Operating or Business Risk in a Firm: the Use of Debt Finance - Essay Example

Question (i) Business and Financial Risk. Business risk is the fundamental inalienable risk of a business or line of business which is not diversifiable. (Moles and Terry, 1997). Business risk refers to the risk that the firm may not meet its short-term or operating liabilities as and when they fall due. (Moles and Terry, 1997; Smullen and hand, 2005). Operating or business risk increases with operating leverage. (Moles and Terry, 1997). Operating leverage or gearing is the ratio of fixed costs to total costs. (Moles and Terry, 1997). Operating risk is therefore high when the ratio is high because fixed costs must be covered irrespective of the number of units of output produced. (Moles and Terry, 1997). A firm faces finances risk if there is a high probability that it might be unable to meet its fixed financial obligations or prior chares such as interest, principal repayments, lease payments, or preferred stock dividends. Financial risk is therefore risk arising from the use of debt finance, which requires periodic payments of interest and principal and may not be covered by the firm's operating cash flows. (Moles and Terry, 1997). The capital structure of a firm is made up of both debt and equity components. Although the use of debt in financing part of the firm's operations is advantageous to the firm, these advantages tend to disappear when too much debt is used. In effect when debt is used above the optimum level, the result is financial distress. (Ross et al, 1999). Ross et al (1999) asserts that debt puts pressure on the firm, since interest and principal repayments as well as short-term payables are financial obligations. In the event where these obligations are not met, the firm may risk some sort of financial distress. (Ross et al, 1999). Debt obligations are fundamentally different from stock obligations in that bondholders are legally entitled to interest and principal repayments more than stockholders are legally entitled to dividends. (Ross et al, 1999). In the event of bankruptcy, which is the ultimate result of financial distress, ownership of the firm's assets is legally transferred from the stockholders to bondholders. (Ross et al, 1999). Stockholders can only claim the leftovers of liquidation proceeds after all the claims of the debt holders have been settled. (Ross et al, 1999). Although debt carries a tax advantage, the costs of financial distress tend to offset this advantage when debt is used above the optimal level. (Ross et al, 1999). The optimal level of debt can be referred to as the debt level that provides the maximum firm value. the value of the firm begins to disappear once this debt level is exceeded. (Ross et al, 1999). The firm should therefore adopt a debt-to-equity ratio that maximizes the value of the firm. (Ross et al, 1999). Question (ii) WCOA Ltd Ordinary Shareholders' Required Rate of Return. Under this section, the required rate of return is calculated under the assumption that the risk class of the new investment remains the same as the risk of the original investment. This calculation is done before and after the issue of the new debentures. Having said this we now calculate the required rate of return before the issue of the new debentures and we later calculate the return after the issue of the new debentures. a) Required Rate of Return for WCOA Ordinary Shareholders Before the issue of the New Debentures.1 Earnings from original investments 64.000 Earnings from new investment 8.000 Total Earnings before interest 72.000 Interest (8% of 320,000) 25.600 Earnings after interest 46.400 Number of shares outstanding 130.000 Earnings per share (EPS) 0,3569 Book Value 260.000 Book Value per share 2 Expected Return on ordinary equity shares (ROE) 17,85% b) Required Rate of Return for WCOA Ordinary Shareholders after the issue of the New Debentures.2 Earnings from original investments 64.000 Earnings from new investment 8.000 Total Earnings before interest 72.000 Interest (8% of 400,000) 32.000 Earnings after interest 40.000 Number of shares outstanding 130.000 Earnings per share (EPS) 0,3077 Book Value 260.000 Book Value per share 2 Expected Return on ordinary equity shares (ROE) 15,38% Question (iii). WCOA Ltd Weighted Average Cost of Capital a). According to Ross et al (1999), Brealey and Myers (ND), the weighted average cost of capital can be calculated as follows: Where B and S are the values for debt and equity respectively. and are the costs of equity capital and debt respectively. This calculation is done under the assumption that the risk class of the firm has been changed by the new investment. It is also assumed that the company is operating in a world without taxes and that capital markets are no arbitrage opportunities in the capital market. Under such circumstances, ordinary shareholders require a return of 15% while both new and old debt holders now require a return of 9%. The total debentures have increased by 80,000 making the total debentures and thus the value of B equal to 400,000. The value for equity (S) is still constant at 260,000. Substituting these figures in equation (1) we get b). If we assume that the cost of capital for the company in ii above is the one calculated after issuing the debentures, that is, 15.38%, we can calculate the NPV of the new investment as follows: (Ross et al, 1999). where is the initial investment, is the cash inflow at time t, r is the discount rate and n is the end of the period. Since the cash inflow is expected to be constant at 8,000, and the cash outlay is 80,000, we can therefore substitute these figures in equation (2) to get the net present value. In this case, the earnings are expected to be constant so we treat it as a perpetuity. Also the interest on this new borrowing is given by 0.08 x 80,000 = 6,400, therefore the net cash inflow will be 8,000 - 6,400 = 1,600. Therefore, -69,892 This NPV is negative therefore implying that the new investment is not worthwhile. In the second case where the risk class of the firm has changed and debentures holders now require a return of 9%, we calculate a new interest figure of 0.09 x 80,000 = 7,200. and value the operations using the weighted average cost of capital just calculated, which is given by 19.75%. For us to arrive at the same NPV like above we can set up the equation as follows: -69,892 = -80,000 + Rearranging we get a value for X equivalent to 1,996.3. This is the after-interest earnings. Since the interest is 7,200, the earnings before interest should be 7,200 + 1996.33, which is equivalent to 9,196.33. Therefore the extra earnings that the firm needs to make to maintain the same value is 9,196.33 - 8,000 = 1,196.33. Question iv Capital Structure and Gearing. In this section we describe how the capital structure will be affected by gearing under the traditional view and under the MM proposition. a) Traditional View. According to the traditional view, the value of a firm increases with gearing only if the firm earns more revenue than before. (Ross et al, 1999). As the company begins to shift from equity into debt, the value of the firm will be increasing provided the earnings are increasing alongside. Looking at the case for WCOA Ltd, if we assume that the earnings per share is a measure of the value of the firm, we can see that maintaining earnings constant at 72,000 without issuing more debentures yields an earnings per share (EPS) figure of 0,3569 and a return on equity of 17.85%. However, as we can see, increasing gearing or issuing new debentures, the EPS drops to 0,3077 and the return on equity drops to 15.38%. These results are so because when gearing is increased without a corresponding increase in earnings, the firm still suffers an interest charge on the debentures without increasing value to the shareholders as measured by the return on equity and the earnings per share. (Ross et al, 1999). Therefore, a firm should only gear up if it is sure that it has a profitable investment to undertake that will enable it to earn more at a level that is higher than the current level. This can be demonstrated by the figure below. Source: Ross et al (1999). The figure above shows the disadvantage and advantage of gearing. As can be seen, the earnings per share depend on the earnings before interest. The higher the figure, the higher the earnings per share. Also, one can see that the break-even earnings before interest will be the earnings before interest that will make the earnings per share equal to the original figure before gearing began. It is only above this figure that the advantage of using debt becomes evident. We can therefore conclude here that gearing provides an advantage to the firm and thus increases firm value only if the firm's earnings before interest are above its break-even earnings before interest. Otherwise, the firm might face financial risk with high gearing given that it will be under the obligation to cover interest payments on the debt while it is not making enough earnings to cover these payments. This might ultimately cause the firm to default on its debt obligations as well as lead it into financial distress. b) Miller and Modigliani MM (1958) proposition I with no taxes According to this proposition, the value of the levered firm is not different from the value of the unlevered firm. (Ross et al, 1999). In particular, the firm cannot change the total of its outstanding securities by changing its debt-to-equity ratio. This implies that the value of a firm is always the same under different capital structures. (Ross et al, 1999). MM's proposition I also implies that no capital structure is any better or worse than any other capital structure for the firm's ordinary shareholders. (Ross et al, 1999). c) Miller and Modigliani MM (1958) proposition II with no taxes MM made a second proposition that the required return to shareholders rises with leverage. (Ross et al, 1996). This is because levered equity has greater risk and thus the higher returns are required to compensate for the extra risk faced by the firm. In the case of the WCOA Ltd, we can observe that as the risk class of the firm changes, debt holders or debenture holders now require a rate of return of 9%, while shareholders require a return of 15%. However, looking at the overall financing cost the weighted average cost of capital, we see that it is now 19.75%. Comparing this with the cost of equity capital of 15%, we see a difference of 4.75%, which is as a result of high gearing. This 4.75% is therefore serving as a compensation for the extra risk faced by the shareholders. This compensation for extra risk is otherwise referred to as the risk premium according to the asset pricing model (CAPM), which states that investors require a compensation for the time value of money as well as risk premium for investing in the equity market. (Brealey and Myers; Ross et al, 1999; Bodie et al, 2002). Question v In the real world, we incorporate the effects of taxes, into the capital structure decision. According to Brealey and Myers (ND), interest is a tax deductible expense while retained earnings and dividends are not. To this effect, the returns to debenture holders avoid taxes at the firm level. (Brealey and Myers). Firms that have no debt in their capital structure suffer higher corporate taxes than firms that use debt. In effect, the interest paid by the company provides it with a corporate tax shield that helps to increase the value of the firm. (Brealey and Myers). To show how taxes can affect the capital structure decision, let's assume that WCOA Ltd pays corporate tax at a rate of 35% and let's consider two options for financing its new investment. Assume that the company finances its investment by issuing new debentures, its earnings per share will be 0.20 while its ROE will be 10% as shown in appendix B. On the other hand let's assume that WCOA Ltd, finances its new investment with the issue of new ordinary shares. This implies that the number of shares outstanding will increase to 170,000, earnings per share will drop to 0.177 and ROE will drop to a figure of 8.87%. These effects are shown in Appendix C. From the foregoing, we can see that in a world with taxes, firm value increases with leverage. These findings are consistent with MM's proposition I in a world with corporate taxes (Ross et al, 1999). Basically MM's Proposition I (with corporate taxes) states that the value of the levered firm is given by the value of the unlevered firm plus the corporate tax shield. (Ross et al, 1999; Brealey and Myers). Also, the after tax weighted average cost of capital is lower than the weighted average cost of capital calculated on the no taxes situation, implying that gearing reduces the cost of debt. Despite these advantages to debt, too much use of debt can lead to financial distress. Therefore the firm must determine the debt level that maximizes its value. This debt level is referred to as the optimal debt level. (Ross et al, 1999). The firm should not add debt above this level as the advantages contributed by the increase in gearing are traded off for costs of financial distress. (Ross et al, 1999). The capital structure decision is therefore important in the real world to the investment decision in that it helps the firm to determine its optimal debt level, which is the debt level at which is the debt level at which the firm can achieve maximum firm value. Above this level, the firm begins trading off any increase in firm value with costs of financial distress. (Ross et al, 1999). Appendix Appendix A: Calculations for the required rate of return under identical risk and before the issue of new debentures. i. The earnings before charging debentures interest have been constant at 64,000 per year for several years while earnings from the new investment are expected to be 8,000. This implies that total earnings should be 72,000 (64,000+8,000). ii. The debentures attract an interest cost of 8% and the total debentures figure amounts to 320,000. iii. The number of shares outstanding is calculated by dividing the book value of the shares by the market value per share. This is given by 260,000/2 = 130,000 shares. iv. Earnings per share is calculated by dividing earnings after interest by the number of shares outstanding. (EPS = 46.400/130,000 = 0,3569) v. Book Value per share is calculated by dividing the book value by number of shares outstanding (260,000/130,000 = 2) vi. The Return on Ordinary shareholders' equity is calculated by dividing earnings per share by the book value per share and multiplying by 100%. (ROE = (0,3569/2) x 100%) (Brealey and Myers, ; Ross et al, 1999). Appendix B WCOA Ltd. New Investment is Financed by Issue of Debentures Earnings from original investments 64.000 Earnings from new investment 8.000 Total Earnings before interest 72.000 Interest (8% of 400,000) 32.000 Earnings before tax 40.000 Tax @ 35% 14.000 Earnings after tax 26.000 Number of shares outstanding 130.000 Earnings per share (EPS) 0,2000 Book Value 260.000 Book Value per share 2 Return on ordinary equit shares 10,00% Appendix C. WCOA Ltd. New Investment is Financed by Issue of Ordinary Shares Earnings from original investments 64.000 Earnings from new investment 8.000 Total Earnings before interest 72.000 Interest (8% of 320,000) 25.600 Earnings before tax 46.400 Tax @ 35% 16.240 Earnings after tax 30.160 Number of shares outstanding 170.000 Earnings per share (EPS) 0,1774 Book Value 340.000 Book Value per share 2 Return on ordinary equit shares 8,87% BIBLIOGRAPHY Bodie Z., Kane A., Markus A. J. (1999). Investments. Fifth International Edition. McGraw-Hill Irwin. Brealey R.A., Myers S. C. (ND). Principles of Corporate Finance. Seventh Edition. Mcgraw-Hill. Moles P., Terry N. (1997)."business risk"The Handbook of International Financial Terms. Peter Oxford University Press Oxford Reference Online. http://www.oxfordreference.com/views/ENTRY.htmlsubview=Main&entry=t181.e983 Ross S. A., Westerfield R. W., Jaffe J. (1999). Corporate Finance. Fifth Edition. McGraw-Hill. Smullen J., Hand N. (2005). "business risk"A Dictionary of Finance and Banking. and. Oxford University Press Oxford Reference Online. http://www.oxfordreference.com/views/ENTRY.htmlsubview=Main&entry=t20.e4270 Read More