The financing decision

Delivered by: Dr Wong Pik Har

wongph@tarc.edu.my

1
The financing decision
Learning outcomes
 Financial strategy formulation
 Impact of financing on investment decision and adjusted
present values

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The financing decision
1 Introduction
 What type of finance to raise to fund the projectDebt or
equity?
2The financial system (financial market, financial
institution, financial asset and liability)
 Financial market (capital market & money market)
3 The basic long term financing decision
 Debt or equity

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Financing decision
The basis long term financing decision –debt or equity
Practical considerations
1 issue costs (prospectus), 2 gearing (financial risk,
bankruptcy cost) 3 tax (tax exhaustion) 4 optimum capital
structure 5 cash flow profile (maturity of debt) 6 risk
profile 7 covenants
 Debt finance is cheaper than equity finance from co. and
debt holder view
Reason:
1. Less risky- deed of covenant, interest paid from co before
equity returns
2. Tax relief - interest paid to debt holders is tax deductable

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Financing decision
The basis long term financing decision –debt or equity
Theoretical considerations
 Assess the way in which a change in gearing/capital
structure impacts on the firm’s WACC
 Debt finance is cheaper than equity finance from co. and
debt holder view
 Increasing levels of debt makes equity more risky
resulting increase the cost of equity and would increase
WACC

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Financing decision
Effects of gearing
 Ungeared co – Co financed only from 100% equity
 Geared co – Co financed by debt and equity
 When co introduces debt as shareholders demand
higher return to compensate the financial risk from
debt financing

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 Financing decision
Ke

 WACC Traditional view

Cpst of capital

Kd

optimum gearing

 Cost of debt- remains constant over a quite large range

because it suffers little risk until the level of gearing is
quite high (bankruptcy cost)
 Cost of equity – starts higher than Kd due to the
systematic risk  finance risk  cannot diversified away.

 WACC – starts =Ke gradually due to tax relief ( 1-T) on

interest. A minimum WACC will reach. Above this level
WACC due to financial risk (bankruptcy costs)
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Financing decision
Traditional view
 In the real world firms do not have high gearing due to
1. Bankruptcy cost
2. Agency cost (manager and owners)
3. Tax exhaustion
4. Impact on debt capacity
5. Restriction by M&A
 Limitation of traditional view on cost of capital
-- it does not compute financial risk premium for equity
when the co has borrowing
--- it is a descriptive theory, difficult to build any
financial theory on it

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 Financing decision
The theory of Modigliani and Miller
 Assumptions
1. The capital market is perfect ie information is costless and
readily available , no transaction cost, investors are rational
2. All co and individuals can lend and borrow at risk free
rate
 Value of firm = present value of the future earnings (cash
flows) discounted at the operating risk (WACC)
 There is no optimum capital structure
 Capital structure is irrelevant
 Dividend policy is irrelevant in determining the value of a
firm
 Firms with identical business risk and same quality of
earnings should have the same firm value
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Financing decision
Effects of capital structure on value of firm
M & M view (with tax)
because of tax relief advantages of issuing debt finance firms
should increase their gearing as much as possible.
 Firm value = mkt value = Equity + Debt

expected earnings (expected future cash flow)

WACC
 Max value of firm should have a minimum cost of
capital  optimum WACC (note: perpetual)

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Financing decision
The theory of Modigliani and Miller
 Value of firm with taxes
 According to M&M, value of a firm is the present value
of expected earnings / cash flows and increase value of the
firm caused by borrowing due to tax relief
Vg = Vu + Dt
Vg = value of geared firm
Vu = value of ungeared firm
D = Mkt value of Debt
t= tax rate Dt = tax shield

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Financing decision
M&M formula – relationship of geared and ungeared
firms
Cost of equity (no tax – ignore tax) Ke
Keg = Keu + D/E (Keu - Kd)
Cost of equity (with tax)
Keg = Keu + (1 – t) D /E [(Keu - Kd)]
- Keg = cost of equity of a geared firm
- Keu = cost of equity of a ungeared firm

WACC (no tax – ignore tax)

WACCg = WACCug
WACC (with tax)
WACCg = WACCug (1- Dt / D+E)
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Financing decision
Reasons why companies cannot have 99% gearing
 Reluctant to lend beyond certain level of gearing
 Co may exhaust its corp tax liability
 Agency cost may increase with higher gearing
 Bankruptcy cost may set in

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Financing decision
Conclusions
 Traditional view  to borrow at the optimal capital
structure, BUT difficult to determine
 M&M  borrow as much as possible
 Compromise  traditional and M&M, extreme gearing is
to be ignore as it is unlikely to lower cost of capital. If a co
is 100% equity it loses out opportunity of using cheap
debt. If a co is highly geared, it  financial risk (cannot
be diversified away) and  cost of capital
 Therefore, in between the extreme, there is probably
a very broad area where the optimum gearing will
be. Finance managers should based on experience to
determine where it is

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Financing decision
Current view by Brealey and Myers
Extent a company can borrow will depend
 The level of healthy profits (cash flow) generated
 Strong asset base as collateral
 View of capital provider as to the acceptance of gearing
 Size of the company-diversified business, less risky
 Tax position of the company-tax credits off-set against
future profits
 Countries where the funds will be invested & borrowed
 Debt capacity – ability to repay such debt
 Company has high value asset and low depreciation eg
property company will have a high borrowing capacity.

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Financing decision
Agency effects on capital structure
When gearing is high, interest of management and
shareholders may conflict with creditors (Lenders, banker,
suppliers). Why?
Management
 Gamble on high risk projects
 Pay large dividends
 Invest in higher risk business areas than the loan was
designated.
To safeguard lenders, often impose restrictive conditions in the
loan agreement
 On the level of dividend; restrictive on the disposal of assets
 Additional debts that can be raised
 Acceptable working capital and other ratios
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Financing decision
Capital structure – practical approach
1. Static trade-off theory &
2. Pecking order theory
1 Static trade-off theory
 Tax deductibility of interest payments induces the firm to
borrow to the margin where the present value of interest
tax is just off-set by the value loss due to agency costs of
debt and the possibility of financial distress
 Firm in static position (not in a rapid growth) can adjust to
a targeted level as long as tax benefits (DT-tax shield) >
bankruptcy cost
 Some industries, profitable firm has low gearing
 Some industries move away from the ideal capital
structure by issuing debts and move back to the optimum
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Financing decision

2 Pecking order theory –

 No well defined target debt ratio
 Prefer internal to external financing
 Debt before equity
The order of preference will be
 Retained earnings
 Straight debt
 Convertible debt
 Preference shares
 Equity shares

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Financing decision
Reasons for following pecking order
 Easier to use retained earnings than go to the external
finance
 No issue costs for retained earnings
 Investors prefer safer securities
 Some managers believe that debt issues have a better
signaling effect than equity share

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Financing decision
Consequences of pecking order theory
 Business will try to match investment opportunity with
internal finance provided this does not affect excessive
changes in dividend payout
 If it is not possible to match investment opportunities
with internal finance, surplus internal funds will be
invested, if there is a deficiency of internal funds,
external finance will be issued in the pecking order
 Established an ideal debt-equity mix will be difficult,
choose internal funds follow by straight debt and last
equity shares

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Financing decision
Limitation of pecking order theory
 It fails to take into account taxation, financial distress,
agency costs or how the investment opportunities that
are available may influence the choice of finance
 The theory explains what business actually do rather
than what they should do

Exercise
Pilot paper Q 4

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Financing decision
Compromise approach
 Select a long run target ratio
 Whilst far from target, decision should be governed by static trade-off
theory
 When close to target, pecking order theory will dictate source of fund
Pecking order v static trade off
 Issue costs – internal generated fund lowest, debt moderate and equity
highest (IPO)
 Asymmetric information- heavy reliance on retention, managers have
more access to more information about the firm, knows that the value of
the shares is greater than the current market value on the weak and semi-
strong form,
Manager forecast may be higher and more realistic than that of the
market, if shares were issued in the situation, transfer wealth from
existing shareholders to new shareholders, prefer internal generated fund.
New issues may signal of bad news

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Financing decision
Signaling to investors
 Important to consider the signaling effect of raising finance
 Raising new finance gives a positive signal to the market
 Investors assess the impact of new finance on a firm’s profit and loss and
balance sheet
Agency effects
 Management may gamble on high risk project
 Pay large dividend to secure company values for themselves
 Hide problems and cut back on discretionary spending
Mitigate agency effects, restrict
 On the level of dividend
 Additional debt
 On acceptable working capital and other ratios
 Disposal of major assets

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Financing decision
Delisting
 Remove from an exchange voluntarily or involuntarily
 Different objective from the original shareholder
 Faced with security and conflict
Private equity and venture capital
 Set of goals, preference strategies buys majority control, try to improve
its results before selling it
Venture capital
 Invest in young growing or emerging co, rarely obtain control

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