Santosh Thakare
Santosh Thakare
:SugarwareZ-048:
Capital Structure, Cost of Capital and Financial Flexibility
by Steffen Diel, Head of Treasury Finance, SAP AG, and Simon Regenauer, Director Capital Markets, Merck KGaA
This article provides a discussion on capital structure, cost of capital and financial flexibility considerations focused on large software companies such as SAP as part of their strategic task to establish and maintain an effective financing framework. The discussed topics are relevant for treasurers mainly from two perspectives: they form an important part of the treasurer’s curriculum as part of recurring strategic funding discussions with senior management; and the discussion broadens the scope of capital structure considerations with regard to the growth and increased importance of intangible businesses (e.g., knowledge based industries) in the global economy during the last two decades versus the role of traditional, i.e., tangible, business models.
The importance of capital structure
How important are capital structure considerations when trying to determine its optimum for a given company? In doing so, we purely take the practitioner’s perspective and abstract from the academic literature around capital structure and enterprise value. We refer to generally accepted models where suitable for this purpose.
The determination and management of the capital structure is a key component of a company’s strategy. The capital structure strongly influences the weighted average cost of capital (WACC) which is the most relevant benchmark for the creation of shareholder value (SV).
The WACC constitutes the basis for determining the discount rate in a discounted cash flow model, the most widely used business valuation method. In addition, the capital structure and several key financial ratios derived from it form an important basis for the analysis of the creditworthiness of a company by third parties (e.g., rating agencies) and debt investors (e.g., banks or bondholders). The determination of a target capital structure by senior management could serve as a starting point for setting up an appropriate framework for financing decisions. This target capital structure and the accompanying financing decisions have to be well understood by investors if deemed to be successfully implemented.
The relatively recent history of enterprise software companies has been characterised by low financial leverage compared to other industries (e.g., discussion and examples can be found in an analyst report by Merrill Lynch). During the last few years, a trend towards more aggressive financial policies, i.e., a higher proportion of debt financing in corporate capital structures (higher financial leverage), has been fuelled by shareholders and analysts with the goal of increasing shareholder returns at the potential expense of debt investors.
In the years prior to the financial market crisis companies with low financial leverage were partly criticised for conducting their business based on an under-levered balance sheet. It has been argued that the WACC of those companies might be too high as a consequence of its high reliance on equity (instead of financial debt) and value could be unlocked by leveraging up, lowering WACC and potentially return cash to shareholders.
The financial market crisis since 2008 has considerably changed that view with investors putting much more focus on corporate cash balances and low financial leverage (‘cash is king’) given a volatile environment of uncertain funding opportunities and rising refinancing costs. This renaissance of a generally more conservative sentiment towards financial policy peaked, for instance, in a cash position that more than doubled between 2006 and 2011 in major US technology companies according to Moody’s.
Impact of capital structure on cost of capital
Equity and debt investors expect different rates of return based on their diverging risk profile. While equity investors bear a higher risk and as a consequence expect a higher return, the cost of debt is further reduced by the tax shield (tax-deductibility of interest expenses). Therefore WACC might be reduced by replacing equity with debt. However, the increase in the company’s leverage will simultaneously increase the required cost of equity since more debt leads to even more risk for the shareholders.
At low debt levels the effects from replacing ‘expensive’ equity by additional debt (including tax shield) will over-compensate the increase in the cost of equity resulting in an overall decreasing WACC. Plugged into a discounted cash flow valuation (DCF) model, the reduced WACC will yield a higher net present value (NPV) of the relevant cash flows and consequently a higher enterprise value (EV).
With an increasing leverage and a higher dependence on debt investors the company not only loses financial flexibility, but its costs of financial distress rise. Bankruptcy costs are a common example of direct costs of financial distress (e.g., out-of-pocket costs such as auditors’ fees, legal and other fees). But significant costs of financial distress can also occur even if bankruptcy is avoided (so-called indirect costs, e.g., higher refinancing costs).
Additional debt puts stress to the company’s cash flow as a defined part of it has to be used for interest and redemption payments. If cash flows decrease due to an economic downturn, the company might get into trouble. Debt investors start to worry that repayments could be endangered and, just like the equity investors, are likely to defend themselves through higher compensation requirements for their risk-taking, i.e., by demanding higher credit spreads which increases the cost of debt.
Taking these effects into consideration, at a certain level of financial leverage the rising costs of equity and debt just offset the positive effect from replacing equity through debt capital. This level marks the theoretically optimal leverage with the lowest WACC. If the leverage is increased beyond that point, WACC starts to increase again. In practice, this point is not easily found and depends also on other, rather qualitative variables, such as business risk and financial policy.
Capital Structure, Cost of Capital and Financial Flexibility
by Steffen Diel, Head of Treasury Finance, SAP AG, and Simon Regenauer, Director Capital Markets, Merck KGaA
This article provides a discussion on capital structure, cost of capital and financial flexibility considerations focused on large software companies such as SAP as part of their strategic task to establish and maintain an effective financing framework. The discussed topics are relevant for treasurers mainly from two perspectives: they form an important part of the treasurer’s curriculum as part of recurring strategic funding discussions with senior management; and the discussion broadens the scope of capital structure considerations with regard to the growth and increased importance of intangible businesses (e.g., knowledge based industries) in the global economy during the last two decades versus the role of traditional, i.e., tangible, business models.
The importance of capital structure
How important are capital structure considerations when trying to determine its optimum for a given company? In doing so, we purely take the practitioner’s perspective and abstract from the academic literature around capital structure and enterprise value. We refer to generally accepted models where suitable for this purpose.
The determination and management of the capital structure is a key component of a company’s strategy. The capital structure strongly influences the weighted average cost of capital (WACC) which is the most relevant benchmark for the creation of shareholder value (SV).
The WACC constitutes the basis for determining the discount rate in a discounted cash flow model, the most widely used business valuation method. In addition, the capital structure and several key financial ratios derived from it form an important basis for the analysis of the creditworthiness of a company by third parties (e.g., rating agencies) and debt investors (e.g., banks or bondholders). The determination of a target capital structure by senior management could serve as a starting point for setting up an appropriate framework for financing decisions. This target capital structure and the accompanying financing decisions have to be well understood by investors if deemed to be successfully implemented.
The relatively recent history of enterprise software companies has been characterised by low financial leverage compared to other industries (e.g., discussion and examples can be found in an analyst report by Merrill Lynch). During the last few years, a trend towards more aggressive financial policies, i.e., a higher proportion of debt financing in corporate capital structures (higher financial leverage), has been fuelled by shareholders and analysts with the goal of increasing shareholder returns at the potential expense of debt investors.
In the years prior to the financial market crisis companies with low financial leverage were partly criticised for conducting their business based on an under-levered balance sheet. It has been argued that the WACC of those companies might be too high as a consequence of its high reliance on equity (instead of financial debt) and value could be unlocked by leveraging up, lowering WACC and potentially return cash to shareholders.
The financial market crisis since 2008 has considerably changed that view with investors putting much more focus on corporate cash balances and low financial leverage (‘cash is king’) given a volatile environment of uncertain funding opportunities and rising refinancing costs. This renaissance of a generally more conservative sentiment towards financial policy peaked, for instance, in a cash position that more than doubled between 2006 and 2011 in major US technology companies according to Moody’s.
Impact of capital structure on cost of capital
Equity and debt investors expect different rates of return based on their diverging risk profile. While equity investors bear a higher risk and as a consequence expect a higher return, the cost of debt is further reduced by the tax shield (tax-deductibility of interest expenses). Therefore WACC might be reduced by replacing equity with debt. However, the increase in the company’s leverage will simultaneously increase the required cost of equity since more debt leads to even more risk for the shareholders.
At low debt levels the effects from replacing ‘expensive’ equity by additional debt (including tax shield) will over-compensate the increase in the cost of equity resulting in an overall decreasing WACC. Plugged into a discounted cash flow valuation (DCF) model, the reduced WACC will yield a higher net present value (NPV) of the relevant cash flows and consequently a higher enterprise value (EV).
With an increasing leverage and a higher dependence on debt investors the company not only loses financial flexibility, but its costs of financial distress rise. Bankruptcy costs are a common example of direct costs of financial distress (e.g., out-of-pocket costs such as auditors’ fees, legal and other fees). But significant costs of financial distress can also occur even if bankruptcy is avoided (so-called indirect costs, e.g., higher refinancing costs).
Additional debt puts stress to the company’s cash flow as a defined part of it has to be used for interest and redemption payments. If cash flows decrease due to an economic downturn, the company might get into trouble. Debt investors start to worry that repayments could be endangered and, just like the equity investors, are likely to defend themselves through higher compensation requirements for their risk-taking, i.e., by demanding higher credit spreads which increases the cost of debt.
Taking these effects into consideration, at a certain level of financial leverage the rising costs of equity and debt just offset the positive effect from replacing equity through debt capital. This level marks the theoretically optimal leverage with the lowest WACC. If the leverage is increased beyond that point, WACC starts to increase again. In practice, this point is not easily found and depends also on other, rather qualitative variables, such as business risk and financial policy.