Cost of capital/ capital structure

Weighted average cost of capital (WACC)

The average post-tax cost of a company’s various sources of finance, weighted according to their relative market values. It represents the minimum return a firm must earn on its existing assets to satisfy its creditors and investors.

Three ways of estimating cost of equity

1) Capital Asset Pricing Model (CAPM)

2) Dividend Discount model

3) Bond yield plus risk premium

Assumptions of the CAPM (5)

-Investors are rational and risk-averse

-Investors have homogenous expectations

-Investors can all lend and borrow at the risk-free rate

-All assets are publically held and traded

-No transaction costs

Problems with the WACC

1) Project risk could be different to the whole firm risk

2) Markets may be volatile (ie beta instability, market risk premium could vary etc)

3) Hard to estimate beta

Defining Beta

Beta is a multiplier. If the market moves by 1%, Beta tells you what your stock is likely to do:

• Beta = 1.0: The stock moves exactly with the market.

• Beta = 2.0: The stock is twice as volatile (Market up 1% - > Stock up 2%).

• Beta = 0.5: The stock is a "defensive" play (Market up 1% - > Stock up 0.5%).

Beta instability

Company systematic risk is not constant over time, leading to instability.

For eg, COVID affected companies’ sensitivities to the market. Market returns were going down, but companies like zoom’s returns were going up. This would lead to a negative sensitivity, which we do not use.

M&M all assumptions

All parties can borrow and lend at the same risk free rate of interest

Investors are rational and risk-averse

There are no transaction costs (including financial distress costs)

There is no information asymmetry

There are no taxes (this is an unrealistic assumption)

M&M First theory of capital structure (1958)

TAXES NOT CONSIDERED

Proposition 1 - Firm value is not affected by leverege

V_L = V_U

Proposition 2 - Leverage increases shareholders’ risk and return

r_E = r_U + (r_U - r_D) x D/E

M&M Second theory of capital structure (1958)

TAXES CONSIDERED

Proposition 1 - Firm value increases with leverage. For permanent debt:

V_L = V_U + T_CD

Proposition 2 - Some of the increase in equity risk and return is offset by interest tax shield

r_E = r_U + (r_U - r_D)(1 - T_C) x D/E

> Essentially, the cost of equity is reduced when the company is levered due to interest tax shield

Which assumption of the M&M theories does the static trade-off theory have relax?

No financial distress costs

Types of financial distress costs

Direct costs:

-Legal and administrative costs (prettly low cost with respect to a firm’s value though)

Indirect costs:

-Lost sales (maybe due to discounting etc)

-Asset at liquidation are only worth a small amount

-Loss of employees, and would be hard to recruit into a financially distressed firm

-Suppliers more cautious

-Lenders require a higher return

Static Trade-off theory

There is a trade-off between the tax advantage of debt and the costs of financial distress - basically a company will leverage as much as it can to benefit from tax shields (before hitting financial distress costs)

Evidence for and against the trade-off theory

For:

Firms with intangible assets tend to borrow less, because they have less collateral, meaning their financial distress costs could be higher, and this is clear evidence of firms sacrificing some tax shield to reduce financial distress costs (perfectly matching the definition of the tradeoff theory).

Against:

There is still some evidence of firms that could take a greater advantage of tax-shielding to get a better trade-off between the benefits and costs of leveraging, not doing so.

There is also evidence that the profitable companies don’t have much debt (which is most likely due to them not needing it because they can use their own cash), which also goes against the idea that a company will borrow as much as it can before attaining financial distress costs - This is direct evidence for the Pecking order Theory

Pecking order theory (prediction)

There is no optimal debt ratio, instead firms will follow the pecking order.

Equity is both at the top (in the form of retained earnings) and at the bottom (issuing shares). This is because managers think that they are giving less away (everything looks fine to investors) when they use retained earnings, and look desperate when they sell shares.

The market “knows” a firm only issues equity if managers feel it is overvalued

Pecking order Theory (order)

1) Firms prefer internal financing

2) After this they prefer debt

3) Firms will use safe debt first then most likely move to hybrids

4) Then equity would be a last resort

Which assumption of the M&M theories does the pecking order theory have relax

No information Assymetry (assumes information assymetry when the CEO knows something and does something like raising equity)

Evidence For and Against the Pecking order theory

For:

More profitable firms tend to borrow less, due to having the cash (in retained earnings) without the need for debt. This goes against the static trade-off theory

Against:

Small, high-growth firms still rely on external financing (equity financing) rather than debt. There could be behavoural reasons for coming to market

Basically the opposite to the trade off theory for and against

Agency Theory - free cash flows

Profitable, mature firms with few growth opportunities should issue debt if they need financing.

This is because:

A manager of a company with free cash flow (from equity) might just waste this money that is just sitting there. Raising debt might help discipline managers, keep them under some pressure to not waste all this money because it needs to be paid back, and with interest.

Market timing theory

There is no “optimal structure”, but a manager can ‘tell’ when their firm is overvalued or undervalued, and the capital structure at a given time will depend on this.

So when the firm is currently overvalued, it will sell shares (becuase the manager knows they can sell shares for more), thus raising equity.

When the manager recognises that the firm is undervalued, it either repurchases shares, or raises debt for financing, rather than trying to raise equity but not being able to sell those shares for much.

Stakeholder Theory

The theory suggests that the relative importance of stakeholder groups will have an impact on the financing decisions of companies.

For eg, companies that are more leveraged are more likely to lay off employees (which are technically stakeholders), so employees might avoid more highly leveraged companies for this reason. A company whose employees are an important stakeholder group should not have too much debt. This is Cornell and Shapiro’s findings.

In terms of customers and suppliers: Companies offering more long-term producs (like cars or computers) must maintain financial stability. Customers won’t buy their car on finance from a company if it is in major debt and financial distress, regardless of the tax-relief - customers and suppliers don’t care about that. Companies selling short term items like food, drinks, clothes, don’t tend to have customers that care about the longevity of the business, so it is less of an issue, and they can leverage much more, with favourable terms.

Evidence for Stakeholder Theory

There is evidence for stakeholder theory. For example, companies in the US selling semiconductors, computer software, machinery etc, all have low book debt ratios. Clothing, retail and telecoms all have much higher book debt ratios. This is clear evidence of Stakeholder Theory

Public Sector Organisations

Have no shareholders (just the government)

Can take on debt from bank loans, bonds etc

Debt financing and repayment schedule may match funding needs (for eg a government-backed company making a bridge that will last 50 years can take out a 50-year bond or loan and use the money to pay for the initial construction and pay it back gradually over those 50 years)

If the company is regarded as safe, then high debt can be supported, the worst that can happen is that the organisation can be ‘re-purposed’ if it gets into difficulty .