How does a lower WACC effect shareholders?

Lowering WACC to effect shareholders

In this blog we are going to look at how lowering WACC can effect a companies shareholders. An optimal capital structure exists when the benefits of financing through debt is balanced against the risk of failing the pay obligated payments (Brick et al. 1983). This is managed through WACC, the weighted average cost of capital. This shows wether a company can reduce their cost of capital (the cost of financing a business)  by managing the balance of debt and equity (Hawkins, 2011). Modigilani and Miller contradicted the traditional view on WACC, arguing that the value of companies depends on business risk, and thus capital structure has no impact on WACC (Modigliani & Miller, 1958). However, this paper had to be revised in 1963 as they had failed to take tax into account. There is a distinct tax advantage to financing through debt so it is easy to say that their first paper was fundamentally wrong.

Example of WACC

If a share price is £100, with the expected return being £15, this becomes the shareholders required rate of return. So, if financing through debt returns £18 per share, then it will still attract buyers as shareholders chase share that give high returns in normal markets. Therefore, for a company to finance through debt, the return must bring a stronger yield. Assuming that a companies risk profile does not change, it suggests that there are benefits to long term interests in share price and dividends.

However, gearing does change a companies risk profile as interest payments remain constant, the company must be able to pay these off.

Applying WACC

It is cheaper for a company to finance it's ventures through WACC, as lenders need a lower return than shareholders, and transactions costs are cheaper than issuing shares. A company must be able to generate more cash than they are paying to investors and shareholders, and thus managers will base any decisions on whether the return is greater than their WACC. Therefore, a lower WACC results in greater investment opportunities.

Finding the balance to protect shareholders.

WACC can be altered through changing a companies capital structure, by raising or lowering company debt based on market values. In order to increase these returns, the obvious action for a company to take is to increase their balance of debt to quickly develop further wealth. The issue here is equity investors would not settle for similar returns when their risk has increased. Given that the world does not operate within a perfect capital market, all stakeholders cannot borrow at the same rate.
Increasing gearing to offset tax can result in a lower WACC. However, as this would increase an equity investors risk of a poor return, it becomes more difficult for companies to do so. High gearing reduces the benefit of a lower WACC, so companies need to be able to distinguish a balance in their market. Given that utility companies operate in a very stable, predictable market, it is possible to operate through high levels of gearing as they can accurately forecast results. However, in an engineering market, which is much more volatile, high gearing can very quickly cause issues.
Correct management of debt can enhance a company's value and act as a wealth maximising factor for shareholders (Jensen, 1986). This is because it is both lower risk and cheaper than ordinary shares (Arnold, 2013). 

WACC applied in reality.

Electrical companies heavily invested in their distribution networks as their returns are based upon their assets. The issue here was that Ofgem, who regulate gas and electricity markets (Ofgem, 2014), capped industry price rises based on assumed WACC of 4.7%. However, the industry argued that this would not be enough to warrant their investment. Despite their concerns, Ofgem argued that correctly managed companies would seen significant returns. Ofgem's publication on this issue can be found here.

Conclusion.

It seems as though there is a fine line in regard to using WACC and it must be managed carefully. A low WACC will increase shareholder returns as a result of potentially gained investments. However, it is not so simple to reduce a companies WACC due to conflicting investor interests (debt and equity investors), tax and gearing issues. This difficulty is shown in the Ofgem example, it is not easy to manage WACC in real scenarios as their decision to maintain a low WACC but demand investment resulted in industry outrage. Therefore, a companies WACC needs to be realistically achieved, allowing them to meet their targets will ultimately benefit shareholders and investors.

References

Arnold, G. (2013). Essentials of Corporate Financial Management. (2^nd ed.). Harlow:Pearson.

Brick, I.E., Mellon, W.G., & Surkis, J. (1983). Optimal capital structure: A multi-period programming model for use in financial planning. Journal of Banking and Finance, 7(1), 45-67. doi:10.1016/0378-4266(83)90055-9

Hawkins, N. (2011). Wacc to the future. Utility Week, 24-25. Retrieved from http://search.ebscohost.com/login.aspx?direct=true&AuthType=cookie,ip,shib,uid&db=buh&AN=66654108&site=ehost-live&scope=site

Jensen, M. C. (1986). Agency costs of free cash flow, corporate finance, and takeovers. The American economic review, 323-329. Retrieved from http://lib.cufe.edu.cn/upload_files/file/20140522/3_20140522_36%20Jensen,%20Michael%20C.,%201986,%20Agency%20costs%20of%20free-cash-flow.pdf

Modigliani, F., & Miller, M. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment (48th ed.). Retrieved from https://www2.bc.edu/~chemmanu/phdfincorp/MF891%20papers/MM1958.pdf

Ofgem (2014) Who we are. Ofgem 'making a positive difference for energy consumers'. Retrieved from https://www.ofgem.gov.uk/about-us/who-we-are