Corporate Financial Strategy

A Few* Selected Issues Relating to Your Assigned Reading

Week 3, Leverage and WACC

MSIN3017/ MSINM013- Lecture Slides Set 1 of 2

*KIND REMINDER (Repeating from Wk 1 first Lec of 2, Orientation): Each Week’s Lecture Slides and
accompanying commentary provide greater depth to no more than 4-5 issues or concepts associated with this
week or last week’s assigned reading. To repeat, by deliberate design, lecture slides and accompanying in-lecture
explanation do NOT cover ALL of the areas for which you are responsible.
 YOUR Checklist for Full Success in CFS– Also per Week 1:
As assignments are
‘FULL’ each week starting
Anything missing from YOUR preparation? Wk 2, distraction of
scrambling to ‘catch up’
may hinder you in the NEW
week’s key understandings!

q  You keep up with ALL assigned readings (notes, outlines as you read
recommended), understanding that lecture slides are deliberately NOT
designed as a substitute for the assignments.

q  In class, you take your own careful lecture note of both lecture commentary,
illustrations, BOTH to deepen your understanding of key concepts
addressed in this course, AND because of your recognition that in-class
commentary has traditionally represented 20+% of the final exam content.

q  You do NOT merely ‘show up and listen’ for the one-hour weekly
workshops; instead, you are fully prepared and attempt to actively
participate each and every week.*

*Given the number of attendees in each workshops, this obviously isn’t always possible, 2
but prepare fully– This is to your benefit!
Today’s Lecture Topics: Agenda

1.  From last week: How adding debt exaggerates investment (CAPEX)
consequences, both good and bad

2. Theoretical foundations of corporate leverage management

3. Getting ‘WACC’d’: Two component blended financing- costs, issues

4. Fact versus fallacy in leverage management

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FIRST, A FEW DEFINITIONS:

Cash Flow (CF): The basic measure of whether or not a company is creating value for
its owners. Simple version: NOPAT + DEPR + A

Discounted Cash Flow (DCF): CFs (above) calculated on present value (PV) basis,
with a rate based on analysed company WACC (below) often being that ‘discounting’
rate.

Free Cash Flow (FCF) simple version: CF – investment (i) outlay for that period.
Closely related to CF, this is a recurring measure of company performance in value
terms, such as cited in Stern 1974 (Earnings Per Share Don’t Count)

Net Operating Profit After Tax (NOPAT): Reported Net Income, but excluding any
non-continuing sources, extraordinary income or financing-derived gains or losses

Weighed Average Cost of Capital (WACC): Commonly used as the discounting rate
for DCF determination (above), this is typically calculated as the AT Cost of Debt x
Debt as % Total Capital (D+E) + CofE x Equity as % of Total Capital

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Revisiting Week 1’s CFO BEST Operating Performance Measure Issue:

ROE and Similar Ratios* Have Considerable Support as the Financial Performance
Measure of Choice for FDs and Thus for Their Firms

•  Denominator “E”: Consistent With MSV

•  Returns-based Numerators: Consistent with fundamentalist’s view that company

worth is primarily generated from ongoing operations.

•  Evolution From ROA: Prior to the beginning of the High Leverage Era, returns on
assets predominated. Gradual shift towards ‘below the line’ numerator after 1982 not
a surprise.

•  Limitations of Engineered Alternatives, Particularly EP: Asset-dependent

measures encounter difficulties with services revenue, particularly fees. Metric-of-the-
month: consider the consultants’ business model.

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*ROE= NI/E. Similars: CFROE, CFROI, EBITDA/CAP etc.
After Tax Cost of Debt is Almost Always MUCH Cheaper Than Cost of
Equity…

BECAUSE of characteristics of debt (borrowing):

1.  Tax shelter benefit of interest deductibility

2.  Priority of debt by seniority in liquidation under bankruptcy statutes

3.  Bond holders have NO rights to dividends, other share-related

distributions, and they do not benefit from appreciation of the subject
company’s share price

However, extreme overgearing both (1) amplifies corporate losses resulting

from poor and/or mistimed expansion or investment decisions (per last weeks
W/S), and (2) high gearing per se can destabilise the firm.
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 1.
FROM LAST WEEK (and Two
Sides of Leverage W/S) DEBT
EXAGGERATES THE
FINANCIAL CONSEQUENCES
OF INVESTMENT DECISIONS,
either good or bad!

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DEBT: Advantages to Borrower (loan) / Issuing Company (Co. bond)…
Usually less than half the cost of equity, on an AT basis
WHY? FOR WHAT THREE REASONS?

As a result of (1) usually (a) reduces the cost of capital and thus (b) increases the
company’s worth, AOTBE

When used in place of equity, reduces DILUTION

When ADDED to the company’s financing, can help support growth-investment w/ a

particularly wide marginal return-to-financing spread, or differential

Extensive: ~78% today (in West) v. ~30% in early 1980s

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Extreme Gearing Brings Opportunities…. But Also Related Drawbacks
1)  Usually less than half the cost of equity, on
an AT basis.
2)  As a result of (1) usually (a) reduces the
cost of capital and thus (b) increases the
company’s worth, AOTBE
3)  When used in place of equity, reduces
DILUTION
4)  When ADDED to the company’s financing,
can help support growth-investment w/ a
particularly wide marginal return-to-
financing spread, or differential
5)  Extensive: ~78% today v. ~30% in early
1980s
Threat of bankruptcy caused by default
on major loans, borrowings
CofC benefits reduced, even reversed if
Financial market perceives material
increase In financial and/or operational
risk, and that is reflected in CofE
Sometimes, inability to fully finance
investment required to stay competitive
because of debt-servicing priority
May decrease Co.’s credit/bond rating
AND IF THE EXTRA FUNDS OBTAINED
FROM NEW BORROWINGS ARE
APPLIED UNPROFITABLY, CORPORATE
LOSSES ARE MUCH GREATER THAN IF
THE FIRM HAD NOT ‘GEARED UP’ ITS
INVESTMENT…
9
 high

Equity (ROE)
Return
on… theorhetical

actual

Assets (ROA)

low high
Gearing level

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SCENARIO  2:  DEBT  ADDED,  10%  RETURN  PER  ADDED  DEBT   LAST WEEK’S 2nd
Lec SET:WARM-UP TO
EQUITY  CONSTANT  AT  10,000   2 SIDES OF LEVERAGE W/S

NI  (PAT)   A   ROA   E   ROE   D   D/E   D/C  

100   10,000   0.0100   10,000   0.0100   0   0   0  

300   12,000   0.0250   10,000   0.0300   2,000   0.20   0.17  

500   14,000   0.0357   10,000   0.0500   4,000   0.40   0.29  

700   16,000   0.0438   10,000   0.0700   6,000   0.60   0.38  

900   18,000   0.0500   10,000   0.0900   8,000   0.80   0.44  

1,100   20,000   0.0550   10,000   0.1100   10,000   1.00   0.50  

1,620   25,200   0.0643   10,000   0.1620   15,200   1.52   0.60  

2,400   33,000   0.0727   10,000   0.2400   23,000   2.30   0.70  

3,670   45,700   0.0803   10,000   0.3670   35,700   3.57   0.78  

5,600   65,000   0.0862   10,000   0.5600   55,000   5.50   0.85  

14,700   156,000   0.0942   10,000   1.4700   146,000   14.60   0.94  

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SCENARIO  3:  SAME  DEBT  ADDED  AS  SCENARIO  2,  BUT  ADDITIONS  LOSE  10%  RETURN  PER  ADDED  DEBT  
EQUITY  CONSTANT  AT  10,000  
NI  (PAT)   A   ROA   E   ROE   D   D/E   D/C  

100   10,000   0.0100   10,000   0.0100   0   0   0  

-­‐100   12,000   -­‐0.0083   10,000   -­‐0.0100   2,000   0.20   0.17  
-­‐300   14,000   -­‐0.0214   10,000   -­‐0.0300   4,000   0.40   0.29  
-­‐500   16,000   -­‐0.0313   10,000   -­‐0.0500   6,000   0.60   0.38  
-­‐700   18,000   -­‐0.0389   10,000   -­‐0.0700   8,000   0.80   0.44  
-­‐900   20,000   -­‐0.0450   10,000   -­‐0.0900   10,000   1.00   0.50  
-­‐1,420   25,200   -­‐0.0563   10,000   -­‐0.1420   15,200   1.52   0.60  
-­‐2,200   33,000   -­‐0.0667   10,000   -­‐0.2200   23,000   2.30   0.70  
-­‐3,470   45,700   -­‐0.0759   10,000   -­‐0.3470   35,700   3.57   0.78  
-­‐5,400   65,000   -­‐0.0831   10,000   -­‐0.5400   55,000   5.50   0.85  
-­‐14,500   156,000   -­‐0.0929   10,000   -­‐1.4500   146,000   14.60   0.94  

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 2.
Some leverage theoretical
foundations

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M&M proclaim that financial return varies with risk, and
deliberately do not differentiate between the composition of
financing (that is, debt v equity)

Modern corporate financial theory emerges from IMPROVEMENTS to

MM’s foundation notions, adding other considerations:

Deductibility of interest on debt, one of the three factors making - borrowing almost
always less expensive than equity (OTHER 2?)

Transfer costs from equity to debt or reverse

At very HIGH levels of gearing, risk of default on senior debt often but not always
leading to bankruptcy

At extremely LOW leverage levels, the publicly-traded company risks continuity threat
as predators have an incentive to exploit that firm’s under-utilised balance sheet,
effectively buying the firm with its own debt (OPM)

.
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Factor in what M&M missed, & modern conceptions of corporate leverage
management emerge, re-shaping the leveraged firm’s risk/return function

Post the
beginning of Heightened threat of debt
LBO era ~1982 default followed by
and concerns administration ‘flattens’ the
about agent gearing return curve at
management, very high levels, even
undergeared sometimes w/ positive CF.
companies Cannot gear to
Risk, perceived as extremes.
undermanaged,
Reward encouraging
‘management
change’, one
way or another

low high
Gearing percentage plus amount
The undergeared (and thus, financially mis-managed) firm is identified
by extremely low D/C ratio, but also by other factors such as

–  GROWTH OPPORTUNITIES FOREGONE low risk expansion

opportunities are deliberately overlooked missed, as that involves extra
funding & debt. Opportunities for other entrants?

–  COMPANY BONUSES AND EXECUTIVE PAY

STRUCTURE: reflect considerations such as assets under management
etc, NOT returns to shareholders (often, these managers have miniscule %
interests in their firms)

–  VALUE SUPPRESSED: Equity-rich capital structure means higher

WACC, thus lower company value AOTBE

DO you suspect that there are many instances of this practice today, at least amongst publicly-
traded companies? Why or why not?
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 3
Getting WACC’d

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 The Cost of Capital reflects component costs and portions
of the firm’s primary financing elements*

WACC has two parts

Cost of Equity Cost of Debt

(WACE) (WACD)

Rate x Portion of
Rate x Portion of
Total Capital
Total Capital

* Long-term ‘permanent’ sources of financing: equity plus LTD long-term debt: corporate bonds, long term bank or other financial
institution borrowings, debentures etc. Excluded: trade credits, seasonal borrowings.
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WACC TOO HIGH (caused by undergearing)
An excessive discounting rate may mean that… WACC

SOME profit-generating, value-creating internal and external investments

may be missed, deliberately

Co. management undercalculates its own firm’s worth, as well as the

true value of possible acquisition targets (based on DCF analysis)

Possible threat to management’s positions, as gross undergearing is

today generally regarded as a indicator of GENERAL mismanagement,
not just financial underperformance

Excessive overall financing costs: the‘fuel’ (support financing) required

to support the company’s ‘value engine’ (investment) is too rich

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WACC TOO LOW WACC
.. Whereas an unrealistically low discounting
rate often means that:

SOME shareholder value-destroying investments (CAPEX) and deals

(M&A) are incorrectly implemented

Co. management OVER-estimates its own firm’s worth– and blames the
financial markets as ‘not understanding our strategy’ when financial
markets fail to confirm that faux-valuation.

In extreme instances, company management make the fatally flawed

mistake of justifying the new CAPEX project or the new acquisition based
on the low interest rate of the specific financing dedicated for that specific
purpose only.

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 Several Perspectives on the Company’s Cost of Capital…
•  In Terms of Financing Providers’ Requirements
Arnold (p. 32): “The rate of return a company has to offer financial providers to induce
them to buy and hold a financial security.

•  Reflecting Current Financing Mix and Costs

The common calculation for SPOT (or present) WACC is the sum of the after tax costs of
(a) LTD and (b) E, respectively, based on the percentage of Total Capital (LTD + E).

•  Reflecting Marginal Financing Mix and Costs

Cost of Capital is some passive financial calculation; the chosen WACC rate helps to
determine whether the next capital expenditure (CAPEX) or the proposed merger
proceeds. On that basis, isn’t it the NEXT cost of debt and equity components that matter

•  Reflecting the Firm’s Point Along Its Competitive Life Span continuum. The
financing profile for the newly created start-up (e.g., Zynga) differs completely from that of
the near-death firm desperately struggling to avoid elimination (e.g., HMV).

•  Consistent With Value-Optimal OCS.

Continued…
21

.
Under the Capital Asset Pricing Model, WACE and WACD
START in the Same Place with RfR, Then Diverge…

(deliberately simplistic)

Cost of Equity = Risk Free Rate + (Equity Risk

Premium x Beta)

Cost of Debt = Risk Free Rate x Debt Provider’s

Minimum Return Requirements x Perceived Specific Risk
Factors of Borrower, adjusted for class of debt (order in
liquidation, return v risk)

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 CAPM Risk Free Rate is shown here as literally the
CofE foundation for calculating costs of the firm’s two
(illustrative) capital components, debt and equity

β Beta: Further adjustment for the (a) share price

pattern and (b) volatility of an individual
company’s shares, compared with the analysed
‘diversified portfolio of common stocks.‘
CofD*
Debt Profit
Issuers’ Margin
Service Cost
+ Solvency Equity Risk Premium: The additional
Risk
Assessment (beyond RfR amount) to reflect the risks to
of Individual Central ERP financing provider associated with a
Borrower Bank to ‘diversified portfolio of common stocks’
Firm Lending
Institution
Cost

Risk Free Rate: Financing cost effectively without

RfR RfR risk, such as sovereign LT government debt of US
(10 or 30 years’), UK (10 years’).
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* After tax
The logic of ‘creating value’ via gearing is often alluring, since increasing
the firm’s debt percentage often lowers WACC

Comp. Portion Cost Tot.

67% D 33% E *Presuming
D 67% 8% 5.36% mCoE=
2.25 x mCoD

E 33% 18%* 5.94%

Tot. 100% -- 11.30%

But this value alchemy may REVERSE if excessive gearing is perceived:

Comp. Portion Cost Tot.

15% **Presuming
mCoE=
E D 85% 8% 6.80% 4.5 x mCoD

E 15% 36%** 5.40%

85% D WHY?
Tot. 100% -- 12.20%
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While the firm’s gearing ratio and its affect on WACC dominates
attention, other, related issues are equally important...

–  HOW MUCH financing is ideal for the company given its present and
future projected productivity (return on tangible investments?), other
considerations

–  HOW STRUCTURED: timing, maturities (of debt), LTD-equity split.

How should that financing be arranged, considering factors including (but
not limited to): existing D and E, external market conditions, assessment of
risks, capital structure that optimises value?

–  AT WHAT TOTAL CAPITAL COST: gearing level, portion (above)

times analysed Cost of Equity and Cost of LTD, taking into account both
present financing and additions/ deletions?

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 4
‘Shooting Bucks Full of
Steroids’

Or, Fact v Fallacy of Leverage-Myopic

Corporate Financial Management

26
“We take a buck, we shoot it
full of steroids, we call it
leverage… leverage debt… it’s
a bankrupt business model.”

-  Gordon Gekko in movie Wall Street

(1985) as cited in Clark & Mills
Masterminding the Deal (2013), 45

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 If SOME Debt is Good, Then Loading Up the Firm Or Deal
With Maximum Debt Must Be Even Better, CORRECT?

•  OCS: No absolute consensus on either (a) how it is determined or (b)

financing or other penalties caused by exceeding that theoretical ideal

•  Deferring the Financial Day of Reckoning: Cutting vital

investment, losing top talent in order to pay oversized P+I often not
spotted at the time.

•  Differing Financial Objectives*: Self-interest ensures that PE

apologist-champions for HLT techniques (See Tribune Corp. from today’s
assigned readings) are amongst the most articulate in touting the
benefits of growth- and viability-choking debt.

HLTs are not always zombies… IF single-dimensional

pursuit of leverage alchemy is balanced against solvency
and debt servicing requirements.
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.
 Category Description Presumptions Advantages Disadvantages

(1) Exploiting Increasing debt-to-capital (D/C) Significant levels of Lowest marginal Subordinating firm’s value-optimal capital
target’s short-term ratio to the highest operational waste WACC rate structure to acquirer-financier’s
remaining level possible while still covering persist, and that possible in compensation scheme.
marginal debt debt servicing over near-term. excessive debt is best theory, but only if
servicing way to resolve that. financial markets Myopic orientation. Risk factors may mean
capacity As debt is significantly lower ignore or INCREASE in Cost of Capital.
(CADS, TIE) cost after-tax than equity, lowers Austerity budgets miscalculate
nominal WACC, thereby caused by unbalanced increases in Outdated notion of using indirect financial
increasing value all other things ST capital structure do financial, influences to improve operating performance.
being equal not permanently harm operating risk May encourages manipulation of debt type
company and form (P+I). Possible to probable
corporate value destruction.

(2) Approach Prevents some of the more Refer to (1) above Maximizes short- Still a myopic capital structure driven more by
(1), but with egregious manipulations of debt term D relative the financier’s objectives than what is best for
normalized servicing requirements possible to C, but with the target. Prospect of higher rather than
debt including in (1). Adequate contingency some lower WACC persists.
P+I, coverage provisions help to prevent safeguards
contingency optimal-peak financing risk (debt against the worst Opposition by those acquirers-financiers who
coverage dependent on abuses of (1) resist effective caps to extreme over-
unrealistic CF performance) leverage.

(3) Cap Designed to correct the outlier In order remain Pursuit of the Another spot (current) technique, with little if
Structure capital structure. competitive, company optimal capital any attention to company’s ongoing financing
Aligned With cannot afford a capital structure in requirements.
Industry structure which is competitive
Leaders’ significantly out of synch terms at the Effective presumption that leaders are at or
Practice with industry/segment forefront of approaching OCS. But if leaders are
leader capital planning, chronically over-geared, value destruction for
all.

(4) Adjusted Capital structure adapted to life Formulistic cap Helps to avoid To champions of extreme leverage,
for CAP stage changes in firm’s restructuring short-term reductions of D/C in latter life stages.
Lifespan competitiveness, CF generation, approaches that ignore capital planning Eliminates some mature & declining
Capital Cost risks. life stage considerations companies as HLT targets.
Implications are incomplete
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Table B.1 from Clark & Mills Masterminding the Deal 2013, Appendix B