The Impact of Financing
1 Introduction
This chapter considers the fact that if a company changes the way in which it is financed (for example, raised more debt to finance a new project) then the cost of capital may change. This would of course affect the investment decision.
2 Modigliani And Miller
Modigliani and Miller did a lot of work on the effect of the financial structure of a company on the cost of capital.
You should already be aware of their conclusions from your previous studies, and you are not required to know their proofs – only their conclusions which are as follows:
2.1 M&M proposition without taxes:
M&M state that (ignoring tax) higher gearing will create more risk for shareholders and hence the cost of equity will increase, but that this is ‘compensated’ for by the fact that there is more debt which has a lower cost.
As a result, they stated that the weighted average cost of capital will stay constant for a company, however the company is financed.
2.2 M&M proposition with company taxes:
Debt interest gets tax relief, which makes the effective cost of debt to a company lower. As a result, even though the cost of equity will increase with higher gearing, the WACC will fall.
Therefore, a company should raise as much debt as possible.
They derived a formula for calculating how the cost of equity will change with changes in gearing. This formula is provided on the formula sheet in the examination, and is as follows:
where:
ke = cost of equity (of a geared company)
kie = cost of equity of the company if ungeared
Ve and Vd are the market values of equity and debt
Kd = pre-tax cost of debt
T = rate of corporation tax
London plc is an ungeared company with a cost of equity of 15%.
They propose raising debt at 8% (pre-tax) and have estimated that the resulting gearing ratio (debt:equity) will be 0.4.
The rate of corporation tax is 30%.
You are required to calculate:
the cost of equity after raising the debt, and
the weighted average cost of capital before and after raising the debt.
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3 Pecking order theory
Pecking order theory states that companies raise finance in the ‘easiest’ way (or the ‘law of least effort’) and that therefore they prefer to use internal funds (retained earnings) first, followed by debt finance, only raising new equity as a last resort.
4 Static trade-off theory
M&M proved that the WACC of a company will reduce as more debt is raised, and therefore a company should raise as much debt as possible.
However, their proof relies on many assumptions which are not completely realistic in real life (such as investors having perfect knowledge, and acting rationally with respect to risk).
Static trade-off theory states that the cost of equity certainly is likely to increase with higher gearing (although not necessarily in a predictable way) and that the cost of debt is certainly likely to be lower. However, because it is impossible in practice to estimate the changes precisely, all we can state it that the WACC is likely to change with different levels of gearing.
If the WACC is likely to change, then there must be a level of gearing at which the WACC is a minimum. The company should aim for this level of gearing and should then maintain this ‘optimum’ level of gearing. (The theory does not predict the ‘optimum’ level – this would be found by trial and error).
5 Adjusted Present Value
M&M stated that the only benefit of using debt (as opposed to equity) to finance a project was the fact that the company gains as a result of the tax saved on the debt interest (the tax shield).
We can use this to provide a way of calculating the gain from a project taking into account the method of financing used.
For adjusted present value calculations, there are two steps:
Calculate the NPV of the project if all equity financed (the ‘base case NPV)
Calculate the PV of the tax benefit on any debt used
The total of the two is the overall gain (or loss) to the company and is known as the Adjusted Present Value (APV).
A company is considering a project that has the following after-tax flows:
0 | (100M) |
1 – 5 | 40M p.a. |
The asset β of the project has been calculated as 1.5.
The market is giving a return of 15% and the risk free rate is 5%.
The rate of corporation tax is 30%
Calculate the gain to shareholders if the project is to be financed:
entirely from equity
70% from equity and 30% from irredeemable debt
70% from equity and 30% from debt redeemable in 5 years time.
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5.1 Other issues in calculating the Adjusted Present Value
Although the most important parts of the calculation are those mentioned above, there are two other matters that commonly occur in exam questions and need taking into account - issue costs and subsidised loans.
Issue costs:
If there are any issue costs mentioned in relation to the raising of the finance, then these need subtracting from the base-case NPV when arriving at the APV.
Subsidised loans:
It may be that the government of the relevant country is prepared to lend some or all of the debt finance required at a lower than normal rate. This subsidy is obviously beneficial and so in arriving at the APV we need to add the after-tax amount of the benefit (i.e. the difference between the normal borrowing rate and the subsidised rate) to the base-case NPV.