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COST OF CAPITAL AND DISCOUNT RATE ESTIMATES
ARIZONA STATE UNIVERSITY
FIN 540 - ADVANCED FINANCIAL MANAGEMENT
WEEK 8
10.1 INTRODUCTION:
In Chapter 8 we looked briefly at the sources of long-term funding for UK businesses.
We will now look at how we can estimate business costs from each of these sources.
Since, logically, the discount rate to be applied to the expected cash flows of a real
investment opportunity in a business must be the opportunity cost of funding to support the
investment, it follows that this discount rate must be related to the cost of each source in some
way. In fact, the use of the average cost of different sources of funding, weighted according to
the importance of each source to a particular business, seems to be considered the standard
way of determining the discount rate. Evidence (Petty and Scott, 1981; Corr, 1983; Al-Ali and
Arkwright, 2000; Arnold and Hatzopoulos, 2000) suggests that this weighted average cost of
capital (WACC) approach is widely used in practice. McLaney, Pointon, Thomas and Tucker
(2004) found that WACC was used in investment appraisal by 53 percent of UK listed
companies. They also found that almost 80 percent of those businesses revalue their cost of
capital annually or more frequently. As we will see later in this chapter, many businesses
mention in their annual reports that they use the WACC as a discount rate.
The standard approach to estimating the cost of a particular capital source is based on
the logic that the discount rate is determined by two factors:
● the present value of the relevant financial asset; and
● future expectations of cash flows from that specific asset.
This is a popular approach in practice, although for estimating the cost of equity, it is
declining in popularity. In Chapter 7 we saw that the capital asset pricing model (CAPM) can
be seen as a logical tool for deriving the cost of individual financing elements. The CAPM
infers the cost of capital from capital market information, addressing risk explicitly through
the risk premium.
This risk premium is based on the covariance of the return on a particular security with
the return on risky investments in general. The CAPM is increasingly becoming the standard
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way for most companies, especially large companies, to derive the cost of equity (see the
evidence cited in Chapter 7 (Section 7.12) on the extent of CAPM usage). The traditional
WACC approach is also capital market-based (we use the current security value in the
calculation), but it deals less formally with risk than the CAPM. Having considered the
traditional approach, we will try to align it with the CAPM philosophy and attempt to reach
some conclusions regarding the theoretical suitability and relative practicality of each
approach.
10.2 COST OF INDIVIDUAL CAPITAL ELEMENTS
An economic asset (which is in the form of debt securities, equity, etc. earmarked for
financing suppliers) has a present value equal to the value of the future cash benefits of
owning the asset, discounted at a rate commensurate with the timing and risk of the respective
cash benefits.
where v0 is the current value of the asset, C is the cash flow associated with the asset,
r the rate of return, and n the number of time periods (usually years) into the future of each
cash flow. For a loan creditor or shareholder, the future cash flows, at any given moment, will
be the future receipt of interest or dividends (paid annually, biannually, or perhaps quarterly)
and, possibly, the repayment of principal at some future date.
where k is the business cost of capital and p0 is the current market price of the security.
Loan notes (or loan stock or debt securities)
With exchange-listed loan notes, we should know:
•
its current market value;
•
the amount and timing of contracted interest payments; and
•
contracted amount and principal payment date.
So, in the valuation expression above, we need to know all the factors except k. Solving for k
will give us the cost of capital figure we need.
Example 10.1 A loan note originally issued at face value is currently quoted on the
capital market at Rp. 93,000 per face value of Rp. 100,000. Full repayment of the face value is
due in exactly five years. Interest of 10 percent of the face value is payable at the end of each
subsequent five years. What is the cost of the loan note? Assume a corporate tax rate of 20
percent.
It may seem confusing why, when the initial loan amount is Rp. 100,000, the amount
to be repaid is equal to Rp. 100,000, the coupon interest rate is 10 percent and the corporate
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tax rate is 20 percent, the cost of borrowing is Rp. 100,000. the note is not 8.0 percent after
tax.
We must remember that our objective in calculating the cost of capital is to obtain the
discount rate to be applied to the investment project. In the previous chapter we have seen that
the appropriate discount rate is the opportunity cost of capital. This means the savings that
would arise from repaying the source of capital, or the cost of further funding obtained from
that source. Currently this would be 9.9 percent after tax. If the business wanted to cancel the
loan notes, it could do so by buying the notes on the capital market at a price of IDR 93,000
(per nominal IDR 100,000). This will save the annual interest payment (after tax) of 8.0
percent of the face value and avoid having to repay the capital after five years. If further
funding were to be raised, perhaps the same business could raise Rp. 93,000 for a loan note
paying Rp. 93,000.
10,000 at the end of each of the next five years plus Rp. 100,000 at the end of the fifth year.
So, either way, 9.9 percent is the right number.
We might also ask why investors at one time were willing to pay Rp. 100,000 (for a
face value of Rp. 100,000) for a loan note that yielded Rp.
10,000 per year. interest (10 percent return). The difference must have arisen because of a
general increase in interest rates and/or because the capital market has changed its perception
of the risk of default (by a particular business) in interest or principal payments. Therefore, a
business's cost of capital is not necessarily static over time. Given the efficiency of capital
markets, the cost of any element of capital is the market's best estimate of that cost in the
future.
Finance lease:
As we saw in Chapter 8, a finance lease is actually a term loan secured by repayment
of capital at certain intervals during the loan period, rather than entirely at the end of the loan
period. If this is not explicitly stated in the lease contract, we can figure out the interest rate
quite easily.
The rental value, at the date of the lease, is the acquisition cost of the asset that is the
subject of the lease. Since this figure, as well as the amount and timing of future rental
payments, can be known, k can be determined. To identify the current cost of the lease, at a
later date, we must take a similar stance to what is required in respect of term loans and
unlisted debentures. We can try to assign a current value to the lease and solve for k in the
valuation expression (Equation 10.2 above). However, we can assume that the opportunity
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cost of lease financing today is approximately equal to the opportunity cost of lease financing
when it was first undertaken.
Trying to value a lease, at a certain date after it has been in operation for some time, is
likely to be quite a difficult task. Therefore, we may still assume that the interest rate implied
in the original contract is still appropriate. Alternatively, some estimates of the rates
applicable to new leases today can be used. We can assess the cost of using a hire purchase to
provide partial financing in the same way as a finance lease.
Major stocks:
The calculation of preferred stock prices is similar to that of debt securities.
The main differences between the two financing methods are as follows:
•
Interest on debt securities attracts corporate tax relief; preference dividends do not.
•
Interest on loans is paid based on contractual obligations; preference dividends are paid at
the discretion of the business directors.
The first point means that taxes should be ignored in the calculation of the cost of preferred
shares. The second implies that more uncertainty is associated with predicting preference
dividends than with predicting loan interest payments, although this makes no difference in
principle.
Common stock:
Ordinary shares are also similar to debt securities in the calculation of the cost of
capital base. Common stock has value because it is expected to generate dividends. How
dividend patterns affect the value of equity will be discussed in Chapter 12.
Ex dividend and cum dividend:
Before we embark on a detailed discussion of dividends and their relation to share
prices, a few things need to be said about the basis of share trading in the secondary capital
market. Usually shares are traded cum dividend, meaning that whoever buys the shares will
receive the next dividend paid by the company concerned. When the dividend is imminent,
the company concerned will 'close' its register of shareholders and pay the dividend to the
shareholders listed on the register, in other words the shares become ex dividend. This means
that anyone who buys shares after that date will not receive the dividend; instead, it will be
paid to previous shareholders who have sold their shares since the closing date. In fact, these
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investors no longer own the shares on the day of the dividend payment. Unsurprisingly, the
share price drops, in line with the value of the upcoming dividend, as the shares move from
being traded as dividends to being traded as ex-dividends.
Whenever the current market price of a stock, pE0, is used in any equation relating to
dividends and cost of equity, we should use the ex-dividend price. If a dividend is to be paid
soon and the stock is trading at the same time as the dividend, we need to subtract the amount
of the upcoming dividend per share to get the equivalent ex-dividend price.
Lower cost of equity
Saying that equity should be valued based on future dividends does not mean
assuming that a particular investor intends to hold a particular stock forever. This is because
the outcome of a future share disposal will depend on the expectation, at the date of disposal,
of future dividends.
Therefore, regardless of whether a disposal at a future date is planned or not, provided
that the valuation is always dependent on dividends, the current value will not be affected.
Common stock dividends are highly uncertain as to their amount. This is different from
interest on loans, which is usually set by contract between the borrower and the lender. It also
differs from preferred stock in that companies usually pay preferred stock dividends, subject
to a set maximum amount, even though there is no contractual obligation to do so.
The uncertainty of common stock dividends causes major problems in cost of equity
estimation. Predicting future dividends is a difficult task. However, one of two simplifying
approaches can be taken:
•
assume that the dividend will remain as it currently is; or
•
assumes a constant growth rate in it.
The assumption of a constant annual dividend increase is not necessarily an
unreasonable assumption. BT Group plc, a telecommunications business, has increased its
dividend by 10 to 15 percent annually for at least five years up to 2015. In its annual report in
2015, the business implied its intention to continue this pattern.
McLaney, Pointon, Thomas and Tucker (2004) found that 28 percent of UK listed
companies use a dividend approach to estimate the cost of equity. Of these, 75 percent include
a growth factor, which is almost always a growth rate based on past trends. Al-Ali and
Arkwright (2000) find that 21 percent of large UK businesses use the dividend approach.
Graham and Harvey (2001) find that 16 percent of US businesses surveyed use this approach,
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and small businesses are more likely to adopt this approach than large businesses. It should be
noted that the CAPM has become the standard way of deriving the cost of equity, in practice.
This is despite the doubts that some have regarding the practical validity of the model, which
we discussed in Chapter 7.
Example 10.2 The common stock of a company is currently trading at a price of
£2.00 (excluding dividends) on the capital market. Next year's dividend is expected to be
£0.14 per share and the next dividend is expected to grow at an annual rate of 5 percent from the
previous year's dividend. What is the cost of equity?
Retained earnings:
As explained in Chapter 8, retained earnings are not a free source of funding. It incurs
opportunity costs for shareholders because, if the profits were distributed, shareholders could
use them to make income-generating investments. However, it is not appropriate to separate
out retained earnings in calculating its cost. When we derive the cost of equity, we derive the
cost of all equity, which essentially includes retained earnings. Thus, provided that the cost of
equity is correctly derived, the fact that equity is partly share capital and partly retained
earnings will automatically be taken into account.
Convertible loan notes:
Convertible loan notes can be viewed as redeemable loan notes on which interest will
be paid until a date in the future when they will be redeemed by converting them into equity.
Therefore, estimating the cost of conversion is an operation similar to valuing debt securities,
except that the redemption amount is unknown, to the extent that we do not know what the
price of the equity shares will be on the conversion date. With respect to estimating the cost of
equity, we can make several assumptions - for example, that equity dividends will remain
constant or will grow at a steady rate.
Example 10.3 Tower plc convertible loan notes currently trading on the capital markets
at a price of Rp. 140,000 per nominal amount of Rp. 100,000. The notes pay annual interest of
Rp. 9,625,000 per nominal Rp. 100,000. They are convertible in exactly five years at the rate
of 50 ordinary shares in the business per nominal Rp. 100,000 loan note. The current price of
the common stock is Rp. 2,200, which is expected to grow at 5 percent per year over the next
five years. What is the cost of the convertible loan notes?
Assume corporate tax is charged at 20 percent.
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10.3 WEIGHTED AVERAGE COST OF CAPITAL (WACC):
We have seen how the cost of each element can be estimated from the current market
price of capital and the predicted future cash flows associated with that element. Most
businesses use at least two of the financing methods we have considered; each is likely to
have different costs. For example, for capital market investors, loan notes tend to carry much
less risk than equity in the same business. Hence, the expectation of return from equity is
higher. Given the different costs of the various elements, which discount rate should be
applied to the estimated cash flows of a prospective investment project?
Target gearing ratio:
Evidence suggests that, in general, businesses have target ratios, based on the market
value of capital, to various elements of financing. In other words, a given business seeks to
maintain equity financing as a relatively fixed proportion (by market value) of total financing.
Similarly, they seek to maintain a fixed proportion of loan-type financing. Small variations
may occur from time to time, but the business is believed to take steps to get back on target as
soon as it is practicable to do so.
Ozkan (2001), who studied 390 UK firms over the period 1984 to 1996, concluded
that, in general, firms have a long-term target gearing ratio. Businesses seem to quickly
readjust their efforts to meet this target whenever they find deviations from it. Graham and
Harvey (2001) found that 81 percent of American businesses surveyed by them in 1999 had a
target gearing ratio. Almost half of the these amounts have 'flexible' targets. Larger businesses
and those with investment-grade debt tend to have more rigid target ratios. Harford, Klasa and
Walcott (2009) examined a number of American businesses involved in takeovers. They find
that there is clear evidence that firms have a targeted gearing ratio and actively return to it
when the firm is disrupted by a takeover. More recently, Tucker, Pointon and Olugbode
(2010) found that 62 percent of London Stock Exchange-listed businesses surveyed had a
target ratio and 44 percent kept the same target for more than a year. A total of 50 percent
based their decisions on their targets on factors internal to each business, but 19 percent based
their targets on what they perceived to be the norm in the industry in which they operate.
Tucker and Stoja (2011) found that businesses operating in 'old industries', such as
mineral extraction, construction and textiles, are more vulnerable to targeting than businesses
in 'new industries' such as IT and leisure. They also note that targets tend to be based on book
value (statement of financial position), rather than market value. This last point implies a lack
of logic as book values tend to fail to reflect the overall value of a business.
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Some, though not many, companies state that they have targets, and even goals, in
their annual reports. For example, in its 2014 annual report, oil company British Petroleum
plc (BP) stated that its target gearing ratio was in the range of 10 to 20 percent. Previously, BP
had stated its intention to maintain its supply in the '20 to 30 percent range' (2009 annual
report). This suggests that the target gearing ratio changes over time, as attitudes and the
economic environment change. BP's actual ratio at December 31, 2014 was 16.7 percent.
The target ratio is believed to exist because businesses decide on the optimal
combination of financing methods. In making this decision they tend to consider factors such
as:
•
interest rate level;
•
the tax advantage of interest on loans over dividends; and
•
stability of their operating cash flows.
They then try to set and maintain this target ratio.
These targets, as we have just seen in the case of BP, are not always fixed; changes in
interest rates, tax regulations and so on can lead to new target changes, which can then be in
place for several years. Targets will also vary from business to business, partly because of
differences of opinion between one management and another. Such differences may also
partly, perhaps largely, arise from differences in the nature of the trade carried on by a
particular business.
The purpose of raising funds other than equity is, perhaps, to try to minimize the cost
of capital. Establishing, and attempting to maintain, a balance of Optimizing between
different sources of funding has a similar goal. Minimizing the cost of capital, in turn, will
maximize shareholder wealth. Whether the attempt to minimize the cost of capital through
gearing actually works is an issue we will return to in Chapter 11. In the meantime, let us
return to the question of the choice of discount rate.
Using WACC as the discount rate:
Using the weighted average cost of capital (WACC) as the discount rate is logical, if
we make three assumptions:
•
There is a known target ratio for the financing element, which will continue for the
duration of the investment project under consideration;
•
The costs of the various elements will not change in the future from the calculated costs; and
•
The investment under consideration has the same risk as the average of other projects
undertaken by the company (assuming CAPM is not used).
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Using opportunity cost means looking at the savings in funding costs that would arise if the
financing were to be repaid versus the investment project being undertaken. Alternatively, it
can be seen as an additional cost to raise the necessary funds to support the project. If there is
a target, repayment of the financing or additional financing will be done according to the
target. For example, a particular business has a target debt/equity ratio of 50/50 (based on
market value). If the company wishes to secure additional funding to support an investment
project, it would in principle do so in the same proportion of 50/50, otherwise it would upset
the existing position (probably 50/50). Similarly, if funding for the project is available but
alternatively repayable to the funding supplier, presumably 50 percent would be used to
cancel the loan notes and 50 percent paid to ordinary shareholders, perhaps as a dividend.
The three assumptions mentioned at the beginning of this section relate to the fact that
in the valuation of investment projects, and in other cases when we want to assess the cost of
capital, what concerns us are future costs. The third assumption, relating to risk, may require
comment. We know from a combination of intuition, casual observation of real life, and the
theory surrounding the capital asset pricing model (CAPM), which we encountered in Chapter
7, that the required rate of return/cost of capital depends in part on the level of risk
surrounding the cash flows of the investment project in question. Therefore, it is not
appropriate to use a WACC based on the past involving an investment project with one class
of risk as the discount rate for an investment with an entirely different class of risk.
Example 10.4 WACC calculation:
Hazelwood plc is financed by:
a. 1 million common shares (par value Rp. 1,000 each). This is expected to yield a dividend
of Rp. 100 per share within one year. The dividend is expected to grow by 10 percent
from the previous year's dividend each year. The current market price of the shares is Rp.
1,800 each; and
b. the loan note is Rp. 800,000,000 (nominal). They will pay interest at the end of each year
of 9.625 percent (of the nominal value) for three years. After that, the loan notes will be
redeemed at face value. Currently, the loan notes are offered in the capital market at Rp.
95,000 (per nominal value of Rp. 100,000).
Assume the corporate tax rate is 20 percent. What is the WACC of the business?
The reality of raising (and repaying) financing and discount rates:
While businesses seem to set and maintain targeted gearing ratios, the practical reality
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of raising and repaying finance is that it is not always economical to raise (or repay) every
additional Rp. 1,000 (or reduction) of finance in just the target proportion. This is because, as
we have seen in Chapter 8, there are considerable fixed costs associated with raising long-
term funds, particularly with share issues. In practice, businesses seem to raise a sizable
amount of funds from each issuance share issuance to take advantage of economies of scale
regarding share issuance costs. This tends to have an impact on the targets that factor into the
actual ratio.
In the last example, the current debt to total financing ratio for Hazelwood
plc is 29.7 percent [i.e., 0.76/(1.80 + 0.76)]. Equity currently accounts for 70.3 percent of the
total. This suggests a target ratio of about 70/30. If the company wants to raise Rp. 1 Billion,
say, to finance a new investment project, it will most likely not raise Rp. 700 Million in
common stock and Rp. 300 Million in debentures. It will most likely raise Rp. 1 Billion from
one source or another. This will shift the gearing ratio from the current 70/30 (approximately).
The business will get back closer to its target by raising additional funding from other sources.
The pattern may be as depicted in Figure 10.1. Here the dashed line represents the target ratio,
with points A to E representing successive actual financing configurations. The business starts
by raising an initial amount of equity capital (0A) followed by an AB amount of borrowing,
perhaps through a term loan or issuance of debt securities. The government may choose not to
raise the amount Ab as sufficient economies of scale with respect to fundraising costs will not
be available for small amounts of borrowing. The next issuance is equity (BC value) and so on
until the current position (E) is reached.
Specific or weighted average cost:
The fact that a particular funding increment will be used in a particular project should
not cause the company to use the specific cost of that funding as the discount rate.
Say, in the case of Hazelwood plc, the funds to finance the project will be obtained
from the issuance of loan notes at a cost of 9 percent. It is clearly wrong to use 9 percent as
the discount rate in valuing the project, just as 16 percent is not appropriate if funding is
obtained through the issue of ordinary shares. Using the specific cost of funds raised may
mean that a project may be acceptable if the venture moves from point C to point D in Figure
10.1 (9 percent cost of finance). However, the same project may be rejected if it moves from
point D to point E, when a rate (cost of equity) would be used of 16 percent. This is clearly
illogical and may lead to some strange investment decisions. It would be much more logical to
use the WACC, provided the company intends to maintain a constant gea ring ratio.
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10.4 DISCOUNT RATE - CAPM VERSUS TRADITIONAL APPROACH:
We have seen two ways to reduce the cost of each of the long-term financial elements:
•
the popular CAPM approach, described in Chapter 7, which can be well applied to any
element of financing, although we tend to concentrate on equity financing in that chapter;
and
•
The diminishing 'traditional' approach adopted in this chapter, which bases the cost of an
element on the market price of the element, i.e. we create an equation containing the
market price of a particular element (e.g. loan stock, equity, etc.), the cash return the
investor expects to receive from the element, and the cost of the element. Only the latter is
unknown and not estimated, so its value can be easily deduced.
Whichever approach is used, if the business is not fully financed with equity, as we have seen
in this chapter, WACC should be used. It seems that some people have the wrong impression
that CAPM and WACC are alternative approaches. In fact, WACC is the correct approach,
regardless of whether CAPM is the tool to estimate the cost of each element. The principle of
calculating WACC will remain the same, whether the 'traditional' or CAPM approach is used.
So, in the Hazelwood plc example above (on page 000), we can derive kE and kL using the
CAPM and then calculate the WACC exactly as shown (on page 288). While both approaches
must consider risk, the CAPM may have an advantage in that it tends to focus more on the
specific project risks that under consideration. With the traditional approach, there may be a
tendency to make an implicit assumption that the risk of the project under consideration is the
same as the risk of the existing activity.
In Figure 10.2 the horizontal green line represents the WACC for a particular business.
Logically, the weighted average risk of existing business projects should be b' because that
level of risk, according to the CAPM, is consistent with a certain WACC value. Only if the
project under consideration has the right risk will the WACC value be the appropriate
discount rate. If Project A (Figure 10.2) is being considered then it should be accepted
because it will have a positive NPV when discounted at rA (the discount rate corresponding to
its risk level) even though when discounted at the WACC, its NPV will be negative.
Similarly, Project B, whose rate of return is rB, will have a positive NPV if discounted at
WACC, but will have a negative NPV if discounted at the more appropriate rate, rB.
Therefore, the use of WACC, based on ongoing projects, regardless of the risks inherent in the
particular project under review, will cause some profitable projects (e.g. Project A in Figure
10.2) to be rejected, while other projects that will reduce the wealth of shareholders (Project
B) may be accepted.
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In practice, businesses tend to specialize in similar projects that may have similar risks,
so the existing WACC may be suitable in most cases. If a project under consideration does not
have the same level of risk as an existing project, an appropriate discount rate can be obtained
by looking at the WACC of a business whose activities (and therefore risks) are similar to the
project under review. This is a similar approach to using the beta of another business, all of
whose activities are of the same type as the project under review, where the project is not
typical of an existing investment business project, when deriving the discount rate through
CAPM.
The practicality of using the traditional approach compared to using the CAPM.
Traditionalists seem to regard the CAPM as a rather fanciful approach to inferring the
discount rate, even though they may disagree with the CAPM in theory. The objection seems
to lie in their recognition of the difficulty of estimating the CAPM parameters (risk-free rate,
expected market return, and beta). Traditionalists are right to be skeptical of our ability to
reliably estimate these (see Chapter 7).
The misconception is that they believe that the forecasts required to arrive at the cost
of capital in the 'traditional' way are less prone to error than the CAPM forecasts.
Typically, the traditional approach looks to use forecasts, either from the expected
future cash flows of the various long-term financial elements, or from the recent history of the
cost of each element. If based on future expectations, these estimates are no more reliable than
those required when using the CAPM. If the WACC, which is used as the rate to discount the
future cash flows of a project, is derived from past evidence, this also seems quite dubious.
Simply extrapolating unquestioningly from the past to the future is not always a good idea,
and seems to be a bad idea in this context. Research evidence shows an increasing use of the
CAPM to derive discount rates, especially among large businesses. CAPM can be particularly
helpful to small businesses in calculating their cost of capital. These businesses usually do not
have a known market value. Version The published beta of large businesses in the same
industry can act as a useful benchmark for small businesses.
10.5 WACC VALUES USED IN PRACTICE:
To illustrate, Dimson, Marsh, and Staunton (2015) estimate that the real (i.e., inflation-
free) return on equity, for businesses in the UK, from 1900 to 2014, averaged about 5.1
percent per year. In fact, this is the average cost of equity. They also estimated that the return
on corporate loans (loans to businesses), over the same period, averaged 1.6 percent per year.
Since most businesses have a significant element of borrowing, and debt tends to lower the
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WACC, we might expect that the interest rate actually used by businesses in the UK would be
in the range of 1.5 percent to 5.2 percent. Survey evidence (Gregory, Rutterford and Zaman,
1999; Al-Ali and Arkwright, 2000; McLaney, Pointon, Thomas and Tucker, 2004) suggests
the average real WACC found in practice in the UK is in the range of 7 to 9 percent, although
many individual businesses estimate their WACC at values outside this range. Table 10.1
presents the WACC of some well-known UK businesses.
The values found by McLaney et al and those shown in Table 10.1 seem to be on the
high side given the findings of Dimson et al. It must be said that none of the businesses
listening to Table 10.1 indicated whether they stated 'real' or 'money' figures. If any of them
gave a money figure, then that figure would need to be reduced, perhaps, by 2 percent to get
an approximation of the real figure. Assuming that the WACC is used by the surveyed
companies as the discount rate for valuing investments (and the real figure is stated), then
valuable investment opportunities may be rejected because companies have too high an
expectation of acceptable returns.
Jagannathan, Matsa, Meier and Tarhan (2016) conducted a survey of 127 large
businesses in the US and found that the cost of capital values used in discounting to value
investment opportunities (15 percent on average) were, typically, about double the value for
the WACC derived from those businesses (8 percent on average). As is the case in UK,
discussed above, it appears that businesses in the US may be failing to capitalize on wealth-
enhancing investment opportunities.
10.6 THE USE OF WACC IN PRACTICE:
Evidence suggests that WACC is the most widely used approach to derive the cost of
capital for investment appraisal purposes. This is the finding of Cohen and Yagil (2007), who
surveyed a number of managers of large businesses in various industries across several
countries. This confirms several previous surveys on the same subject.
10.7 MORE POINTS ABOUT WACC:
There are two other points to be made about using WACC as a discount rate, but since
these require an understanding of the contents of Chapter 11, we will leave them until the end
of that chapter.
Estimated cost of capital:
•
The cost of capital (k) is the IRR for a set of cash flows, such that the current market price
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of an investment is equal to the sum of the discounted values of all future cash flows
associated with that investment, from a business point of view.
•
Market prices are used because k opportunities are required.
•
With perpetuity, k = annual interest (or dividend) payment/current market price.
Loan notes
•
Interest payments are tax deductible; effective interest payments are somewhat less than
the coupon rate.
•
Redeemable; redemption payments are not tax deductible.
Major stocks
•
Treated like a loan note, except:
•
dividends are not tax deductible;
•
dividends do not always have to be paid.
Common stock
•
Need to make assumptions regarding future dividends, usually:
•
constant (perpetual) - treated like preferred stock; or
•
assumes a constant dividend growth rate, g [g = proportion of retained earnings
(b) multiplied by the rate of return on retained earnings (r)].
•
Assuming constant growth
Other issues:
•
The specific cost of capital should not be used as the discount rate, even if the investment
is funded from that specific element - use the WACC.
•
WACC estimates cannot be considered completely accurate due to the many assumptions
that must be made, especially in estimating the cost of equity.
•
Like its normal approximation, the WACC tends to be forward-looking, and this is
appropriate when used as the basis for a discount rate to assess potential investment
opportunities.
•
If required, WACC estimates are based on the overall scale of the business. This may give
a rate that does not match the discount rate of a particular project.
•
Based on the long-term average rate of return of equity investments, it seems that some
businesses may be seeking too high a rate of return for their investments.
15
GEARING, COST OF CAPITAL AND SHAREHOLDER WEALTH
11.1 INTRODUCTION:
At several points in this book so far, we have come across the fact that most businesses
obtain some of their long-term funding through borrowing. This is sometimes achieved
through the issuance of debentures or bonds, but usually through term loans from banks. All
of these give the lender the contractual right to receive interest, usually at a predetermined
interest rate and on a specific date. Usually, the loan must be repaid or redeemed so the
contractual right extends to the amount to be repaid and to the date of repayment. (Some
debentures are perpetual, meaning that they do not need to be repaid.) The key point about
debt financing, in the current context, lies in the fact that neither interest nor repayment is a
matter for the discretion of the lending business. Interest on loans is an annual charge on
profits. This must be met before shareholders, who generally provide most of the funding, can
participate.
In Chapter 2 we found, under some assumptions, that funding through loans versus
equity does not seem to make any difference to shareholder wealth. In this chapter we will
develop the points raised in Chapter 2. Alongside this, we will also explore the traditional
view that capital gearing does have an impact on shareholder wealth. After this we will review
the evidence and try to reach a conclusion on the matter.
11.2 IS DEBT FINANCING AS CHEAP AS IT SEEMS?
It is widely believed that capital markets price securities so that expected returns on
equities are higher than those on term loans and debt securities. Historically, this belief has
held true over all but a relatively short period (see, for example, Dimson, Marsh and Staunton,
2015). Does the cheapness of debt financing really mean that shareholders will benefit from
its use in a business's capital structure?
Example 11.1 La Mer plc has one asset, a luxury yacht, which it leases to wealthy
vacationers. The profitability of the business over the next few years is estimated at
€140,000,000 per annum. La Mer is financed entirely by equity, i.e. 1 million ordinary shares
whose current market value is £1 each. The business pays out the entire profit each year to
shareholders as dividends. La Mer plc intends to purchase an additional similar vessel, which
is also expected to generate annual profits of £140,000,000 per annum, at a cost of £1 Billion.
16
11.3 BUSINESS RISK AND FINANCIAL RISK:
Table 11.1 shows the annual dividend per share for La Mer (assuming that a second
vessel is acquired and all available profits are paid out as dividends) for each of the two
financing schemes mentioned above (all equity and 50 percent debt financed) for different
levels of charter profit.
Borrowing increases the return (in Thousand Rupiah) on equity compared to that
obtainable in an all-equity structure where annual profits are above IDR 100,000 per vessel.
However, when annual profits per vessel fall below IDR 100,000, the presence of debt
financing weakens the position of ordinary shareholders. In fact, below a profit of Rp. 50,000
per vessel, the profit earned is not enough to cover the interest payments. Assuming there are
no other assets, the company may have to sell one of its vessels to provide financing to meet
the interest payments.
At almost any profit level, bondholders can look at the situation with confidence. After
all, they have the legal right to insist on interest payments and repayment of their capital.
They even own the vessel as security. Only in the event of a major loss in the market value of
the yacht would the position of the debenture holders be seriously jeopardized.
If gearing is present, the risk faced by equity holders will increase beyond the risk they
would bear in an all-equity business. To business risk, the normal risks inherent in real-world
investments, are added financial risk, which is the risk caused by the burden of the obligation
to meet fixed financial costs, as illustrated in Table 11.1. Figure 11.1 illustrates the
relationship between business and financial risk where operating returns fluctuate. The
magnitude of business risk depends on the commercial activities of the business; financial risk
depends on how the business is financed.
Financial gearing has the effect of accentuating fluctuations in returns to shareholders.
The underlying fluctuations are related to business risk. Gearing adds the effect of financial
risk to this.
Intuition and real-world observation tell us that risk and return are interrelated. When
investors perceive high risk, they require high returns. Therefore, in reference to the example
above, while gearing will increase the expected dividend per share for ordinary shareholders
from 14p to 18p, it will not necessarily increase the share price (and therefore shareholder
wealth). The increase in expected dividends also comes with a wider range of possible
outcomes (see Table 11.1).
As we saw earlier, not all new possibilities generated by gearing to shareholder returns
are bad news. For example, for La Mer, Table 11.1 shows that for every charter profit per
17
vessel above IDR 100,000 per year, the common stock dividend will be increased. However,
as we saw in Chapter 6, most investors are risk-averse. This means that the possibility that the
profit per vessel could be below IDR 100,000 by a certain amount is likely to be more
significant to them than the possibility that the profit could be greater by the same amount.
La Mer's ordinary shareholders will only be better off through the introduction of
gearing if the capital markets, when reassessing the situation following the issuance of the
loan letter and the purchase of the second yacht, price the ordinary shares so that the expected
yield is less than 18 percent.
11.4 TRADITIONAL VIEW OF GEARING:
The traditional view is that if the expected rate of return on an equity investment in
yacht chartering is 14 percent, then this will not be unduly affected by the application of
capital gearing, at least not to a moderate degree. This view of the effect of gearing on capital
market expectations of returns on equity, loans and WACC is illustrated in Figure 11.2.
Figure 11.2 shows that, as gearing increases, both equity investors and lenders
perceive additional risks and require higher returns. However, at lower gearing levels, neither
group requires a large increase in returns to compensate for this risk. As a result, the WACC
decreases. As gearing reaches higher levels, the issue of risk becomes increasingly important
to both groups, so expected returns start to increase dramatically. Now the WACC starts to
rise sharply. While the point at which the rate of return demanded by each group begins this
sharp rise is not necessarily the same, there is a point (or, perhaps, a series of points) at which,
according to the traditionalists, the WACC is at a minimum. This is the optimal gearing level
in Figure 11.2. At this point shareholder wealth is maximized, i.e. the price per share will be at
its peak. Note that the graph of share price against gearing level will resemble the inversion of
the WACC (k0) curve in Figure 11.2. That is, the share price and shareholder wealth and
business value will be maximized at the optimal gearing level.
The reasoning underlying this traditional view is that lenders will realize that, at high
levels of gearing, their sense of security will be significantly diminished and they will begin to
demand higher interest rates to compensate for the higher risk. At the same time, up to a
certain level of gearing, equity shareholders will not see the increased risk to their returns as
too significant. However, after that point, they will start demanding large increases in yields
for further increases in gearing.In general, the traditional conclusion is that gearing is a good
thing, in terms of maximizing shareholder wealth, at least up to a certain level, otherwise it
will start to have an adverse impact on WACC and, therefore, on shareholder wealth. During
18
the 1950s, some observers began to question the value of gearing, and found it difficult to
reconcile the "something for nothing" aspect of the traditional view with the rapidly growing
belief that securities are efficiently and rationally priced.
11.5 MODIGLIANI AND MILLER'S VIEW OF GEARING
In 1958, Modigliani and Miller (MM) published an article, now almost legendary,
questioning the traditional approach to the gearing problem. MM argued that, in the presence
of rational pricing in capital markets, it is impossible for a business to increase its total market
value (lower its WACC) simply by doing what the rest of us could theoretically do: borrow
money. They assert that if a particular business is expected to generate income at a certain
level, it should be valued regardless of how it is financed. Example 11.2 To see how MM's
assertion would work in the case of La Mer, let us assume that the company raised Rp. 1
Billion for a second vessel by issuing a 10 percent loan note (i.e., borrowing at 10 percent
interest). p.a.). Let's also assume that there is another business, Sea plc, which is identical in
all respects with La Mer, but entirely financed by 2 million ordinary shares at £1 each. Let's
also assume that La Mer's share price remains at £1 (as MM predicts).
Franco, the holder of 1 percent of La Mer's equity (i.e., 10,000 shares), expects a profit
of Rp. 1,800,000 per year. because, as we have seen, each is expected to yield 18p pa. Franco
could also earn the same expected income by selling his shares for Rp. 10,000,000, borrowing
an amount equivalent to 1 percent of La Mer's loan (i.e., Rp. 10,000,000) at an interest rate of
10 percent per annum. and using this total of Rp. 20,000,000 to purchase 1 percent of common
stock in Sea (20,000 shares). The Sea shares are expected to yield 14p each and a total of Rp.
2,800,000, which, after paying interest on the loan, will result in Rp. 2,800,000.
Since securities (indeed, all economic assets) are valued solely by reference to their
expected rate of return and risk, each of the above positions should have the same value to
Franco, or to any other investor. Both positions offer the same risk/return expectation. If, in
the above situation, Sea's share price falls below La Mer's, Franco can switch from the
original position to the alternative position, having the same expected return and risk, but
benefiting from the switch. Since the sale of La Mer shares and the purchase of Sea shares can
be done simultaneously (an action called arbitrage), risk-free profits are available. The actions
of Franco, and others who saw this opportunity, would increase the demand for Sea shares and
the supply of La Mer shares. As a result, the share price would become equivalent to the value
of IDR 1,000 per share. MM's main point is that, if Franco wanted to engage in gearing but
wanted to own shares in Sea, this could be achieved by personal gearing, i.e. self-made
19
gearing.
Similarly, another individual, Merton, who owns shares in Sea but wants to invest in
La Mer despite not being involved in the gearing, can easily cancel the investment in La Mer.
Merton could do this by selling the Sea shares, lending the same proportion of money to
invest as La Mer borrowed from its total financing (IDR 10,000,000) and using the remaining
IDR 10,000,000 to buy La Mer shares.
MM Assumptions:
MM analysis is based on several assumptions, which we will now consider.
Shares can be bought and sold without transaction costs:
This is clearly unrealistic: brokerage commissions and other fees are associated with
stock trading. But it is doubtful whether the weakness of this assumption really weakens the
proposition. It may mean that investors will not be able to profit by exploiting small instances
of mispricing of the shares of geared and non-directed companies, relative to each other.
Larger instances of mispricing can be exploited despite transaction costs.
Efficient capital market:
The evidence seems to suggest that they are efficient, for practical purposes, in their
weak and semi-strong forms (see Chapter 9). This implies that investors will look through the
financial packaging and realize that income from a particular risk class is equally valuable
regardless of how it is packaged. This seems to be a reasonable assumption.
Equal interest rates between borrowing and lending, businesses and individuals:
Obviously, this is not valid. In particular, there is usually a difference between the
interest rates at which individuals and businesses can borrow. Large corporations, in
particular, can often offer good security, can borrow large amounts and can take advantage of
borrowing opportunities that are not open to most individuals (for example, borrowing
abroad). The importance of this assumption lies in the question of home gearing, where
investors borrow on their own account and buy shares in businesses that are not yet managed.
However, there is no reason why the investor exploiting the stock mispricing has to be an
individual; it can be a large institutional investor. After all, most investments in stock
exchange-listed securities, at least in the UK, are made by institutions and not by individuals.
Nor does every investor in the economy need to exploit a mispricing to correct it. The actions
20
of a few investors, who are well positioned to take advantage of the situation, are sufficient.
Perhaps the weakness of the assumption This is not enough to question MM's proposition too
seriously. MM also makes the implicit assumption that the cost of business borrowing does
not increase with the level of gearing. This seems less plausible. This is a point that we will
come back to later in this chapter.
No bankruptcy costs:
This assumption suggests that if a business is liquidated, shareholders will receive, in
return for their shares, a value equal to its market value immediately prior to liquidation. This
assumption describes a situation where, as a result of a business defaulting on interest and/or
capital payments, it is liquidated at the instigation of the lender. Such an action would
obviously be more likely in a highly geared business.
This assumption is invalid because transaction costs will be involved in the disposal of
business assets, legal costs will be incurred if the business is formally wound up and, perhaps
most importantly, real asset markets are not generally efficient when it comes to asset sales in
the same way as capital markets. This last point implies that a machine worth Rp. 1,000,000
to Business A may not necessarily have the same value to Business B, as B, for some reason,
may not be able to use it as effectively as A. Prior to liquidation, the value of A's equity may
be partly based on the Rp. 1,000,000 value of the machine, but when the machine is to be
sold, it may only fetch Rp. 500,000 In addition, there are costs to managing a potentially
insolvent business, even if the business is salvageable.
The lack of validity of this assumption weakens the MM proposition in its broad form.
But it is doubtful whether this assumption really matters if the gearing level is moderate,
which is usually the case in practice. On the other hand, the existence of bankruptcy costs may
be the reason for the low gearing levels we tend to see in real life.
There are two businesses that are identical in revenue (cash flow) and risk, one is
entirely equity-based, the other is geared towards:
This assumption is most likely not entirely correct. However, this does not seem to be
an important obstacle to the validity of MM propositions. The CAPM, and modern portfolio
theory in general, states that business risk can be explicitly addressed, making it possible to
link two businesses with different risks. That is, there is a well-established mechanism for
pricing risk, which allows the returns on one company's shares to be aligned with those of
another company. Yet even if the CAPM etc. are questioned, Stiglitz (1974) points out that
21
two such businesses need not exist for the proposition to be valid.
The logical conclusion of this view is that there is an optimal level of gearing and it
lies at 100% gearing. This arises from the assumption that the cost of equity increases at a rate
that would eliminate the benefits of low-cost debt financing at all gearing levels, if not for the
fact that interest on borrowings is tax deductible. The fact that interest is tax deductible means
that the larger the loan amount, the greater the tax benefit to the business.
Figure 11.4 shows MM's after-tax view of capital gearing. There is a difference with
the pre-tax position depicted in Figure 11.3. In the after-tax case, borrowing costs are low
enough (due to tax relief on interest payments) to increase the amount of debt financing to
reduce the WACC to a greater extent than the increase in shareholder demand increases it.
Thus the WACC line slopes downwards.
But it is doubtful whether this 100 percent debt financing conclusion can be sustained
in practice. At very high gearing levels, lenders will realize that their security has been
significantly eroded and that, although they are merely lenders, as risk takers, they are actually
shareholders. Therefore, they will seek a rate of return that compensates for that risk: the same
rate of return that shareholders want. This means that at very high levels of gearing, both
before tax and after tax, the cost of borrowing will increase significantly. For MM's
conclusion to hold, this requires the rate of increase in the cost of equity to start falling. In
Figure 11.4, if the cost of borrowing line will start to rise at high gearing levels, the WACC
line can only continue its downward path if the cost of equity line becomes less steep.
(Remember that the WACC line is the average of the other two lines.)
The idea of the rate of increase in the cost of equity, as gearing increases, suddenly
starting to decrease at high gearing levels seems implausible. Why should investors start
behaving contrary to all the theory and evidence of investor reaction to increased risk? This
points to a weakness in MM's analysis.
11.6 OTHER THOUGHTS ON THE TAX ADVANTAGES OF DEBT FINANCING:
Miller (1977) shows that the tax benefits derived from a particular business will
depend on the personal tax positions of lenders and shareholders. As such, businesses will
tend to attract investors (both lenders and shareholders) that are compatible with their capital
structure. This is known as the client effect, where certain policies attract certain types of
investors. If Miller is right about this, the implication is that businesses should avoid changing
their capital structure as this will cause investors to sell their loan notes or shares and invest
the money in businesses that match their preferences. This is because the transaction costs
22
associated with selling and buying securities will adversely affect investor wealth. In addition,
the uncertainty caused by changes in gearing levels may make stocks less attractive, thereby
adversely affecting stock prices. It is probably fair to say that the question of the tax benefits
of gearing remains unanswered.
11.7 CAPITAL/FINANCIAL GEARING AND OPERATING GEARING:
We have seen earlier in this chapter that the presence of debt financing in the capital
structure accentuates the effect of variations in operating profit (i.e., before interest) on
returns to shareholders. This is because, at significant levels of gearing, interest payments
represent a large fixed commitment, which must be met regardless of the level of operating
profits.
There is also the aspect of adjustments in business operational activities. This means
that it's not just capital gearing that causes shareholder returns to vary. In fact all operations
have fixed costs, independent of the level of capital gearing sales revenue (fixed costs), and
costs that vary according to the level of sales revenue (variable costs). The relative proportion
of each of these types of costs, in relation to total costs, varies from business to business,
depending on the nature of the activity. This phenomenon is known as operating gearing. A
business is said to have high operating gearing if most of its total costs are fixed costs.
11.8 ISSUES RELATED TO CAPITAL GEARING AGENCY COSTS:
The fact that shareholders, in practice, have to rely on directors (the shareholders'
agents) to manage the business may lead to the business being managed in a way that may not
always provide the best benefit to shareholders. If the directors act sub-optimally, from the
point of view of shareholder wealth maximization, the shareholders will suffer the
consequences.
In the context of capital gearing, such costs may arise because gearing may be in the
best interest of shareholders but less attractive to directors. If gearing lowers the cost of
capital, shareholders will welcome this. However, the need to meet interest payments and
provide funds to repay the loan at the contractual date, imposes a discipline on directors that
they may prefer to avoid. On the other hand, Jensen (1986) points out that the compulsion to
make interest payments at a certain level might deter directors from making investments that
are incompatible with the rate of return that such investments are likely to generate; in other
words, directors are likely to be more cautious in taking on investments that might be
detrimental.
23
Higher levels of gearing are expected to lead to greater bankruptcy risk, but to some
extent this may not outweigh the tax benefits of gearing; the net effect is a lower WACC.
Since investors tend not to keep a large portion of their funds in the stock of a particular
business, they may be prepared to accept bankruptcy risk. In contrast, managers tend to have
only one employer. Therefore, the risk of collapse of the company's business will be much
more important to employees than to shareholders. This may cause managers to avoid gearing.
It may also represent an agency cost.
Signal:
There is an opinion that borrowing additional amounts may be interpreted, by the
investor community, as a signal that the directors are sufficiently confident in the future cash
flows expected to be generated by the business investments to be prepared to make regular
interest payments to the lenders.
Client effect:
It seems likely that certain shareholders are interested in or, at least, satisfied with the
level of capital gearing of a particular business. That is, the shareholders are satisfied with the
risk/return trade-off implied by the level of capital gearing of the business. As we saw above
(on page 310), an investor's tax position can give rise to client effects. As we have seen
earlier, a company changing its level of capital gearing can have an adverse impact on
shareholder wealth.
11.9 EVIDENCE ON GEARING:
Before proceeding to some sophisticated studies relating to gearing, it is worth noting
some important points that emerge from casual observation.
•
Most businesses have some level of capital gearing. This seems to be particularly true
among large businesses. Very few raise all oftheir financial requirements from equity
shareholders. Assuming that management is pursuing the goal of shareholder wealth
maximization, they may use gearing to achieve that goal. Therefore, rightly or wrongly,
management seems to believe that gearing lowers WACC.
•
Very high gearing levels are rarely seen. Management does not seem to believe that
business value can be maximized (WACC minimized) with very high levels of
gearing.
Some businesses made public comments on the benefits of financial gearing. Reckitt
24
Benckiser Group plc's health and household goods business (Dettol®, Clearasil®, Strepsils®,
etc.) said in its 2015 annual report about financial gearing:
The objectives of capital management are to safeguard the Group's ability to remain
viable, to provide returns to Shareholders and benefits to other stakeholders, and to maintain
an efficient capital structure to optimize the cost of capital.
Of course, optimizing the cost of capital will maximize shareholder wealth.
Some formal evidence:
The questions whose answers are particularly interesting are:
•
Does WACC change gearing as suggested by traditionalists and MM (after tax)?
•
Does it move to a minimum level at certain gearing levels of less than 100 percent and
then increase as gearing increases, as traditionalists assert?
The publication of MM's article on capital structure was followed by a number of studies that
addressed the above questions.
Modigliani and Miller (1958) themselves led a study using data on a number of oil and
electricity utility companies. They came to the conclusion that the WACC is independent of
the level of gearing (supporting their pre-tax proposition).
Weston (1963) criticized MM results on the basis that they oversimplified the
assumptions. Weston himself used data on electric utility businesses to show that the after-tax
MM proposition was valid as the WACC appeared to decrease as gearing increased. Miller
and Modigliani (1966) returned to the field and, again using electric utility businesses, they
also found evidence in favor of the after-tax proposition.
Hamada (1972) found that the cost of equity increases with the level of gearing.
Masulis (1980) found that the announcement of a firm's intention to increase its gearing level
tends to be associated with an increase in its equity price. Similarly, the announcement of an
intention to reduce gearing tends to have an adverse impact on equity value. This clearly
supports the MM proposition after tax. It also implies that, if there is an optimal level of
gearing, investors are likely to believe that the businesses are operating below that level.
DeAngelo and Masulis (1980) found an increase in business value along with
gearing increases up to a certain point, and decreases in value as debt increases. This is due to
the fact that tax advantages may become increasingly less valuable with higher gearing
because the business may not have sufficient taxable operating profits to justify the interest
expense: in other words, the tax deductibility of interest becomes irrelevant. Barclay, Smith
and Watts (1995) found, based on US data, that tax-deductible interest is a factor in the level
25
of gearing, but not a very significant one.
Homaifar, Zeitz and Benkato (1994) found evidence based on US data that gearing
levels tend to be higher when businesses are exposed to higher corporate tax rates: in other
words, the greater the value of the tax shield, the higher the level of corporate tax debt. They
also found that large firms tend to have higher levels of gearing than small firms, perhaps
reflecting the greater ease with which large firms can obtain external funding. This tax and
size point is confirmed by Ozkan (2001), using UK data. He also found evidence that
businesses have a target gearing ratio that they want to return to quickly when they deviate
from that target. He concludes from the fact that they return to the target quickly that the
losses caused by not being in their optimal position are very large. Eriotis, Vasilou and
Ventoura-Neokosmidi (2007) found, based on an analysis of 129 businesses listed on the
Athens Stock Exchange, that large businesses in Greece tend to have higher levels of capital
gearing than small businesses.
Graham and Harvey (2001) found that, among the American firms they surveyed, the
tax benefits of debt financing were seen as an important factor in capital gearing decisions.
This is especially true among large businesses with higher tax rates. They also found that
businesses do not see potential losses from bankruptcy as an important issue, except for
businesses that are already relatively financially weak. On the other hand, many businesses
are concerned about their debt credit rating (AAA, AA, etc.). This may indicate concerns
about financial distress. Graham and Harvey also found that only 19 percent of firms did not
have a target gearing ratio, although some of the 81 percent of firms had fairly flexible ratios.
Cohen and Yagil (2010), who surveyed managers at a number of large businesses
across industries and countries, generally found the same as Graham and Harvey regarding the
key issues in funding decisions. The formal evidence seems to answer the first question
above: WACC decreases as gearing increases. However, this does not really answer the
second question. So we don't know from the formal evidence whether the WACC bottoms out
below 100 percent, after which it starts to increase.
A survey conducted by Cohen and Yagil (2007) found large differences between
industry sectors in terms of gearing levels. The average level of gearing is highest in banking
and finance businesses (where debt accounts for 72 percent of total financing). The lowest is
in technology businesses (where debt is only 26 percent). The survey results show a
significant relationship between the level of financial gearing and the level of business risk (as
measured by beta). Businesses operating in sectors that are considered the riskiest tend to have
the lowest levels of debt financing.
26
There also seems to be international differences in the level of equipment.
Cohen and Yagil (2007) looked at relative gearing levels in Canada, Germany, Japan, the UK
and the US. They found that debt to total value in the UK averaged 49.0 percent. This
compares to an average across all businesses in the survey of 50.0 percent and considerable
variation between countries. Businesses in Japan had the highest level of gearing (62.1
percent) and the United States the lowest (41.6 percent). These differences may be explained
by national commercial characteristics. For example, high corporate tax rates tend to
encourage borrowing; the UK has relatively low tax rates. In addition, bank financing is more
traditional in some countries than in others: for example, it is more prevalent in Germany and
Japan than in the UK.
11.10 GEARING AND COST OF CAPITAL – CONCLUSION:
The central question regarding gearing is whether in fact it is the traditionalists or the
MMs who best explain the gearing effect. The traditional view is that shareholders do not pay
much attention to the increased risk posed by increasing the amount of gearing until it reaches
a high level. This seems naive. It seems to contradict most evidence of capital market
efficiency. Tests of capital market efficiency show that few important issues go unnoticed. It
seems clear that increasing the level of gearing is very significant for shareholders, as gearing
increases the range of possible returns. Since most investors appear to be risk averse,
increasing the range of possible returns is unattractive to them. The formal evidence on the
impact of gearing cited above also contradicts the traditional view as it appears that the level
of gearing broadly affects equity returns and WACC as suggested by MM (after tax). On the
other hand, a cursory observation suggests that corporate management does not seem to
believe in very high levels of gearing, which supports the traditional view. There is a conflict
here. Perhaps these two factors can be harmonized.
MM's (after-tax) analysis relies on a number of assumptions, most of which do not
seem to be oversimplified to undermine the conclusions. Two of these assumptions, however,
call MM's propositions into question. These are:
● that there are no bankruptcy costs; and
● That the interest rate demanded by the lender remains the same at all rates
gears. We will now take a closer look at these two assumptions.
MM Assumptions Revisited No
bankruptcy costs
The importance of this assumption lies in the fact that the existence of a high level of
27
Debt finance exposes a business to the risk that it will not be able to meet its payment
obligations to lenders, at least not out of its operating cash flow, if the business should
experience a particularly adverse trading period. While it is equally true that an all-equity
business may have difficulty paying dividends in similar economic circumstances, there are
important differences.
Lenders have a contractual right to receive interest and capital repayments on the due
date. If they do not receive these, they have the legal power to enforce payment. The exercise
of such powers can, in practice, lead to the liquidation of assets and the closure of the
business. For the reasons we have discussed (mainly through the seemingly inefficient market
in real assets), this will usually be to the detriment of ordinary shareholders and do so
significantly.
This is supported by research evidence. Andrade and Kaplan (1998) estimated, from a
study of 31 businesses that became financially distressed during the 1980s, that the cost of
bankruptcy, or close to it, represented between 10 and 20 percent of the business value. This is
widely supported by Cohen and Yagil (2007), who asked surveyed managers to estimate the
cost of potential bankruptcy. The average response was around 10 percent. If we take a
hypothetical insolvent business that is financed 50/50 by debt and equity, the cost to
shareholders (who would normally bear all the costs) represents between 20 and 40 percent of
the value of their investment - a very significant amount.
In contrast, neither in an undirected business nor in an ungeared business, do ordinary
shareholders have the right to enforce the declaration and payment of dividends. The risk of
insolvency may be insignificant at low levels of gearing, if only because a shortage of cash for
interest payments can be borrowed from some other source - a possibility perhaps not
available to a highly geared business in distress.
The interest rate demanded by the lender remains the same at all gear levels
At very low levels of gearing the lender's position is one of great security, with the
value of their loan probably covered many times over by the value of the business assets. As
gearing increases, this position is eroded to a very high degree by lenders, as they provide
most of the finance, bearing most of the risk.
Returning to Example 11.1 (La Mer), suppose that a business that does not need to
expand (i.e., just one yacht worth IDR 1 Billion) is financed 90 percent with equity shares and
10 percent with loan notes. Here the value of the yacht would have to fall by 90 percent before
the lender's security would be jeopardized. Even if the equity/debt ratio moved to 80/20, the
lenders' security, while slightly weakened in theory, would be no less in practical terms than if
28
they had provided only 10 percent of the finance. However, if the ratio is moved to 10/90,
only a small drop (10 percent) in the value of the yacht will make the lender assume the risk.
Naturally enough, lenders will demand high returns to encourage them to lend to a particularly
suitable business, perhaps something like the returns expected by equity shareholders.
Logically, the lender will not see the risk (and required return) increase significantly
with an increase in gearing at the lower end. After all, unless the asset on which the security
rests is highly volatile in value, an asset value/debt ratio of 5/1 may be as good as 10/1;
lenders can only demand to be paid once. If this ratio increases to closer to 1/1, lenders will no
doubt start to look at things differently.
11.11 TRADE-OFF THEORY:
It is noteworthy that neither of the above two 'weak' MM assumptions significantly
affect the position at lower gearing levels. However, at higher levels, they start to loom large.
Given this, and in light of the evidence we have briefly discussed, perhaps we can draw a
tentative conclusion.
Up to a moderate level of gearing, the tax advantages of borrowing will cause the
WACC to decline as more gearing is introduced, as estimated by MM (after tax). Beyond a
moderate level, the risk of bankruptcy (for shareholders) and the introduction of real risk to
lenders will increase the returns required by each group, making the WACC a very high
number at high gearing levels. Figure 11.5 illustrates this conclusion with kE, k0 and kB all
following the same pattern as shown in Figure 11.4 (MM after tax) up to a moderate level of
gearing and then all starting to increase to very high levels as further gearing is introduced.
Most likely, in real life, 'moderate' is not a fixed point for a particular business; but
rather a range below which the MM proposition can be sustained, but definitely not beyond.
The key question is, what does 'moderate' mean? The problem is that 'moderate' is likely to be
difficult to define and, therefore, a matter of judgment for financial managers. It should be the
point at which a balance is struck between tax advantages, on the one hand, and bankruptcy
costs and increased borrowing costs, on the other. This will vary from industry to industry and
to some extent will depend on the business risk (perhaps measured by beta) of the investments
made by a particular business. As we have seen earlier, businesses that are viewed as having a
high level of business risk tend to have relatively low levels of financial gearing.
11.12 PECKING ORDER THEORY:
It was argued, first by Myers (1984), that businesses do not follow the trade-off theory
Cost of capital
(%)
29
or, at least, do not follow its principles. Central to Myers' pecking order theory is the idea that
businesses are reluctant to issue new shares. There seem to be three reasons why businesses
should be reluctant:
⮚
As we saw in Chapter 8, issuing shares is costly.
⮚
It is thought that managers often feel that the share price of their business is too low for its
true value. Issue new shares at this 'low' value,
Under these circumstances, it would be detrimental to existing shareholders and not
beneficial to shareholders who take up the new shares.
⮚
Based on the previous point, managers are concerned that the market may view
issuance of shares as a sign that the board of directors believes that the share price is too high.
expensive on the stock market. Alternatively, it may be seen as an act of desperation,
which is only done when the company has no other options. Both of these points are likely
to complicate the issuance and may lead to a low issue price.
As a result, according to the pecking order theory, businesses will tend to finance their activities
based on the following order of preference:
1. Retained earnings.
2. Debt is relatively cheap to obtain, especially if it takes the form of a term loan from a bank
or similar institution.
3. Issuance of shares (as a last resort).
Pecking order theory is sometimes put forward as a strict alternative to trade-off theory, but it
is possible that the two can work together. For example, businesses may broadly follow the
principles of the trade-off theory but try to fund new equity from retained earnings (and avoid
issuing new shares) and, perhaps, rely more on debt financing than the capital markets strictly
dictate.
Evidence on pecking order theory:
Graham and Harvey (2001) conducted a large survey of senior managers' attitudes in a
large sample of large US firms in 1999. The scope of the study was broad, but they paid quite
a bit of attention to testing the pecking order theory. Graham and Harvey found that the
behavior of US managers seems to be consistent with both theories. They found that
businesses were reluctant to issue new shares because they considered existing shares to be
undervalued. This seems to be an important consideration in share issuance decisions. They
report that senior managers in more than two-thirds of businesses believe that their shares are
undervalued.
Deloitte (2007) conducted a survey of senior financial managers in major UK
30
companies in the fall of 2007. The survey showed that 63 percent of these managers believed
that the stock market undervalued their business. This was despite 60 percent of them
believing that the market fairly valued the business in general. This is consistent with the
pecking order theory. Cohen and Yagil (2007) found that 72.5 percent of the managers
surveyed believed that their business was undervalued by the market. Graham and Harvey
(2001) also find that most businesses have a target gearing ratio, which is inconsistent with
the pecking order theory. Frank and Goyal (2003) tested the pecking order theory based on
what most businesses in the US actually did (not what managers perceived) over the period
1980 to 1998. They found that the businesses behaved exactly as expected in line with the
trade-off theory and not as expected if the pecking order theory was valid. Khan and Adom
(2015) replicated Frank and Goyal's study, but over the following ten years (1999 to 2009),
and reached a similar conclusion. They found no reluctance on the part of businesses to raise
equity finance. Bunn and Young (2004), who take a similar approach to Frank and Goyal but
use UK data, find clear support for the trade-off theory. Mehrotra, Mikkelson and Partch
(2005) analyze the behavior of 98 businesses in the US and conclude that they seem to act in a
manner consistent with trade-off theory, but not with pecking order theory. Barclay and Smith
(2005) found that businesses seem to have a target gearing ratio, which is in line with trade-
off theory. They also note that the US businesses they analyze appear to be prepared to
deviate from the target over a period of time, and appear to temporarily follow the rules of
pecking order theory. Beattie, Goodacre and Thomson (2006) surveyed a number of UK firms
and found that about half of the firms had a target gearing ratio, which is consistent with
trade-off theory. The other half do not follow the trade-off theory at all, or only partially
follow it; their behavior seems to be consistent with the pecking order theory. Cohen and
Yagil (2010) felt that the responses of the managers they surveyed showed support for the
pecking order theory. Specifically, they found that the frequency with which the firms raised
new finance from various sources was exactly as the theory predicted. That is, the most
frequent is retained earnings, followed by debt, and new share issuance comes last. Dang
(2013) reviewed evidence from the UK, France and Germany and found that businesses tend
to return to their target gearing ratios quickly and that their capital structure decisions seem to
be better explained by the trade-off theory than the pecking order.
Discussions of the two theories often suggest that they are strict alternatives; businesses
follow one or the other. On the contrary, evidence suggests that most businesses clearly
follow the trade-off theory and have target gearing ratios that reflect their individual view of
the trade-off. But this can often be overcome, at least in the short term, by
31
considerations that reflect pecking order theory. Tucker and Stoja (2011) found that for UK
businesses, trade-off and pecking order theories often go hand in hand, with retained earnings
typically used to return to target when additional debt increases have upset the balance.
11.13 POSSIBLE DETERMINANTS OF CAPITAL GEARING:
After reviewing the theory and evidence regarding capital gearing, we may be able to
summarize the factors that will influence business decisions regarding capital gearing. These
are:
❖
Cost of servicing capital. The prevailing interest rate will be a relevant factor.
❖
Tax rates. In the UK, and even more so in many other countries, there is a clear tax
advantage to paying £1 of interest on a loan over paying £1 of dividends.
This will generally encourage the use of debt financing.
❖
Tax capacity. Tax-deductible expenses have no value unless there is taxable income
against which they can be determined.
❖
Fluctuating sales revenues and/or high operating supplies. Any one of these factors, and in
particular a combination of them, could lead to
large fluctuations in the returns paid to common shareholders. This may expose
shareholders to an unacceptable level of risk in relation to the returns they earn. It may also
increase the risk of bankruptcy and related costs for shareholders.
❖
Nature of business assets. Businesses with assets of significantly greater value based on
'survival' as opposed to bankruptcy sales, i.e. business
with high potential bankruptcy costs, will most likely avoid high gearing levels.
❖
Reluctance to issue new shares. Businesses usually feel that the market undervalues their
shares and do not want to issue new shares at a price that is too high.
'undervalued'. There is also a fear that the market will perceive the share issuance as a last
resort, meaning that the business is in trouble.
❖
Capital raising costs. Most equity financing comes from retaining profits. Here the cost of
'issuance' is zero, while the issuance of
shares, even the issuance of shares, is relatively expensive. Debt financing tends to be
cheap to raise. Inevitably, these facts will influence most decisions regarding capital
gearing.
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11.14 MM, MODERN PORTFOLIO THEORY AND CAPM:
Before leaving the subject of capital gearing and its effect on WACC, perhaps we
should consider how this relates to modern portfolio theory in general, and capital asset
pricing models in particular. At the beginning of this chapter we have seen that the application
of capital gearing exposes ordinary shareholders to two types of risk, namely business risk
and financial risk. The question that now arises is how they relate to specific risk and
systematic risk.
We should recall from Chapter 7 that business risk has two components, the specific part
or can be diversified and the systematic part that must be borne by the investor. Image
11.1 illustrates the relationship between business risk and financial risk; it shows that financial
risk only adds to or accentuates business risk. Therefore, it makes sense that if business risks
are specific and systematic, then this is also true for financial risks. This means that, like
business risk, some financial risk can be diversified away; it also means that some of it cannot
be eliminated through diversification.
11.15 WEIGHTED AVERAGE COST OF CAPITAL REVISITED:
Towards the end of Chapter 10 it is said that there are two points about the use of
WACC that should be considered now.
Cost of capital elements of financing at different gearing levels
We have seen in this chapter that the cost of various elements of long-term finance
depends partly on the level of capital gearing. The basic principle of MM and traditional
models is that, as gearing increases, the cost of equity also increases. Whether we infer the
cost of capital using the traditional approach (based on market prices) or by using the CAPM,
the figures we calculate will be based on a particular level of gearing and, therefore, that level
of gearing will affect the deductible. If that gearing level is not the level relevant to the
investment under consideration, the WACC to be used as the discount rate should reflect the
difference in gearing levels. For example, the equity of a business may be calculated to have a
cost of 10 percent per annum. However, this requires a certain level of adjustment. Let's say in
this case we are talking about a business that is entirely equity, i.e. zero gearing. Suppose the
business borrows to fund a new project. This means that, all other things being equal, the cost
of equity will increase. If we now want to calculate the WACC to discount the estimated cash
flows of the new investment project, we have to adjust the cost of equity from 10 percent to
reflect the level of gearing before we do the weighted average.
33
Adjusted net present value:
Related to the previous point is the fact that we have the problem of running a positive
NPV project which will change the gearing level (unless the business is fully financed by
equity) and, therefore, the WACC. The value of a positive NPV project belongs entirely to the
shareholders and increases the value of the equity. This changes the WACC. This means that
the WACC used to deduce the NPV is wrong.
The problem is that until we can deduce the NPV, we don't know what the right
gearing ratio and WACC are. Without knowing the correct WACC, we cannot calculate the
correct NPV.
The most practical way to solve this problem is to summarize the NPV in two stages.
We first calculate the NPV under the assumption that the entire investment is financed by
equity and then, when we know the NPV on this basis, we adjust it for the tax impact of debt
financing. This is very similar (for good reason) to the relationship between directed and
undirected business value that appears above.
Capital (financial) gearing (CG):
⮚
CG means financing partly through fixed-yield financing (in practice, usually through
loans instead of preference shares).
⮚
Loans are relatively cheap because:
⮚
low risk for lenders;
⮚
tax deduction.
⮚
CG has the potential to increase shareholder returns.
⮚
CG has the effect of increasing the variability (risk) of returns to holders.
shares.
Traditional view:
•
Two reasons why borrowing becomes cheap leads to a decrease in WACC.
•
Shareholders and lenders are equally indifferent to the increased risk at lower gearing
levels.
•
As gearing increases, both groups start to worry - demanding higher yields - WACC
increases.
•
WACC decreases (equity value increases) with the introduction of gearing -
reaches minimum value - starts to increase again - optimal gearing level.
34
Modigliani and Miller (MM) view:
•
Shareholders are immediately concerned with gearing as it increases the range of their
possible returns.
•
Ignoring taxes, 'cheap' debt financing is offset by an increased cost of equity so the
WACC remains constant at all gearing levels - there is no optimal level - managers do
not need to think about gearing questions.
•
With taxes, interest rates are cheap enough to cause the WACC to fall even if the cost
of equity increases - the conclusion of all debt financing - makes no sense because in
practice, interest rates will increase at high gearing levels.
Modern view: trade-off theory
•
MM may be right that gearing is beneficial only because of tax breaks.
•
At high gearing levels, the cost of a business going into liquidation (bankruptcy) is
significant.
•
Generally well supported by evidence.
•
Conclusion: businesses should prepare for the point at which the benefits of tax relief
are balanced against the potential losses from bankruptcy - in which case the WACC is
at a minimum and the value of the business is at a maximum.
Pecking order theory
•
Managers are reluctant to issue new shares because:
•
Issuing shares has high issuance costs;
•
many managers believe that the market undervalues their business shares; and
•
Some managers believe that the market views share issuance as an act of desperation.
•
The main order of fundraising is:
1. retained earnings;
2. debt financing;
3. equity issues - as a last resort.
•
The pecking order theory can be seen as a constraint on the trade-off theory, rather
than a strict alternative to it.
•
Evidence from the pecking order theory shows that it is not widely applied as a
primary financing strategy, although it can survive in the short term.
