What are “Financing Decisions”?
Financing decisions refer to the decisions that companies need to take regarding what proportion of equity and debt capital to have in their capital structure. This plays a very important role vis-a-vis financing its assets, investment-related decisions, and shareholder value creation. An integral part of financial decisions is the consideration of the cost of capital, which companies must take into account. For any investment worth undertaking, the expected return on capital must be greater than the cost of capital (i.e. weighted average cost of capital (WACC)). Further, the cost of capital is an important ingredient in the valuation of a company by investors.
The financing decision seeks to optimize the WACC by looking at a company’s capital structure, specifically the cost of equity and the cost of debt. If a company wants to create value for shareholders, it needs to ensure that it’s ROIC (Return on Invested Capital) is greater than the WACC. As part of financing decisions, companies aim to minimize their cost of funding while maintaining a stable credit rating and the ability to finance new projects.
Key Learning Points
- If a company wants to create shareholder value, its financing decisions should ensure that the WACC remains lower than its ROIC
- To calculate the WACC, we need to calculate the cost of equity and cost of debt and the proportion of debt and equity in the capital structure
- Investment banks can help companies in their financing decisions
Financing Decisions, Cost of Debt, Cost of Equity, and WACC
In order to establish the WACC of a business, we need to consider the cost of debt, which is based on market rates.
The formula is:
Kd = rf + spread
Rf: government bond yield (i.e. the risk-free rate)
Spread: reflects the company’s long-term credit rating
After establishing the cost of debt, we need to consider the cost of equity (Ke) – using the Capital Asset Pricing Model (CAPM)
Stated below is the CAPM Model, which is used to calculate the cost of equity:
Ke = Rf + Bp * (Rm – Rf)
Ke = Cost of equity
Rf = Risk-free rate
Bp = Beta of an investment or business
Erm = relates to expected return in the market
(ERm – Rf) = Risk Premium for taking on equity risk
Once we have these two components, we can bring them together to calculate the WACC (based on the long-term capital structure of a company).
The formula for the same is:
WACC = Kd * Debt/Total Capital * (1-t) Ke * Equity/Total Capital
Total capital = debt + equity (at market value)
T = Tax Rate
Financing Decisions and Investment Banking
Investment banks can help companies in minimizing their cost of capital (WACC).
Corporate financing decisions usually involve equity capital, debt capital, and risk management, and investment banks offer a range of services related to these. Investment banks can provide advice such as accessing equity capital markets and guiding companies as to whether they should consider an Initial Public Offering (IPO) and how best to execute this. Regarding debt capital markets, they can assist in investment-grade and leveraged finance capital markets. Other decisions may be regarding structured finance and corporate derivatives. When companies think about capital, they need to consider a foreign exchange when raising capital in different currencies, and interest rates for risk management and investment banks can offer experienced advice on this.
Financing Decisions, WACC, ROIC, Creating Value for Shareholders – Example
Given below is the calculation of WACC of a company (ADIDAS). The post-tax cost of debt and cost of equity has already been given. Its share price from its Public Information Book (February 11, 2019) was Euro 199.50 (i.e. the current market price at that time). The number of current shares outstanding is also from the same source (i.e. 200.3 million). The Equity at Market Value is equal to the product of the current market price and the number of current shares outstanding.
Next, we need the market value of debt. However, we use the book value of debt as a proxy number. They will not be too far apart from the underlying value of the debt. The book value of debt can be obtained from the balance sheet of the company and equals Short Term Borrowing + Other Current Financial Liabilities + Long Term Borrowings + Other non-current financial liabilities.
Finally, the WACC is calculated and one can view that the ROIC (23.9%) is significantly higher than the company’s WACC (7.3%). Therefore, we can conclude the company’s financing decisions are such that it is creating value for its shareholders.