FINANCING DECISIONS

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Business and Financial Risk

To repeat some of the material from the section on financial analysis; risk creation and management is the mechanism by which corporate or personal wealth is enhanced or destroyed. Without risk there is no return other than that available from Treasury Bills which is as close as we can get to a risk free rate of return. Business or operational risk comes from being in business and is created when new assets, products or markets are acquired by the firm. The most common analytical approach is to calculate a breakeven point where the firm estimates the minimum level of sales needed to cover fixed operating costs and leave them "breaking even" or not losing money. A favorite presentation tool is a breakeven chart although there are limits to its applicability across wide ranges of sales levels.

Financing risk considers the fixed costs and repayment constraints of debt and how it changes the risk/return tradeoff of the equity investor. An all equity firm has a different financial risk profile than a firm using a combination of debt and equity financing. The all equity firm has the luxury of not being required to meet interest obligations should the operating activities of the firm be unsatisfactory. The tradeoff, however, is that they are limited to acquiring only those assets they can finance with equity funds which is likely to mean a lower level of asset investment and associated cash flows relative to a firm willing to accept the risk of borrowing. The accepted analytical tool is the EBIT/EPS chart which simply compares the EPS (Earnings Per Share) under one financing alternative relative to another financing strategy at different levels of EBIT (Earnings Before Interest and Tax). The chart does not address the risk issue in any way nor does it account for the reality that financing costs change as financial risk changes, but it is a start.

In the United States, we refer to operating risk analysis as measuring the "operating leverage" and the financial risk analysis as "financial leverage". In most other countries, it is referred to by the label of "gearing" rather than leverage. The basic premise is the same; what is the effect of a change in sales on EBIT in the case of operational gearing and what is the effect of a change in EBIT on Net Income with financial gearing. If you visualize the sprockets on a bicycle; the front chain ring is larger and carries more teeth than the rear or driven sprocket. The relative difference between the number of teeth on the two sprockets is referred to as gearing; the higher the gear, the faster the bicycle will travel for a given foot speed rotation and the lower the gear, the more able the cyclist is to climb steep hills. The same is true of business; the higher the level of operating gearing, the greater the change in EBIT for a given change in sales. The gearing relationship is also valid for the financial activities in that higher gearing carries more effect. Unlike a bicycle, however, business can employ the same amount of gearing in reverse as it does going forward. If the firm utilizes a high degree of operational gearing and sales decline, it will accelerate the decline in EBIT. The same holds true for the financial gearing in that higher gears mean a greater drop in net income for a given decline in EBIT. The two measures can easily be combined in a measure of total firm gearing (DCL or Degree of Combined Leverage) wherein you can estimate the percentage change in net income for a given percentage change in sales simply by multiplying the combined gear ratio times the change in sales. The only problem with looking at total gearing for the firm is that you aren't completely sure which form of risk is driving the result. Gearing is great fun when things are going well and sales are rising; it is great misery when applied to sales declines. In many respects, the label "gearing" is much clearer than the label of "leverage" which we commonly use in this country, but the concepts are identical.

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Capital Structure Theory:

This is probably the most discussed aspect of modern corporate finance if you take the number of finance text chapters and finance journal articles as a measure of activity. It is not clear that it deserves quite so much attention since the capital markets are dramatically more "efficient" than the market for corporate assets so it is reasonable to surmise that most financing decisions are made in a highly competitive atmosphere where it takes some real effort to get it wrong! Debt and equity capital suppliers tend to be extremely self interest motivated and typically have a great many investment alternatives from which to choose so it is unlikely are easily fooled by claims of higher potential return or lower potential risks. Nevertheless, understanding the basics of financing the firm or developing its capital structure is essential to managing assets since most firms must seek financing in order to acquire the assets needed to be successful.

(As a side note: You need to appreciate that academic careers rise and fall on the basis of publications. In today's research environment, the relevance of the topic or findings is of less importance than the quality of the statistical measures employed and the depth of the data set used for the analysis. Since securities are traded in an open capital market, the data is readily available which means it is possible to develop a data set upon which to perform an analysis and develop a publishable article or paper. The same is not true of corporate asset investments since most firms are hesitant to provide proprietary information to a researcher who may, in turn, be tempted to reveal it to competitors even if they promise anonymity in the published work. Therefore, a great deal of academic research in the area of finance is focused on the capital markets and how it relates to the firm rather than being focused on the more critical managerial issues of how to find and select rewarding investments.)

It is worth establishing at an early point that "financing does not create firm value"! Value is derived from cash flows generated by the assets held by the firm and how well they are managed whether those assets be physical or human in nature. You would not pay more for a new home than its market value regardless of how it was financed by the seller. You will be using your own financing mechanism whether that be a significant equity investment or a substantial mortgage so the financing decisions made by the seller have no relevance to you. Financing strategies in a corporation determine how the "pie" or asset values and associated cash flows are distributed among the various funds suppliers, but does not in itself create value. Financing may facilitate the acquisition of more or better assets which, in turn, may enhance cash flows but those flows come from the assets and not from the financing.

We make the assumption that we operate in a relatively efficient market where competition and self interest insure that risks and returns are properly priced into debt and equity securities. In other words, no one is going to offer you excess returns without taking commensurate risks unless there is a glitch in the market which you can quickly exploit before it is discovered and instantly erased by all other market participants. The traditional definitions of market efficiency are:

It is obvious that strong form efficiency is unlikely to ever exist since it would say that all investors are equally well informed as management inside the firm. First, there is the issue that providing all of the company's trade secrets, etc. would destroy its competitive advantage since competitors would also know exactly what is being done inside the firm. Second, how can a manager justify a salary beyond minimum wage since they would not know anything not already known by everyone else? Self interest insures that management will always have some information it is not sharing with the rest of the world since that is how they create corporate and personal value.

The U.S. capital market is generally regarded as being semi-strong efficient and much of the recent concern with insider trading and other corporate scandals goes to the issue of protecting that efficiency. If market participants become convinced that "the game is rigged" in the sense that they have no hope of ever winning, they would rationally cease to play and our access to capital for new companies and new products would come to a screeching halt. Our capital market is the envy of many parts of the world where new businesses and new approaches cannot obtain funding without the right political or family connections. Capital is allocated in those environments according to the personal preferences of those controlling the capital rather than being allocated to the best use which is the case in a functioning, open market. We may not always agree that every product in the marketplace was worth funding, but unless the market remains open and relatively efficient there is no way to insure access for those projects that are worth funding.

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WACC

The weighted average cost of capital (WACC) is a measure of the current price of funds supplied to a firm based on the market rates of return for their debt and equity. Assuming a rational market (which it ultimately turns out to be), the market price of funds supplied to the firm reflects the market's perception of risks being taken by the firm relative to similar companies taking similar risks. An efficient market would not allow a firm to have a funds cost different from other market participants taking similar risks since market traders would instantly take advantage of the discrepancy and it would disappear. Therefore, we look to the market's expected return on holding debt or equity securities for a given firm as a measure of its "cost" to the company. Looking back to our discussion of capital budgeting, the WACC becomes the minimum acceptable return on our investments since earning less would disappoint funds suppliers and they react badly when disappointed. There are some conceptual problems in that the weighted average cost of capital is based on risks associated with existing assets of the firm and its current operating strategy. If new investments change that risk significantly, the WACC would also change but it is difficult to predict the market's reaction to such changes. Using a WACC based on current funds costs as a discount rate for assets with different risks than existing assets can lead to problems. More on this subject later...........

The WACC is computed largely as its label implies; it is a weighted average of the after tax cost of funds supplied in the form of debt or equity. For example, look at a firm with the following capital structure:

Begin by determining the market value based proportions supplied by each source of funds:

Source
Market Value
Proportion
Debt
$2,500,000
33.33%
Preferred
$1,500,000
20.00%
Common
$3,500,000
46.67%
Total
$7,500,000
100.0%

Then, determine the after tax cost of each source of funds based on the market based before tax cost. Note that equity is already in after tax mode since it is not tax deductible for the firm. (Yes, there are some interesting quirks relative to preferred stock dividends on shares held by a parent company, but we are ignoring those little tweaks at this point.) Therefore, the only adjustment needed in this example would be to account for the tax deductibility of debt interest which we can easily find by multiplying the before tax cost of debt times (1-tax rate) to determine the after tax cost to the firm. Using the debt cost and tax rate from above: [7.5% * (1-.34)] = [7.5% * .66] = 4.95% after tax cost for debt.

Combine the proportions with the after tax costs to arrive at the weighted average cost of capital (WACC):

Source
Proportion
 
After Tax Cost
 
Weighted After Tax Cost
 
Debt
33.33%
*
4.95%
=
1.65%
 
Preferred
20.00%
*
8.50%
=
1.70%
 
Common
46.67%
*
10.25%
=
4.78%
 
WACC
     
8.13%
 

Note that proportions and costs are based on current values for debt and equity. The calculation of the WACC is primarily done in order to estimate the current cost of funds as a part of the effort to make good investment choices going forward. The fact that you were able to borrow money at a lower interest cost at some point in the past is of no relevance since those funds are already spent and any new debt obtained for new assets would carry the current market rate. Therefore, we are looking for the current interest rate on debt acquired today. It can be estimated by calculating the yield to maturity using current prices of existing debt or a firm might estimate what lenders would charge if they were to borrow money today. The book value of debt may not be the correct value to use in estimating proportions if the current cost of debt is different from the historical cost. Remember that prices and rates are inversely related. Market rates on debt are typically stated in before tax terms since that is the basis upon which it is issued so the firm adjusts for its own particular marginal tax rate in order to find the after tax cost.

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Costing Equity Sources of Funds

Finding the "cost" of equity is somewhat more challenging since we do not have the advantage of a contract with a stated cost as would be the case with debt. Instead, we are taking data from the marketplace and imputing or estimating a cost based upon the premise that shareholders are rational and always act in their own self interest. The current market prices of common and preferred stock should reflect the present value of expected future rewards from holding either of those two classes of equity and we use that information to estimate what expected return the shareholder must have wanted when setting the current market price.

Preferred stock will provide an annual cash flow to the investor equal to the stated dividend rate times the par value of the preferred shares. In most cases, the par value of preferred stock is $100.00 so a dividend rate of 7.5% would indicate an annual dividend of $7.50. Dividing this annual cash flow by a current market price of $88.24 would yield the a current preferred stock "cost" of 8.5%. If the firm were to issue $100.00 par value preferred in today's market, it would presumably have to offer a stated dividend rate of 8.5% since that is the current required return on preferred stock bearing this level of risk. Note that the preferred stock cost is found by dividing the contractual dividend by the current market price of those shares. Since we know that market price, we can easily find the total market value of preferred stock by multiplying the market price per share times the number of preferred shares outstanding.

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Dividend Growth or "Gordon" Model:

Common stock is more challenging still to "cost" since there is no contractual obligation for a dividend to be paid on these shares. One of the older but still valid models for pricing common is called the dividend or "Gordon" or constant growth model. (The "Gordon" label refers to Myron Gordon who was the author of the original academic article postulating this model.) The model is relatively straightforward in concept; it simply states that current common stock prices reflect the expected present value of future cash dividends to be received by investors. Since it is likely that dividends or the capacity to pay dividends will grow over time, it incorporates a growth expectation.

This model has currently been supplanted by the more popular Capital Asset Pricing Model (CAPM), but still has an important role to play both as a sanity check on the results from the CAPM and for use in firms not using the public equity market due to being closely held and non-traded equity where no market price exists. Instead, the user would substitue an estimated market value if the firm were to be sold to another buyer. Note that inflating this estimated market value will result in a lower estimate of equity cost which could easily lead to making inappropriate investment decisions due to an artificially low cost of funds. Therefore, estimating the current market value of the firm is not a good place to allow egos to run wild; we are trying to make good future business decisions rather than pump up estimated personal worth!

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Capital Asset Pricing Model (CAPM):

The currently more popular model for "costing" common stock is called the Capital Asset Pricing Model or CAPM . It has been developed as a part of modern portfolio theory and is appropriate for those firms with publicly traded shares or non-traded firms who can find and substitute a traded firm with similar risk characteristics in the same industry as a 'proxy' for them were they themselves to be a traded stock. The basic premise is that a rational investor can always obtain the risk free rate of return through the purchase of risk free Treasury securities whether they be short T-Bills or longer T-Bonds. In order to induce these investors to take the additional risk associated with owning equity shares, they must be paid a market premium or return in excess of the risk free rate. If they were to hold a perfectly diversified portfolio of stock (not a difficult task), they would earn the average market rate of return. Subtracting the risk free rate from the market rate of return would tell you the expected additional return or market premium obtained by moving from risk free securities to a diversified portfolio of common stock. Historically over the past 75+ years, this premium has been averaging approximately 7 to 8% per year above the 90 day Treasury Bill rate. This is an arithmetic average and will likely not apply perfectly at any given moment in time, but it is a good approximation of what a long term equity investor should expect to obtain from a diversified portfolio of common shares.The full set of data can be found at this site: Historical Returns. The data comes from the Federal Reserve Bank of St. Louis and is arranged in the format shown to provide it to interested students of this subject. Exploring the data is worthwhile since it will make it painfully obvious that the average rate of return is made up of some dramatic highs and lows in the stock market. You cannot earn the average return without being a consistent participant in the market, but an additional return of 7.3% per year compounded over time provides a compelling motivation to hold shares of common stock.

The CAPM therefore says you should earn the risk free return plus a market premium if you hold a diversified portfolio of common stock. An individual company, however, is not a diversified portfolio so your market premium or reward for the risk of holding common stock needs to be adjusted for the added risk imposed by holding a single stock. This added risk is measured by comparing the volatility of an individual stock to the volatility of the overall stock market using a statistical measure called "beta". A beta can be easily computed using regression analysis or, more likely, using the computed beta from a variety of public sources. Value Line, for example, computes and publishes a beta for each stock in its reports or you can use the Internet to find one. A commonly used source is Yahoo Finance where you enter the stock symbol for any particular company, click on "More Key Statistics" and the beta will be shown as one of those statistics. There are other similar services, but the estimated beta is typically similar although slight differences will always exist since different sources would look at volatility over different time periods. Since we are doing all of this to estimate the cost of common stock in a WACC which will, in turn, be applied as a discount rate on estimated future cash flows of new asset investments, it is not clear that becoming obsessed over the exact beta number is particularly rewarding. A beta greater than 1.0 simply says that historically this company is more volatile than the overall market and a beta below 1.0 means it has been less volatile than the market as a whole. Large and diversified firms tend to have a beta fairly close to 1.0 since the company has been configured to be relatively stable which means it is likely to have a share price that roughly tracks the overall economy and stock market up and down.

For example, the following beta numbers were found in late August, 2013 for some participants in the commercial banking sector:

 
52 wk. price range
Beta
Bank of America
$7.83 - $15.03
2.11
Citigroup
$29.20 - $53.56
2.13
J.P. Morgan Chase
$36.71 - $56.93
1.80
U.S. Bancorp
$30.96 - $37.97
.89
Wells Fargo
$31.25 - $44.79
1.06
S & P 500
1343.35 - 1709.67
1.00

At the time this information was obtained, the 90 day Treasury Bill rate was .03%. Employing that rate as the risk free rate and using 7.3% as an average market premium (market return less risk free rate) , the following expected returns would be determined using the CAPM:

 
Beta
Expected Return
Bank of America
2.11
16.52%
Citigroup
2.13
16.68%
J.P. Morgan Chase
1.80
14.09%
U.S. Bancorp
.89
6.97%
Wells Fargo
1.06
8.30%
Market
1.0
7.83%

Thus ends the premise that large banks are less risky than the overall market! Seriously, the market is simply stating that some banks are currently demonstrating a relatively high degree of stock price volatility in comparison to the overall market and investors in those stocks should demand a higher return for the increased volatility associated with some of the current events in the credit markets. The CAPM is based on the premise that risk and return are related in a long term market although daily fluctuations outside these estimates are to be expected.

The numbers were calculated using the CAPM formula:

The price range data has been included to indicate that while interesting, it is not a very good beta predictor since the beta measures changes in a given stock relative to changes in the market as a whole calculated on a frequent basis over a period of time. A stock could vary within a relatively narrow price range, but if it did so with more pronouced changes relative to changes in the overall market on a consistent basis, the beta would be relatively high. The beta we observe reflects the firm's existing business and financial risk. In the data above, some of the banks have dealt with significant mortgage or related investment issues during the past year which created price volatility while investors sorted out the impact of the new information. Using a historical beta to predict future returns implies that you believe the same volatility factors will remain in force during the forecast period.

Beta's above 1.0 are considered by some investors to be aggressive in that the price of the stock is moving in the same direction as the market but in a more pronounced manner. Beta's below 1.0 would be considered defensive in that they will move in the same direction as the market but not as much which is beneficial in a declining market. Of course, combining stocks with opposing beta values can result in a more diversified portfolio and the overall portfolio beta will trend toward 1.0. The same is true of large companies with diversified product lines since their overall cash flows tend to be relatively smooth over time and more closely approximate those of a diversified portfolio.

Using the CAPM to estimate equity costs requires that you accept some assumptions:

  1. Markets are efficient and investors are economically rational
  2. The firm will demonstrate the same volatility in the future as in the period used to calculate the beta
  3. All significant factors that influence share price and related return are captured by the beta
  4. The equity you are pricing is traded in the public market or you can find a proxy of similar risk/return

These are heroic assumptions so I would not obsess over the level of mathematical precision employed in the calculations. You are simply attempting to establish the parameters of what a reasonable shareholder would expect to earn on their investment given the known risk/return tradeoffs. Asking the CAPM model to do much more is pushing it further than it was ever really intended to go. We know that we need a reasonable estimate of equity cost in order to determine the WACC for the firm and we are trying to establish that cost as accurately as possible. However, we have to accept the reality that the result will be applied to decisions about an uncertain future.

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