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After studying this module you should be able to
 
1. describe why the cost of capital used in capital budgeting should be calculated as a weighted average of the various types of funds the company uses, regardless of the specific financing used to fund a particular project.
2. calculate the after-tax cost of debt, the cost of preference shares, the cost of ordinary equity and the weighted average cost of capital.
 
3. describe the theoretically preferred method of calculating the weights in order to calculate a weighted average cost of capital.
4. explain why a company-wide cost of capital may be inappropriate for capital investment decision-making within a particular company division.
 
5. explain why dividends are considered to be relevant and yet dividend policy is considered irrelevant; explain why some investors may favour a high dividend payout.
6. explain what is meant by the terms information content of dividends, the clientele effect and residual dividend policy.
 
7. discuss the possible benefits to a New Zealand firm of repurchasing its own shares.
 

 
Ross Chapter 17 covers the cost of capital, while Chapter 18 discusses dividend policy. These are exceptionally important topics, so be sure to read them carefully. Some topical issues relating to dividend policy include
 
• Why is it that most high-tech companies get away with paying no dividends to their shareholders?
• How has the high-dividend policy for state-owned electricity companies contributed to the problem of insufficient back-up electricity generating capacity in NZ?

 

p. 546 Financial policy and cost of capital
 
To use the WACC (weighted cost of capital) for decision-making process, there are two assumptions. First, the risk of the project under examination must be approximately equal to the risk of all new projects being undertaken by the firm. Second, the firm does not materially change it financing policies as a result of the investments undertaken. Here we assume that firm has a fixed debt/equity ratio that it maintains in optimal proportions, called the target capital structure.
 

p. 548 Estimating g
 
There is a typo in the table: the dividend for year 20XX+4 is 1.50 instead of 1.45.
You can use TVM concept to calculate g: (1.50/0.95)1/4 – 1 = 0.121. Notice the compounding period is 4 years.
 

p. 553 The weighted average cost of capital
 
Note that the WACC is a weighted average of the cost of debt and the cost of equity. The term “weighted” refers to the proportions of debt and equity in the capital structure. So, if 40% of our financing is from debt at a cost of 10%, and 60% of our financing is from equity at a cost of 20%, then using equation 17.6, the WACC is calculated as follows
 
WACC (unadjusted) = [(E/V)  RE] + [(D/V)  RD] = (40%  10%) + (60%  20%) = 16%
When calculating the weights to use for the WACC calculation, we revalue all permanent sources of financing from the balance sheet to market values. Hence for equity, we take the market value of equity (ie. the current share price) and multiply by the number of shares on issue. This essentially revalues the book value of equity (paid-up capital plus retained earnings) to a single market value. If interest rates have changed, then the market value of
each permanent source of financing (ie. E/V and D/V).
 

p. 557 Budgeting problems
 
Recall that net present values are calculated by discounting the forecast cash flows by the cost of capital. However, the WACC can only be used when the capital structure of the firm is not expected to change (see above). This means that conventional approaches to NPV analysis may be inappropriate in a small business context. Read the following section that summarises the conventional approach, and contrasts this with a technique called the equity residual NPV. debt will be different to that noted on the balance sheet. From this we are then able calculate the percentage of each permanent source of financing (ie. E/V and D/V).
 

NPV analysis for large firms

 
In a large firm when there are routinely several projects under consideration, the particular financing method used for the accepted projects is unlikely to materially affect the firm’s target capital structure. It is unlikely that any one project will be financed in the same proportion as the target, because financing tends to be raised in economical blocks. Equity may be used at one point, and then debt raised on the next occasion when funds are needed. Nevertheless, the actual overall capital structure will usually conform closely to the target.
 

Example: Noddy Ltd has a target capital structure of 30% debt and 70% equity. The actual financing raised for Noddy’s accepted projects resulted in very little deviation away from the 30% debt and 70% equity target.
 
If each project was discounted at a cost of capital consistent with the actual financing employed for that particular project, then projects to be financed with more costly equity would have less chance of being accepted and projects to be financed with less costly debt would be more likely to be accepted. This is likely to result in non-optimal decisions, so the cash inflows from the project need to be assessed independently of the particular method of financing. Consequently, for a large firm it is generally appropriate to discount all projects at an overall cost of capital that reflects the overall target capital structure.
 

In such an analysis, the operating cash inflows in the numerator of the NPV should exclude interest on debt, as the cost of debt has already been incorporated into the denominator as part of the cost of capital. Loan proceeds and repayments should also be ignored. This is the approach taken by Ross.
 

NPV analysis for small firms
 
In a small firm, there may be very few projects under consideration, and when the accepted projects are undertaken, the financing often causes significant deviations in the capital structure of the firm.
 
Example: Winkie Ltd is a small manufacturing firm that carries 20% debt and 80% equity. If it undertakes to purchase some new machinery to expand their product offerings, then additional debt will be raised. This will cause the capital structure to change to 40% debt and 60% equity. The loan will be paid off over a five year period. The debt-equity ratio will therefore change every year over the next five years as the debt is paid off. Given that the capital structure will change over time, the weighted average cost of capital is not suitable as a discount rate to assess the proposed project.
 

Where the debt-equity ratio of a firm is expected to change as a result of accepting projects, it is necessary to undertake a slightly different approach to calculating the NPV. This approach, called the equity residual NPV, requires modifications to the initial investment, the numerator and the denominator in order to calculate the NPV.
 
The initial investment should reflect only that proportion of the investment financed with equity. The numerator should include not only the operating cash flows, but also the financing cash flows (principal and interest repayments). The net cash inflows are then discounted at a risk-adjusted cost of equity capital.
 
Example: Winkie will need a down payment of $20,000 in order to purchase machinery costing $100,000. The balance will be financed with a bank loan at 8% interest to be paid off over five years, with payments of $20,037 per year. The operating cash inflows are expected to equal $25,000 per year (before depreciation, interest and taxes) for ten years. The risk-adjusted cost of equity capital for this project is considered to be 11%.
 

p. 558 Example 17.6
 
At the end of example 17.6, the present value of the cash flows ($114.613181 million) is determined by taking the $10 million cash savings and dividing by the WACC minus 6%. Ross is using a variant of the perpetuity equation – that of a growing perpetuity. Do you recall the constant growth formula for valuing shares on p.183? It is essentially a formula to value a growing perpetuity: a year 1 dividend that is growing at a constant rate of g per year in perpetuity. ie. P0 = D1/(r-g). This formula can also be used to value other constantly growing cash flow streams. In example 17.6, the $10 million is not really a single cash flow at the end of period one. Rather, it is a constantly growing perpetuity, growing at a rate of 6 per cent per year.
 

p. 583 Taxes and Imputation
 
In Chapter 18, Ross describes some aspects of the income tax system. Some of the differences in terminology and tax rates between New Zealand and Australia are highlighted below in Table 1. In New Zealand, capital gains are not taxable either to individuals or to companies. Like the Australian system, our individual tax rates are progressive. In New Zealand, for taxable income up to $14,000, tax is levied at a rate of 10.5%. The marginal tax rate is 17.5% for income from $14,001 to $48,000, 30% for income between $48,001 and $70,000, while income in excess of $70,000 is taxed at 33%.
Both Australia and New Zealand have a dividend imputation system, with the New Zealand system being implemented in 1988. In a dividend imputation system, companies and shareholders are treated as a unit, whereby company distributed profits are taxed at the marginal tax rate of the shareholders.
 

Dividends paid by New Zealand companies out of tax-paid profits are known as imputed dividends (as opposed to franked dividends in Australia), and for income tax calculations for individual shareholders, must be “grossed-up” to equate to the pre-tax profit of the company. The tax withheld by the company is treated as a withholding tax. Given that the company tax rate is 28%, if a fully imputed dividend is paid, then shareholders who are taxed at a marginal rate of 33% will have further personal tax to pay. However the amount of tax paid by the company is claimed as a tax rebate by the shareholder. So the shareholders would receive a credit for the amount of tax paid by the company equal to 28% of the grossed-up dividend. Example: Assume a company has earned taxable income of $5,000, and paid out dividends to the sole shareholder whose personal tax rate is 33%.
 
Company taxable income $5,000
Corporate tax at 28% 1,400
Available for dividends $3,600
Cash dividend paid to shareholder $3,600
Add: Corporate tax/imputation credit 1,400
Before-tax profit 5,000
Shareholder tax at 33% 1,650
Cash receipt after tax $3,350
 

Equivalently, the shareholder has received a cash dividend of $3,600, and paid tax of $250 ($1650 less a tax credit of $1400), to yield $3,350 after tax. Note that the tax of $250 paid by the shareholder is equal to 5% of the company taxable income ($250/$5,000). So the total tax paid on the company taxable income is $1,400 (28% of $5,000) paid by the company, plus $250 (5% of $5,000) paid by the shareholder, for a total of $1,650 (33% of $5,000).
 

p. 583 Example of dividend effects on shareholders
 
Most of the discussion from the textbook holds equally well in New Zealand. However, given that capital gains do not attract tax in New Zealand, the results of the table on page 585 need to be modified. If capital gains are not taxable, but otherwise using Australian tax rates the results are as follows:
 

Net cash flow Comparison to
dividend payment
Shareholder A (0%) $9,700 less $300
Shareholder B (19%) $23,598 less $110
Shareholder C (32.5%) $62,478 $25 more
Shareholder D (37%) $125,523 $70 more
Shareholder E (45%) $131,103 $150 more

We can summarise the implications of these results for New Zealand as follows 

• For investors whose personal tax rates are less than the corporate tax rate, tax biases lead to a preference for dividends rather than capital gains.
• When investors’ personal tax rates equal the corporate tax rate, there is no tax-induced preference for dividends or capital gains.
• For investors whose personal tax rates exceed the corporate tax rate, tax biases lead to a preference for capital gains rather than dividends.
 

p. 585 Table 18.3 – Errata
 
Please make the following correction (noted in bold) to the first note below Table 18.3: “* The tax payable …: 0% (A), 19% (B)… There is tax payable for income over $18,200.”
 
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p. 588 Tax and legal benefits from high dividends
 
New Zealand superannuation funds are taxed on fund earnings and on employers’ contributions (but only in excess of 2% of the employee’s salary for Kiwisaver and complying schemes). The applicable rates of tax on fund earnings vary hugely, depending on the type of investments (fixed income or equity), whether they are New Zealand, Australian or overseas shares, whether the scheme is a PIE (portfolio investment entity), and the taxable income of the members. The tax rate on employers’ contributions is 33% or less, depending on the annual income of the employee. Details can be found at the IRD web site www.ird.govt.nz.
 

p. 588 Information content of dividends
 
The second point made is that “…Because of the high taxation of some individual investors, a high-dividend policy may be best.” This is not true in New Zealand. High tax rate investors would likely prefer to avoid the extra personal tax payable on dividends (33% – 28% = 5%) by receiving tax-free capital gains via share price appreciation which should arise through the firm’s retention and reinvestment of earnings.
 

p. 593 Dividend stability
 
It is true that companies generally attempt to maintain a stable or increasing dividend. However, in New Zealand, the Companies Act 1993 established a new regime that attempts to protect creditors by placing a constraint on the payment of dividends.
Under the current act, dividends and other distributions to shareholders (such as share repurchase) can only be authorised by the board of directors after a two-part solvency test has been conducted. Firstly, a company can only make a shareholder distribution if it has sufficient liquidity so that it “is able to pay its debts as they become due in the normal course of business”9. Secondly, a company balance sheet must be sufficiently strong such that the “value of the company’s assets is greater than the value of its liabilities, including contingent liabilities”10. Failure to comply with the solvency test may result in personal liabilities to the company directors.
 

p. 594 Dividend streaming
 
To encourage overseas investment in New Zealand, the imputation tax regime extends to non-resident investors through a type of dividend streaming. Non-resident investors are unable to use imputation credits on their overseas tax returns, so it was necessary to devise a scheme that allowed for an equivalent result. The dividend-paying company is allowed to claim a tax credit for imputation credits attached to dividends paid to non-residents. The company in turn, is required to pay a supplementary dividend to the non-resident investor equal to the amount of tax credit gained.
 

p. 594 Dividend reinvestment schemes
 
In New Zealand, some firms have dropped their dividend reinvestment plans (DRP) as they do not require such large injections of equity capital.
For tax purposes, dividend income reinvested by virtue of a DRP is treated the same as a cash dividend. They are both subject to the dividend imputation regime.
 

p. 595 Share Repurchases
 
The repurchase of shares by companies in New Zealand is governed by the Companies Act 1993. Repurchased shares may be held as “treasury stock”, and re-issued at a later date.
In New Zealand, the taxation of share repurchases depends first upon whether the repurchase is via the stock market (on-market) or off-market and second upon the firm’s motive. On-market repurchases are treated as non-taxable capital gains in the hands of the shareholders. Off-market repurchases may also be treated as non-taxable capital gains in some circumstances, however, if the purpose is to pay a dividend to shareholders, then the distributions will receive the same tax treatment as dividends.
 

After studying this module you should be able to
 
1. assess the impact of financial leverage on shareholders by calculating the breakeven EBIT, ROE and EPS for alternative capital structures.
2. explain the M&M Propositions I and II of capital structure.
3. describe how business risk and financial risk affect the systematic risk of a firm, and relate these to the two components of a firm’s cost of equity.
4. describe the factors that are relevant in determining the optimal capital structure.
 

Study Notes

In Ross Chapter 19, we look at leverage and identify the factors that affect the optimal capital structure of a firm. Capital structure refers to the proportions of debt and equity used to finance the firm’s assets. This topic is relatively theoretical, as there are no simple, definitive tools to tell us the ‘optimal’ debt level. Nevertheless, we can gain some insight into the various factors that influence the decision. Some topical issues relating to capital structure are:
• Why is it that companies such as Telecom and Transalta have high levels of debt, while companies in the mining sector have little debt?
• How does a firm decide on the appropriate level of debt?

Read Chapter 19, noting the following comments.
 

p. 631 Optimal Capital structure
 

The discussion of the tax shelter benefits of debt is rather deceptive. Recall that under the dividend imputation tax system, equity holders are no longer subject to double-taxation on their dividend income. While it is true that interest on debt is tax-deductible, and dividends are not, the effect of the introduction of the dividend imputation system has been to reduce taxes on dividend income and thereby reduce the relative tax advantages offered by debt. Examining Figure 19.6 (p.632), we can see that if the present value of the tax shield on debt is reduced, then the optimal amount of debt that maximises the value of the firm, is lower. Furthermore, in Figure 19.7 (p.633), one can observe that by removing the relative benefit of the tax deductibility of debt, the cost of debt curve, labelled as RD
 

 (1-TC), would shift upward. This will cause the WACC curve to be flatter, with the minimum cost arising at a lower debt/assets ratio. Consequently, the optimal capital structure will occur at a lower level of debt. This tendency has been confirmed by research in both Australia and New Zealand, and is further evidenced by the fact that listed company debt levels generally fell subsequent to the implementation of the dividend imputation system
 

p. 635 Corporate versus personal borrowing
 

The examples demonstrate that the relative advantages of corporate versus personal borrowing depend on the incidence of taxation. Example Taxation Preference for corporate versus personal borrowing
19.5 none indifferent
19.6 corporate and personal taxes exist (without dividend imputation) prefer corporate borrowing
19.7 dividend imputation with 100% credits indifferent
 

p. 639 Observed capital structures
 

The reasons for the observed capital structures in Australia apply equally well in New Zealand. Parry, Wirth and Bennett11 examine some selected New Zealand industry debt ratios, and note the tendency for a negative relationship between volatility of cash flows and the use of debt. They point out that “volatile industries – such as Energy, Mining, and Ports – have tended to have lower debt levels”, and they produce the following table of the debt ratios (debt/total assets) prevailing in selected industries.
 

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