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EXCEL PROFESSIONAL INSTITUTE 3.3 ADVANCED FINANCIAL MANAGEMENT LECTURES SLIDES FREDERICK OWUSU PREMPEH

EXCEL PROFESSIONAL INSTITUTE Lecture 8 Theories of capital structure traditional and Modigliani and Miller (MM) & Adjusted present values

EXCEL PROFESSIONAL INSTITUTE Lecture 8 Theories of capital structure Traditional and Modigliani and Miller (MM)

Traditional View of WACC The traditional view is as follows. (a) As the level of gearing increases, the cost of debt remains unchanged up to a certain level of gearing. Beyond this level, the cost of debt will increase as interest cover falls, the amount of assets available for security falls and the risk of bankruptcy increases. (b) The cost of equity rises as the level of gearing increases and financial risk increases. (c) The WACC does not remain constant, but rather falls initially as the proportion of debt capital increases, and then begins to increase as the rising cost of equity (and possibly of debt) becomes more significant. (d) The optimum level of gearing is where the company's WACC is minimised.

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 lower cost of debt. As a result, they stated that the weighted average cost of capital will stay constant for a company, however the company is financed.

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. As a result, 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.

Example: 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: (a) the cost of equity after raising the debt, and (b) the weighted average cost of capital before and after raising the debt.

Pecking order theory starts 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. The preferred 'pecking order' for financing instruments is as follows. (a) Retained earnings. To avoid any unwanted signals, managers will try to finance as much as possible through internal funds. (b) Debt. When internal funds have been exhausted and there are still positive NPV opportunities, managers will use debt to finance any further projects until the company's debt capacity has been reached. Secured debt (which is less risky) should be issued first, followed by unsecured (risky) debt. (c) Equity. The 'finance of last resort' is the issue of equity.

EXCEL PROFESSIONAL INSTITUTE Adjusted Present Values (APV) method

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: (1) Calculate the NPV of the project if all equity financed (2) 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).

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: (1) Calculate the NPV of the project as if it s all equity financed to find base case NPV (2) 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).

Make sure you use the cost of debt to discount the tax relief on interest costs and not the cost of equity. Often in exams you will be given the risk-free rate of return. As tax relief is allowed by the Government and is almost certain, there is an argument for saying that all tax relief should be discounted at the risk-free rate. However, there is the opposing argument that the risk of the tax relief is the same as the risk of the debt to which it relates, and therefore the tax relief should be discounted at the cost of debt. The risk-free rate would also not be used if the company was unlikely to be in a taxpaying position for some years. In the exam we suggest that you make clear the reasons for choosing the discount rate that you have chosen to discount the tax relief, and add a comment that an alternative rate might be used.

Issue costs: The costs of issuing the finance needed for the project may also be brought into APV calculations. Issue cost is not discounted as it is assumed to be paid at time 0. Tax effect of issue costs = Tax rate Issue costs Discount rate Spare debt capacity: Projects may yield other incremental benefits, for example increased borrowing or debt capacity. These benefits should be included in the APV calculations, even if the debt capacity is utilised elsewhere. Subsidy: You may face a situation where a company can obtain finance at a lower interest rate than its normal cost of borrowing. In this situation you have to include in the APV calculation the tax shield effect of the cheaper finance and the effect of the saving in interest.

The main advantages of the APV are as follows. (a) APV can be used to evaluate all the effects of financing a product, including: (i) Tax shield (ii) Changing capital structure (iii) Any other relevant cost (b) When using APV you do not have to adjust the WACC using assumptions of perpetual risk-free debt.

The main difficulties with the APV technique are: (a)establishing a suitable cost of equity for the initial discounted cash flow (DCF) computation as if the project were all equity financed, and also establishing the all equity β (b) Identifying all the costs associated with the method of financing (c) Choosing the correct discount rates used to discount the costs

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