As mentioned within my first blog Do Corporate Objective Conflict? We had
pointed out that from an Anglo-American
organisation perspective; the primarily objective for any organisation is
shareholder wealth maximisation (Watson & Head, 2013). Therefore, within
the company, top management will need to make decisions based upon wealth
maximising triggers; company financing and the cost of capital.
Cost of capital: An opportunity cost
Within managerial decisions, the cost of capital needs
to be calculated for investment decisions in order to enhance shareholder
wealth (Arnold, 2013). As a financial manager, I need to think what rate of
return will influence shareholders to hold onto their shares. Likewise, from a
shareholders perspective, I need to consider whether this rate of return is sufficient
for the given level of risk. If not, are there better opportunities elsewhere? The
image below displays an opportunity cost to invest in Steady Plc over Volatile
due to acquiring an equal profit with relatively lower risk.
Note: Image retrieved from Newcastle Business School but
reviewed from Arnold (2013). Corporate Financial Management.
However, the difficulty that Managers face is that a
cost of capital is subjective due to different shareholder attitudes towards
risk (Arnold, 2013). A survey conducted by Jacobs & Shivdasani (2012),
found that out of the 300 participants, not one survey gave the same answer
over a decision around a calculated investment opportunity.
The Traditional
Trade-off Model
The traditional trade-off model suggests that a company
can achieve value through finding the optimal capital structure (Graham &
Harvery, 2002) that reduces the weighted average
cost of capital (WACC) from an increased debt to equity ratio. WACC is the associated
bench mark that investments will need to surpass in order to yield additional
benefits for future ventures. Mixing the company’s capital structure with
equity and debt will necessitate a lower WACC and thus, a lower hurdle rate for
investments. Overall this would minimize the firms cost of financing (Graham
and Leary, 2011) and enhance shareholder value
as a result.
If the company is solely dependent on equity finance,
there is a higher risk for investors thus, high returns are demanded. While
Debt has a lower risk, it is cheaper thus; the expected rate of return is
lower. Since debt is a lower cost than equity, it would be logical to suggest
that as a company, we should be taking on more debt by increasing the gearing
level and reducing the WACC as a result.
So what benefits does debt bring? Firstly, it provides
the benefit of Tax. The profit from operations will be reduced due to interest
on the loan. Because of this tax shield, less money will be required by Tax
authorities and therefore, a greater financial benefit to shareholders (Arnold,
2013).
However, a high level of debt has its risks. As shown
in the graph below, an increase of debt lowers the WACC and increases
shareholder wealth as a result. However, past the optimal threshold, financial
risk increases- outweighing the benefits from the low cost of debt. To cope
with this added risk, shareholders will require a greater level of return hence;
an increase in equity as shown below. This increase in equity starts to
outweigh the impact of the extra debt. If a company is exposed to too much
debt, there is a probability of cash flow difficulties and an added risk that the
company cannot pay of its debt and interest. As a result, the company is in
financial distress. The WACC has increased and the maximisation of shareholder
wealth disintegrates.
Note: Image
from Newcastle Business School.
To conclude, debt can increase and decrease the WACC
relative to the market’s reaction to the added risk. This concludes that there
is a complex relationship between debt and equity within a company’s capital
structure.
Case Study: BT
Ofcom calculated the estimation of BT's cost of
capital where the WACC reduced from 10.1 % to 8.6 % within 2 years due to an
alternation in interest rates. However, it was then revealed that this calculation,
as a result, would cut the price of subsidiary's wholesale products nationwide.
If companies that use BT as a provider e.g. TalkTalk reduce the charges to
their customers, BT may have to do the same. Potentially, Revenue and Earning
figures may drop substantially.
Modigliani
& Millar (1958)
However, Modigliani and Millar state that a company’s
capital structure is affected by business risk. Hence, capital financing has no
impact on the WACC - opposing the traditional model.
According to M&M they conclude that:
“Total
market value of any company is independent of its capital structure.”
However, to criticize M&M’s argument, they do not
take taxation into account in addition to no costs associated with financial
distress and liquidation.
As mentioned previously, debt has the major benefit of
being a tax deductible expense which can be offset against profit. Due to criticisms
of their first published work, a revised paper was published in 1963 to take
tax into consideration.
Therefore, the graph below displays the tax shield
element of debt that reduces the WACC and, as a result, will increase company
value and shareholder wealth as a result.
Note: Image
from Newcastle Business School
Conclusion
There needs to be a compromise between debt and equity,
where debt will reduce the WACC and increase shareholder value up to a
reasonable level. But what is reasonable? Again, it is subjective. As mentioned
in the introductory test, investors have different attitudes towards risk. The
higher level of debt could therefore increase or decrease the WACC; dependent
on how the market will react to the increasing levels of gearing.
References
Graham, J., &
Harvey, C. (2002). How do CFOs make capital budgeting and capital structure
decisions?. Journal
of applied corporate finance, 15(1), 8-23.
Graham, J. R., &
Leary, M. T. (2011). A review of empirical capital structure research and
directions for the future. Annu. Rev. Financ. Econ., 3(1),
309-345.
Jacobs,
M. T., & Shivdasani, A. (2012). Do you know your cost of capital?. Harvard
business review, 118.
Markowitz,
H. (1952). Portfolio selection*. The journal of finance, 7(1),
77-91.
Watson and Head (2013) Corporate Finance: Principles and Practice: http://capitadiscovery.co.uk/northumbria-ac/items/1666514
