Is it possible to boost shareholder wealth by altering capital structure?
The first question to answer is what capital structure entails. A company’s capital structure refers to the combination of stock and debt financing it employs to finance its assets. Some businesses may be entirely funded by equity and have no debt, while others may have a low degree of equity and a large level of debt. The finance decision is the choice of what mix of stock and borrowed money to use.
The weighted average cost of capital is directly affected by the financing decision (WACC). The simple weighted average of the cost of equity and the cost of debt is known as the WACC. Because the weightings are proportional to the market values of equity and debt, the WACC will change as the proportions of equity and debt change. As a result, the first significant item to grasp is that as a company’s capital structure changes (i.e., the mix of equity and debt finance changes), its WACC will alter as well.
However, before we get into the nitty gritty of capital structure theory, you might be wondering how the financing decision (i.e., changing the capital structure) relates to the larger business goal of increasing shareholder wealth. The market value of a corporation is equal to the present value of its future cash flows discounted by its WACC, given the premise that wealth equals the present value of future cash flows discounted at the investors’ needed return.
It’s important to remember that the lower the WACC, the higher the company’s market value – as illustrated by the following simple example: when the WACC is 15%, the company’s market value is 667; when the WACC is 10%, the company’s market value rises to 1,000.
As a result, if we can adjust the capital structure to reduce the WACC, we can raise the company’s market value and hence boost shareholder wealth.
As a result, the hunt for the best capital structure becomes a race to find the lowest WACC, because the lower the WACC, the higher the company’s value/shareholder wealth. As a result, it is the responsibility of all finance managers to determine the best capital structure for the lowest WACC.
What mixture of equity and debt will result in the lowest WACC?
Because the WACC is a simple average of the cost of equity and the cost of debt, one’s natural reaction is to question which of the two components is the less expensive, and then to have more of the less expensive and less of the more expensive to lower the average of the two.
The explanation is that the cost of debt is less expensive than the cost of equity. Due to the lower risk of debt compared to equity, the required return to compensate debt investors is lower than the required return to compensate equity investors. Debt is less hazardous than equity since interest is frequently set and mandatory, and it is paid before profits, which are in fact optional. Another reason debt is less hazardous than equity is that, in the case of a liquidation, debt holders would receive their capital payback before shareholders since they are higher in the creditor hierarchy (the order in which creditors are paid out), whereas shares would be paid out last.
Because of the difference corporate tax treatment of interest and dividends, debt is also less expensive than equity from a company’s perspective. Interest is removed from the profit and loss statement before the tax is calculated, giving corporations tax benefit on interest. Dividends, on the other hand, are deducted after the tax is determined, therefore firms do not receive any tax relief on dividends. The cost to the corporation is $7 million if interest payments are $10 million and the tax rate is 30%. The fact that interest is tax deductible is a huge benefit.
Let’s get back to the subject of what stock and debt combination will result in the lowest WACC. The natural and instinctual answer is to ramp up by substituting part of the more expensive equity with less expensive debt in order to lower the average, or WACC. However, if more debt is issued (i.e., gearing is increased), more interest must be paid out of profits before dividends can be given to shareholders. The increased interest payment raises the volatility of dividend payments to shareholders since, even if the firm has a bad year, the increased interest payments must be made, which could affect the company’s capacity to pay dividends. This increase in the volatility of dividend payments to shareholders is sometimes referred to as an increase in shareholder financial risk. If the financial risk to shareholders increases, they will want a higher return to compensate them for the increased risk. As a result, the cost of equity will rise, causing the WACC to rise.
Because Keg is a function of beta equity, which encompasses both business and financial risk, when financial risk rises, beta equity rises, Keg rises, and WACC rises.
The fundamental question is whether the reduction in WACC produced by having a larger amount of cheaper debt or the increase in WACC generated by an increase in financial risk has a greater impact. To find an answer, we must look at the numerous hypotheses that have evolved over time in regard to this subject.
Can equity be cheaper than debt?
Companies desire the cheapest possible funding if all other factors are equal. Debt is usually always the better option because it is less expensive than equity.
Because interest paid on debt is tax deductible, and lenders’ expected returns are lower than equity investors’, debt is less expensive than stock (shareholders).
However, there are debt restraints and limitations – the company may be unable to exceed a specific Debt / EBITDA ratio, or it may be required to maintain an EBITDA / Interest ratio above a certain level.
As a result, you must first evaluate these limits to discover how much Debt a company may raise, or whether it must rely on Equity or a combination of Debt and Equity.
Why is the cost of equity always greater than the cost of debt?
Depending on who is engaged, the cost of equity refers to two different concepts. The cost of equity is the required rate of return on an equity investment if you are the investor. The cost of equity defines the required rate of return on a project or investment if you are the company.
A firm can raise capital in one of two ways: debt or equity. Debt is less expensive, but the corporation must repay it. Although equity does not have to be returned, the tax benefits of interest payments make it more expensive than borrowed capital. Because the cost of equity is higher than the cost of debt, it offers a higher rate of return.
Can debt be more than equity?
The debt-to-equity (D/E) ratio is a measure that shows how much debt a corporation has. In general, lenders and investors perceive a firm with a high D/E ratio to be a higher risk because it indicates that the company is borrowing to fund a major portion of its prospective growth. What constitutes a high ratio depends on a number of criteria, including the industry in which the company operates.
Why cost of debt is cheaper than cost of equity?
For numerous reasons, debt is less expensive than equity. The main reason for this is that debt is exempt from taxation. Interest is calculated on the debt based on earnings before interest and taxes. As a result, we pay lower income taxes than when using equity financing.
Is debt or equity better?
When it comes to debt vs. equity financing, the best option for you may differ depending on your present needs and ambitions.
In most cases, taking on debt financing is a better option than giving up equity in your company. You give up some—possibly all—control of your company when you give away equity. By involving investors, you’re also complicating future decision-making.
Taking on debt, on the other hand, is a very short-term strategy that keeps you in control of your company as long as you can pay off the debt and interest in full.
Is equity riskier than debt?
Many businesses have more debt than equity, but Google is an exception. Google is debt-free today. Is this, however, a good thing or a negative thing?
I (Joe) was recently facilitating a meeting with employees of a small business that had recently been acquired by a larger public company. Prior to the merger, the little business had no debt. “Why do we have debt in this new company?” the prior owner of the small firm inquired during the balance sheet discussion. “I despise debt.”
The majority of us are unconcerned about debt. Consumer debt is wreaking havoc on our economy, as we all know. So, why is debt beneficial to a business?
A corporation should use debt to finance a major percentage of its business for two reasons.
To begin with, the government incentivizes businesses to employ debt by enabling them to deduct debt interest from corporate income taxes. With a corporate tax rate of 35% (one of the highest in the world), that deduction is extremely appealing. After accounting for the tax advantage associated with interest, a company’s cost of debt is frequently less than 5%.
Second, debt is a considerably less expensive source of capital than stock. The fact that equity is riskier than debt is the first step. Because common shareholders are often not legally obligated to receive dividends, they expect a particular rate of return. Because the company is legally bound to pay the debt, it is far less hazardous for the investor. Furthermore, when a company goes bankrupt, shareholders (those who contributed the equity funds) are the first to lose their money. Finally, stock appreciation accounts for a large portion of return on equity, which necessitates sales, profit, and cash flow growth. Due to these dangers, an investor typically seeks a return of at least 10%, although debt can usually be found at a lower rate.
It would be illogical for a public firm to rely solely on its shareholders for funding. It’s a waste of time. Debt is a lower-cost source of capital that allows equity investors to earn a better return by leveraging their money.
So why not finance a company totally with borrowed money? Because taking on all of the debt, or even 90% of the debt, would be too hazardous for the lenders. To keep the average cost of capital low, a company must balance the use of debt and equity. The weighed average cost of capital, or WACC, is what we call it.
Returning to Google. It’s a roughly $22 billion firm that’s debt-free and inefficient. Google’s concern is that their cash flow and profit are so good that they can fund the company with retained earnings. However, as Google matures and its growth slows, I believe debt will become a more crucial source of funding.
How can cost of equity be reduced?
Lowering the cost of stock or changing the capital structure to include more debt are the most effective approaches to lower the WACC. Because the cost of stock reflects the risk of generating future net cash flow, lowering the company’s risk characteristics lowers the cost of equity.
What is the difference between cost of debt and cost of equity?
The rate of return expected by shareholders on their investment is known as the cost of equity. Bondholders demand a certain rate of return on their investment, which is known as the cost of debt.
How does debt affect cost of equity?
While there are various methods for calculating a company’s cost of equity, it is simply the amount of return a company must pay on its shares in the form of dividends and appreciation in order to entice investors to buy them and so support the company. It can also be considered as a gauge of the firm’s risk, since investors would demand a larger return on risky company shares in exchange for taking on more risk. The consequence of debt is to raise a company’s cost of equity because higher debt often leads to increased risk.
What if debt-to-equity ratio is less than 1?
A debt ratio of less than one indicates that the company has less than $1 in liabilities for every $1 in assets, indicating that it is theoretically “solvent.” When the debt-to-equity ratio is less than one, it means the owners have committed the remaining funds to purchase the company’s assets.
Why is equity over debt?
The term “equity financing” refers to money raised through the selling of stock. The primary advantage of equity financing is that funds are not required to be repaid. Equity finance, on the other hand, is not the “no-strings-attached” alternative it may appear to be.
Shareholders purchase stock with the expectation of owning a small portion of the company. The company is then accountable to its shareholders, who require constant profits in order to maintain a strong stock valuation and pay dividends. The cost of equity is generally higher than the cost of debt because equity financing carries a bigger risk for the investor than debt financing does for the lender.
What is the difference between equity and debt?
Debt securities imply a loan to the company, whereas equity securities indicate ownership in the company. Debt securities offer a predetermined return in the form of interest payments, whereas equity securities have variable returns in the form of dividends and capital gains.
