost of issuing equity rather than debt - Real cost of stock price decrease and issurance costs vs. foregone investment(opportunity cost of repaying debt rather than keep&invest) or increase in expected distress costs(level of debt and economy distress)
- If still reluctunt - seek to reduce the cost(by providing more information or deferring), or use hybrids(just as what pecking order says)
- (Empirically) Capital structures differ in different industries
Insights from the tutorials #
- Financial risk is the additional risk shareholders are exposed to due to a company’s use of debt finance
- Default risk is the risk that a borrower may not be able to make repayments
- Every company will have financial risk as long as they introduces debt into their capital structure even if their default risk is zero. Business risk is the innate risk related to opperations, i.e. all firms have it.
- Companies cannot borrow as many as they want as introducing more debt introduces financial risk, causing the cost of equity to increase - which is an implicit cost of debt
- Companies in Australia are under imputation tax systems so there is little tax benefit from lending more debt
- Any borrowing, regardless of how little they were, will create financial risk, which drives the cost of equity to go up