International Finance and Financial Management

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