Fin management materials / 2P4AFM-Session03_j08

SESSION 03 – WEIGHTED AVERAGE COST OF CAPITAL AND GEARING

MM’s WACC relationship can also be illustrated

Firstly, WACC by the usual approach:

MM’s equation for the cost of equity can also be checked

Keg = Keu + (1 – T) (Keu – kd) DE

=10 + (1-0.35)(10-5) 390400

=13.33%, (as per the dividend valuation model above)

¾Conclusion

MM’s theory with tax implies 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.

¾This is not true in practice; companies do not gear up to 99.9% as there are obviously many other factors to consider apart from those in MM’s model.

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SESSION 03 – WEIGHTED AVERAGE COST OF CAPITAL AND GEARING

4.4Practical considerations in choosing a gearing level

¾These will include:

business risk of the firm

the risk of financial distress

type and quality of assets for debt security

personal tax position of the shareholders and debt holders

tax exhaustion (not enough profit to fully utilise the tax shield)

agency costs (increasingly restrictive debt covenants e.g. restricting dividends)

issue costs

market sentiment

5PECKING ORDER THEORY

As an alternative to issuing new shares (or debts) a company can finance its investment projects using retained earnings i.e. using internal finance rather than external finance.

¾The potential amount of internal finance available = operating cash flow – interest – tax

¾The actual amount of internal finance used then depends on the dividend decision.

¾Note that Microsoft did not pay any dividends for many years - it reinvested all cash to produce growth of the company and its share price. Any shareholder that required a dividend could simply sell some shares to take a capital gain and create a “homemade dividend”.

¾Company managers may prefer to use internal finance rather than external finance for the following reasons:

a belief that using internal finance costs nothing – in fact this is not true as retained earnings belong to the shareholders who expect significant returns.

“asymmetry of information” – external investors do not have as much knowledge of the business as the management and are therefore often reluctant to provide finance or will only provide it at high cost. This is particularly significant for SME’s which often have problems attracting new investors due to little public knowledge of the business. Using internal finance avoids the problem.

no issue costs on internal finance

internal finance avoids possible change in control due to issue of new shares

taxation position of shareholders who may prefer to make a capital gain than receive current income via dividends.

¾This preference for internal finance has been refereed to as “Pecking Order Theory”

¾Once internal sources of finance have been exhausted then the firm obviously has little choice but to consider an external issue. Research suggests that managers will then favour a debt issue over a new equity issue – as debt is easier and faster to raise than equity, has lower issue costs and interest is tax deductible.

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SESSION 03 – 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 M&M with corporate tax. Each model has useful elements even if the conclusions of such models lack practical relevance.

Pecking Order Theory is a practical model as opposed to theoretical. It is based upon real world evidence that company managers have a preference for using internal finance rather than face the complications of dealing with external investors.

FOCUS

You should now be able to:

¾understand the weighted average cost of capital, how it is estimated and when it should be used;

¾discuss static trade-off theory of capital structure;

¾apply the theories of Modigliani and Miller, their assumptions, evaluate their implications and limitations;

¾discuss the practical model of Pecking Order Theory.

EXAMPLE SOLUTION

Solution 1