Issues with WACC and capital structure policy

1. CAPM

1. is then estimated

1. should be treated consistently in the net cash flows and in the cost of capital
2. project is evaluated after tax basis
3. *insert FORMULA

1. Determine the permanent source of capital the company utilises
   1. Debt

      Annotations:

      • - Bank overdraft - Money market loans - Commercial bills - Promissory notes - Bonds - Debentures - Unsecured notes - Mortgage loans - Finance leases - Term loans
   2. Equity

      Annotations:

      • - Ordinary shares - Preference shares - Retained earnings
2. Cost each component of capital are based on CURRENT conditions Historical value is irrelevant
   1. Calculate after tax cost of debt: after tax kd= before tax kd (1-te)
      1. te: effective company tax rate
   2. Calculate cost of equity
      1. CAPM
      2. DFC approach (Dividend Valuation Models)
3. Weight each component to determine the WACC (value each source of funds and total value of projects)
   1. Appropriate weights: the proportion that each source of funds represents of the total sources used to finance proposed projects
   2. Current capital structure can be used
      1. if cap structure is expected to change, use company's target capital structure
   3. Weight should be calculated using current market values rather than book values
      1. consistent with the way source of fund is calculated
      2. reflect the amounts investors can realize from selling the investment

Annotations:

• 1. Capital markets are perfect 2. Companies and individual can borrow at the same interest rate 3. There are no taxes 4. There are no cost associated woth the liquidation of a company 5. Companies have fixed investment policy so that investment decisions are not affected by financing decisions

1. Proposition 1 Conservation of Value
   1. The value of an asset remains the same, regardless of how the net operating CF generated by the asset are divided between different classes of investors
   2. Two firms with identical operating CF but different capital structures should have the same total value
   3. If one firm is more valued than the other(VL>VU)
      1. In a competitive market, investors will recognise the relative mispricing of shares in the two companies and will seek to make an arbitrage profit by selling shares in L and buying shares in U
      2. This will force the price of L down and price of U up until the mispricing is eliminted
2. Proposition 2 Conservation of Risk
   1. Firm value is expected cashflow/cost of capital
      1. ke>kd
      2. k is the weighted average of ke and kd
      3. So it follows therefore that we can decrease k by getting funds from a cheaper source (debt)
      4. By lowering k we increase the value of the firm
   2. The cost of equity of a levered firm ke=k0+(k0-kd)(D/E)
      1. k0= compensation for business risk
      2. (k0-kd)(D/E) is compensation for financial risk
      3. When debt increases total risk is conserved, but it is concentrated upon a smaller number of shareholders and hence required returns increases
   3. The introduction of relatively cheap debt into the firm's capital CF will not decrease cost of capital of the firm's CF nor the value of the firm
      1. Direct cost of debt (explicit): debt
      2. Indirect cost of debt (implicit): increased required return required by the shareholder

1. Leverage will increase firm value because interest on debt is a tax deductible expense resulting in an increase in the after tax net CF to investors
   1. PV of tax shield= tcD
2. M&M Proposition1 with taxes
   1. value of levered firm is equal to value of an unlevered firm of the same risk class plus the present value of the tax saving
      1. VL=VU+tcD
         1. k=ke(E/V)+kd(1-tc)(D/V)

1. The imputation system implies that firm income distributed as dividends is effectively taxed at the shareholder's marginal rate - just like interest income
   1. capital gains may be tax-advantaged for some investors
      1. t interest = t dividends t dividends > t cap gain hence, t interest >t cap gain
         1. There might be a tax-induced reason to issue equity rather than debt where shareholders generate their returns via capital gains

1. As debt increases, financial risk increases and thus the probability of default (bankruptcy or risk of financial distress also increases
   1. Debtholder bear realised bankruptcy costs
      1. Greater default probability, higher interest rate charged by debtholder
         1. Higher interest charged, lower leveraged
   2. Shareholder bear expected bankruptcy costs in the form of more expensive debt
2. The possibility of a tradeoff between opposing effects of benefits of debt finance and cost of financial distress may mean that optimal capital structure exists
   1. VL=VU+tcD-PV(expected bankruptcy costs)
      1. GRAPH! VERY IMPORTANT

1. Management's announcement of a new equity issue may be interpreted as a sign that management believes that its equity is overpriced
   1. cause a decrease in share price
      1. prefer debt than equity
         1. but debt involves transaction costs and open company to external scrutiny
            1. Preference for using retained earnings over debt finance
2. This theory does not lead to optimal cap structure
   1. Rather cap structure is reflection of the firm;s need for external finance
      1. It explains that
         1. negative inta-industry correlation between profitability and D/E
         2. Negative share price reaction on annonucement of equity issue

1. Companies with general used assets can borrow more than firm specific assets
2. Company with tangible assets are able to borrow more than the intangible assets

1. Unless CF is paid to investors, manager could destroy value
   1. Invest in -ve NPV
   2. Increase consumption of perquisites
   3. Increase leverage to soak up free CF

1. Asset substitution problem

   Annotations:

   • Shareholder in a company with outstanding debt own a call option on the assets of the company Call option values increase with increasing volatility
   • A company with outstanding debt may have an incentives to take higher risk projects, even the project may reduce overall market value of the firm
2. Underinvestment problem

   Annotations:

   • Firm close to bankruptcy may pass up +ve NPV projects because nobody will be willing to finance them
   • Existing s/h will not contribute equity as first gains from investing in +ve NPV projects accrue to debtholders New s/h will not buy equity at existing prices but require a substantial discount -Existing s/h will reject as their interest is diluted
3. knowing this debtholder will
   1. build into their required return compensation for any expected losses from this activity, making debt more expensive
   2. insist on restrictive lending condition that inhibit these activities