Learning Module 3: Cost of Capital Advanced Topics

Learning Module 3 Cost of Capital: Advanced Topics EXAMPLE 1 External Factors and Cost of Capital GW is a junise analyst researching twes companies that are in the same indus try but headquartered, and seeking to raise capital, in different countries. GW gathers the following information on each country's capital market Feature Country A Country B Credit spreads Wide Volatility in mar High Law Capital availabilny High Low Corporate tax rate Low High 1. Which country is more likely to have lower capital costs for corporate issuers, and why?! Selution Country B is more likely to have lower costs of capital for corpoute issu ers. All else equal, given a higher corporate income tax rate in Caantry corporate issuers in that coeatry would benefit front a lower after-tax.cost of debt. The higher the company's marginal income tax rate, the greater the attractiveness of asing debt in the company's capital structure because of the associated tax savings benefit, assuming interest expeme is tax deductible and the company has taxable income Additionally, corporate issuers in Country 8 benefit from narrow credit spreads, low volatility in interest rates, and a low inflation rate, all of which contribute to lower costs of capital for corporate issuers. When interest rates und volatility aer relatively low and/or credit spreads are narrow, the cost of debt und equity capital is lower than in periods of high interest rates and volatility and wide credit spreads Further, the higher supply of capital available in a given market oben leads to move favorable terrns for corporate innuers, resulting in a lower coat of cajutal 2. Country A is considering tax legislation that, if passed, would raise the cor porate income tax rate from 15% to 25%. What effect is this likely to have on the cost of debt for corporate issuers in Country A? Solution The tax legislation under concidenation would raise the corporate inconue tax rate in Country A from 15% to 25% and have the effect of lowering the after tax cost of debt for corporate issuers in that country. As long as a com pony has the taxable income before interest available to offset the interest an daht, there is a benefit to the tax deductibility of interest and, therefore, a lower cost of debt. 3. What asumption are you making in drawing conclusions regarding the effect of tax legislation in Country A? Solution The assumption necessary for the tax legislation to have an effect on com panies costs of capital depends on whether the interest is deductible for tas purposes. If interest is not deductible, there would be no effect on the WACC; if interest is deductible and the company has taxable earvings, the effect is to reduce the WACC EXAMPLE 2 Company-Specific Factors and Cost of Capital GW next gathers the following common size balance sheet and other selested information on the two companies Company 1 Company 2 Cash and epivalents 15% 10% 7% Marketable securit 12% 19% Accenta rawable Imantary Other current aмити Property, plant, and equipment (et) 29% 24% tangible assets and goedwill Other sorts 10% 5% 21 Other Sered mat Net debt/EBITDA 25 124 High Operating leverage Low 27% Sales from top five customers Pat Call Festares in existing dit securities 1. Which company is more likely to have a lower cost al capital bustify your response Solution Company I is likely to have a lower cost of capital. It has a larger persuntage of cash and equivaleets and marketable securities (20%) than Company 2 (17%) Company 1 also has a much lower percentage of intangible assets (10%) than Company 2 (24%). In general, companies with primarily tangible and liquid assets are likely to be able to access debt and equity capital at low er cost than companies with a high proportion of intangible assets. Compa ny I's higher proportion of tangihle property, plant, and equipment might also allow the company to access detit capital at lower cost because of ita ability to pledge these assets as collateral Company I also operates with lower financial leverage, as indicated by a lower net debt-to-EBITDA ratio (2.1 versun 2.5) and a higher IC ratio (12.6 verses 7.9). Companies with lower levels of debt, typically measured by leverage ratios such as a lower net debt-to-EBITDA ratio of a higher IC ratio, will have lower capital costs. Company I also operates with lower operating leverage, reflecting a cost structure that includes a lower percent age of fixed costs and a more diversified customer base (top five customers accounting fee 15% of total sales versus 27% for Company 21. Companies with lower operating leverage and lower customer concentration risk tend to have greater stability in their earnings and cash flow streams and thus are Dikely to have lower costs of capital than companies with high volatility in these streams. Finally, the existing debt securities al Company I have embedded put optimes that allow investors to sell the securities back to the company price to maturity it interest rates rise. In contrast, the existing deht securities of Company 2 have embedded call options that allow the company to call the securities prior to maturity if interest rates rise. The put option is a benelit to lavestors whereas the call feature is a benefit to the issuer, which leads to putable bonds having a lower cost or yield than otherwise comparable callable bonds KNOWLEDGE CHECK 1. Identify whether each of the following factors would positively or negatively affect an issuer's cost of capital. An issuer 1. with a high degree of operating leverage. II. with relatively high earnings predictability III. seeking capital in a m region with a high supply of available capital IV. seeking capital in a region with weak legal and regulatory systems. Solution Factors I and IV would likely lead to an issuer having a higher cost of capital. Companies with higher operating leverage will experience greater earnings volatility for a given change in revenue than companies operating with lower operating leverage. Higher earnings volatility leads to lower earnings pre dictability which typically leads to a higher cost of capital. Further, issuers seeking capital in regions with weak legal and regalatory environments will face higher costs of capital to compensate investors for the weak investor protections Factors II and III would likely lead to an issuer having a lower cost of capital. Higher earnings predictability typically leads to a lower cost of capital. Fur ther, a high supply of capital available in a given market often leads to more favorable terms for corporate issuers, also resulting in a lower cost of capital 2 . Identify which issuer, based solely on its given business model characteris tics, would likely have a lower cost of capital and be able to support a higher proportion of debt in its capital structure. Justify your selection. Company 1 Pay-per-use model Asset base consists largely of intangible assets 60% of revenues come from largest five customers Company 2 Subscription model Assets base consists largely of tangible assets No more than 1% of revenues come from a single customer Solution Company 2 is correct. Companies with subscription-based business models are typically characterized by fairly predictable revenues and earnings than