BT buys EE- Capital Structure

BT buys EE – Capital Structure and WACC

In a previous blog I wrote about BT’s recent announcement that they were acquiring EE.  I went into details regarding their share price movement and market efficiency.  In this blog, I am going to write about capital structure, the Weighted Average Cost of Capital (WACC) and how BT have financed their acquisition with EE.

A companies’ WACC is calculated by the weighting of the cost of debt and equity in proportion to their contributions to the total capital of the firm. A company needs to provide a rate of return which is level with the amount of risk that the investor is undertaking by purchasing their shares.  The WACC establishes the minimum return needed on an investment to satisfy shareholders that the level of risk they are taking is in line with their returns, if this is too low investors will realise their levels of investment are too high risk for their percentage return and they would sell shares to receive a better return elsewhere (Arnold, 2013).

As debt has lower costs involved compared to equity, it could be suggested the ideal situation to reduce this cost would be to increase a company’s amount of debt, obviously this is not the case. Debt finance is a cheaper method compared to equity due to lenders requiring a lower rate of return than ordinary shareholders (Minnix, 1999).  By using debt finance there are also tax advantages, debt interest can be offset against pre-tax profits therefore, reducing the amount of tax paid. I believe this could be why BT has funded a large proportion of their acquisition with debt. So in theory, for BT to reduce their WACC they need to increase their gearing level, generally speaking this reduces the cost of capital.  However, this does not come without risk; there is the risk of Financial Distress (Diamond, 2010).

I have created a diagram below showing what generally happens to the overall cost of finance and the risk of a company becoming financial distressed when the level of gearing changes.

If a company is heavily financed by debt then the costs of financial distress could become a real issue and involve large costs.  A lender would need to cover the risk of the company becoming bankrupt and facing liquidity, therefore the debt interest increases.  BT have used a combination of equity and debt to purchase EE, they are generally seen as a stable company therefore, I think they are unlikely to be at risk of financial distress costs. Although an increased amount of debt decreases the WACC, due to it being cheaper than equity, too much debt will increase WACC due financial distress costs and shareholders wanting higher returns to cover their rate of risk. Shareholders may become concerned if the gearing levels are too high, this may depress the share price and destroy shareholder value.  Therefore, ideally a company’s capital should be balanced with debt and equity to help control their WACC.

When BT announced their acquisition they said they would raise £1 billion by selling shares.  One of the main advantages of raising capital through equity is the ability to retain profits if they are facing financial difficulties, whereas debt repayments are strict and lenders would need paying back regardless of the companies’ performance. However, a costly method of financing, ordinary shareholders demand higher returns than the interest rates on debt therefore an increased amount of equity increases a companies’ WACC.  Looking at two extremes of 100% debt or equity involve large costs, therefore there must be a balance?

Bringing us nicely to the concept of an optimal capital structure, this is suggested by the WACC calculation. Brennan and Schwartz (1978) provided the first quantitative examination of there being an optimal leverage between debt and equity, their theory had many limitations however it was an important start for finding a balance between the two (Leland, 1994).  Finding an appropriate balance is different for each individual company, for example energy and water suppliers are able to be highly geared due to their products being a necessity, creating a stable market.  They have a high and constant reliable demand and their cash flow forecasts are easy to predict, therefore they can accurately calculate whether they would be able to cover the costs of debt.  I do not think this is necessarily the case for BT as there are other communication providers, which are highly competitive. BT have balanced the capital structure of purchasing EE by raising £1 billion in shares, increasing their debt and giving Deutsche Telekom 12% of BT and Orange a 4% stake (Financial Times, 2015).

In 1958, Modigliani & Millar argued that a companies’ capital structure has no impact on their WACC therefore, there was no such thing as an optimal structure.  They made three main assumptions to validate their argument:

·         There is no taxation

·         We live in a world with perfect capital markets, with perfect information available to all economic agents and no transaction costs

·         There are no costs of financial distress and liquidation (Modigliani & Miller, 1958)

These were heavily criticised after they published their argument on these assumptions, which were fundamentally wrong.  They later revised their theory in 1963 to include taxation due to the deductibility of interest payments in the tax system, many companies use debt to reduce the amount of tax they pay therefore reducing their WACC. Their revised theory, incorporating tax, combined with their previous assumptions made their theory correct as the market value maintained the same, arguing that the capital structure of a company is irrelevant and they used Arbitrage Theory to back this up.  Their new theory however, argued that there was no financial risks with gearing and increased levels of interest and financial distress rates did not exist.  Therefore arguing an increased level of gearing would reduce companies’ WACC and this would continue to decrease.  In reality, we know this is not the case and yet again their theory was disproved (Brick et al., 1983). 

It is vital for a company to discover their optimal structure in order to maximise their value, however this is a complex process and can be affected by many variables.

References

Arnold, G. (2013). Essentials of Corporate Financial Management. (2nd ed.). Essex: Pearson Education Limited

Brick, I. E., Mellon, W. G., Surkis, J., & Mohl, M. (1983). Optimal capital structure. Journal of Banking and Finance, 7(1), 45-67. doi:10.1016/0378-4266(83)90055-9

Diamond, J. (2010). Forum: Corporate debt and taxes. National Tax Journal, 63(1), 149-150. Retrieved from http://search.proquest.com/docview/203281269?pq-origsite=summon#

Leland, H. E. (1994). Corporate debt value, bond covenants, and optimal capital structure. The Journal of Finance, 49(4), 1213-1252. doi:10.1111/j.1540-6261.1994.tb02452.x

Minnix, R. (1999). Combining the benefits of debt and equity. International Financial Law Review, 18(8), 12-13. Retrieved from http://heinonline.org/HOL/Page?handle=hein.journals/intfinr18&id=439

Modigliani, F., & Miller, M. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment, The American Economic Review, 48(3), 261-297. Retrieved from http://www.jstor.org/stable/1809766?origin=JSTOR-pdf&seq=3#page_scan_tab_contents

The Financial Times (2015). BT seals £12.5bn deal to buy EE. Retrieved from http://www.ft.com/cms/s/0/9a74a0ec-ac6c-11e4-9aaa-00144feab7de.html#axzz3TFFZD3nX