CHOICE OF OPTIMAL CAPITAL STRUCTURE

-case study Transgaz SAProfesor

coordonator:
Conf.Dr. Anamaria Ciobanu
Masterand:
Cîrstea Raluca Daniela
Bucharest
July 2008
Master:
Financial Management and
Capital Markets
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1. About this paper
The scope of this paper was to determine whether the successful
Transgaz IPO at
the end of 2007 was the best (cheapest) financing solution for the
company. In
December 2007, the state decided to increase the capital Transgaz
through an IPO.
The decision was welcomed by the stock market and the 225.963,5
thousands RON
representing 1.177.384 shares was subscribed in full. The question this
paper is trying
to answer is whether this amount could have been borrowed more
cheaply.
To answer this question, I have firstly summarized the most important
financial
theories regarding capital structure. Firstly, I have talked about general
finance
theories, in order to see if there is such thing as an optimum structure, at
which the
cost of capital for a company reaches a minimum. Once this issue settled,
I passed
further with my inquiries on the cost of various components of the capital
structure.
I started by evaluating various methods of computing share capital cost. I
took
into account two models: dividend growth model and the capital asset
pricing model
(CAPM). Based on the advantages and the disadvantages identified at this
stage, I
chose one of them to evaluate Transgaz cost of share capital. The next
step was to
evaluate the cost of debt. To reach this goal, I first stated theories that try
to identify
the characteristics of debt that best suit a company. The cost of
redeemable debt can
be then computed using an IRR function. At last, I considered theories that
try to give
a guide on how to compute a company’s optimal structure. Again, I chose
the one that
fitted best Trangaz situation.
On the last chapter of my paper I applied the theories identified in the
previous
steps. I computed a cost of share capital, of debt and finally reached an
optimal
structure of the company. Based on that optimal structure, I compared
the cost before
and after the IPO and the cost of having IPO and going in debt.
The conclusions drawn aren’t as clear as one might think. Both options
(IPO and
debt) provide a similar cost of debt and the resulted value of firm is not
very different
from one option from another.
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2. Optimal capital structure in the financial theory
There are several theories regarding the existence of an optimal
structure:
� Traditional theory – according to this theory the wighted average cost of
capital drops up to a point and the increases as the indebtness rises also.
The optimum
capital structure will be at the point of minimum WACC. Therefore,
according to this
theory there is such thing as an optimum capital structure and a company
can increase
its value by using debt wisely;
� Modigliani-Miller theory (MM) – is totally different than the one presented
above. According to MM theory, capital structure has no influence on
WACC.
Moreover, the company’s value will be determined the total income and
the degree of
operational risk corresponding to those incomes. The has, nevertheless,
some strong
assumptions that do not apply in the real life;
� Pecking order – this is not a classical theory, which tries to give solutions
in
finding the optimal capital structure. It sort of explains management
preferences in
financing choices. According to this theory, the preference for the finance
sources will
be as follows: retained earnings, debt (plain and convertible) and share
capital
(preference and ordinary). As one might notice, the cheapest finance for
the
management is retained earnings, while the most expensive are common
stock.
Other theories have tried to find optimal financing resources based on the
life
cycle of the company. For start-ups, share capital is the main source of
finance and
eventually some bank loans. In rapid expansion stage, the finance needs
increase, but
share capital remains the main resource. The increase in finance is
generally obtained
by venture capitals and even going public. In maturity stage, some
companies prefer
to finance their investments internally, while others use debt. When
reaching decline,
the resources exceed investments opportunities and, therefore,
companies may
repurchase debt or share capital.
Also, there are a series of influencing factors that may induce preference
for one
way of financing or another. The most important ones would be:
� Asset type – a company with lots of tangibles assets will have greater
indebtness than one with many intangibles;
� Uncertainty of operational income – a company with uncertain operational
income will have less debt in its capital structure;
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� Income tax – the biggest the income tax, the greater the leverage (due to
the
tax shield);
� Flexibility needs – the biggest the need for future flexibility, the less debt
in
the capital structure;
� Creditors’ difficulty in monitoring management’s actions – the more
difficult, the less debt.
I assumed that there is such thing as optimal capital structure and
therefore past to
methods of computing various capital components.
3. Cost of share capital
There are two main methods of computing share capital cost:
� Dividend growth model – the model is rather simple, assuming a constant
return on dividends and a constant growth rate of these dividends. The
model is
expressed as follows: g
P
ke = DPS +
The main drawback of the model is that it does not incorporate risk.
� CAPM – is in fact a method of estimating risk, which approximates
shareholders’ wealth by adding a premium risk to an average return. The
starting
point is the minimum return (generally represented by the return of the
treasury bills)
and a risk premium is added to compensate for the company’s risk. The
model is
expressed as follows: ke = Rf + β(Rm - Rf).
The incorporation of risk is made through β – defined as covariance
between the
return of a title and the return of the market.
Due to the fact that the model incorporates risk, we used it to evaluate
the cost of
share capital for Transgaz.
4. Cost of debt
The cost of redeemable debt can be computed using the following formula
n
d net
n
2
d net d net
0 (1 k )
..... i P
(1 k )
i
1k
Pi
+
+
++
+
+
+
=
The type of debt can be determined based on the following factors:
� Maturity – the company must match its asset maturity with the finance
maturity in order to minimize bankruptcy risk;
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� Fixed vs. floating rate – this decision must be taken based on whether the
cash flows corresponding to the project will be influenced by inflation.
� Currency of issue – this decision has serious impact on the exchange rate
risk, which appears whenever the cash flows are generated in a different
currency than the one of the loan.
5. Case study – Transgaz SA
Cost of share capital
We chose CAPM for estimating chare cost of capital of Transgaz:
ke = Rf + β(Rm - Rf)
For estimating the BETA for Transgaz, we used a proxy, since the CAPM
method requires computing beta based on stock market quotations. The
proxy we
chose was represented by Transelectrica, which is also a utilities
company, most of its
capital being also owned by the state. We unleveraged the beta obtained
and
subsequently, we corrected with the gearing of Transgaz. The beta
obtained was of
0.93. By using also a RFR of 7% and a market (represented by BET-C)
average
return of 18%, we obtained a share capital cost of 17%.
Cost of debt
Firstly, we defined the type of debt that would best suit Transgaz
financing
needs. We determined regressions between the operational income, on
the one hand,
and the RFR (to determine influence of interest rate), GDP (to establish
whether
operational income is cyclical), inflation (to determine whether the debt
issued should
be floating rate) and exchange rate (to identify the currency of issue):
1. interest rate : Operating income =0.8 –0.08*RFR Transgaz income
are not
significantly influenced by the interest rate;
2. GDP : Operating income= 0.56 +1.12*GDP – this shows that the
company is
cyclical, and that its operational income depends on the stage the
economy is
in;
3. exchange rate :
a. USD : Operating income = 0.85 –1.06*E/R USD – there is a
significant influence of USD exchange rate on operating income. This
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can be explained through the fact that gas price is expressed in USD,
and that Transgaz transfers this cost to its consumers;
b. EUR : Operating income = 0.79 – 0.51*E/R EUR – this influence is
not significant ;
4. inflation: Operational income=0.9 – 0.3*inflation – little effect on
the
operating income from the inflation.
The results showed that Transgaz operational income is not influenced by
the
interest rate or the RON/EUR exchange rate. The other factors have
significant
influence, and, as a consequence, the company should issue fixed rate
debt,
denominated in USD.
Since the duration of fixed assets is generally of 20-50 years, I chose a
maturity
of 20 years for the loan. Based on the BB+ rating given by S&P to
Transgaz for long
term corporative debt, I established an interest rate on the loan of 10.2%
(7%+3.2%).
We obtained an 8.41% interest rate.
WACC
We computed the WACC in three situations: before the increase in capital,
after
the IPO and in the situation under which the company would issue debt.
Existing structure
Before the IPO, the company had a gearing of 26%
Results of the analysis
Current Optimum Variation
D/(D+E) 26% 80% 54%
Beta 0.93 3.12 2.19
Share capital cost 17% 41% 24%
Interest rate 9% 7% -1%
WACC 14.94% 14.10% -0.84%
This shows that the company was very close to the optimum structure,
since the
WACC was of 14.94% instead of 14.1%
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IPO structure
As a result of the IPO, the leverage decreased up to 20%.
Results of the analysis
Current Optimum Variation
D/(D+E) 20% 60% 40%
Beta 0.86 1.60 0.74
Share capital cost 16% 25% 8%
Interest rate 9% 7% -1%
WACC 14.86% 14.23% -0.63%
Again, the company is very close to its optimum, with a WACC of 14.86%
as
opposed to a 14.23% (corresponding to a 60-40 debt/equity structure).
The beta of the
company in this case is of 0.86, beta that reflects the low risk due to
reduced
indebtness.
Proposed structure
On the previous stage we obtained a 60%debt -40%equity optimum
structure.
This means that the company could have lent the money instead of going
public.
As one can see the WACC diminished to a 14.34%, closer to the optimum.
The
change is not significant so, therefore, we can say that the company did
not make a
disadvantageous decision regarding financing.
6. Conclusion
Summarizing the findings in previous chapters:
Structure Debt
percentage
Beta Ke Kd net WACC Firm value
Tds RON
Initial 26.42% 0.93 17.23% 8.57% 14.94% 755,603
IPO 20.25% 0.86 16.46% 8.57% 14.86% 990,795
Debt 43.61% 1.17 19.87% 8.57% 14.34% 1,000,972
Optimum 60.00% 1.60 24.63% 7.31% 14.24% 1,008,322
Results of the analysis
Current Optimum Variation
D/(D+E) 44% 60% 16%
Beta 1.17 1.60 0.43
Share capital
cost
20% 25% 5%
Interest rate 9% 7% -1%
WACC 14.34% 14.24% -0.70%
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It is easy to see that the WACC is very similar in all four cases. The
variation is
registered in the value of the firm. In the finance by debt it increases by
1% (almost
10 mil RON). Since the difference is rather small in relative size, the
management
took a good decision in going public.
The company benefited from the great exposure, it has access to an
immense
source of finance and it also had a great influence on the Romanian stock
market.
Nevertheless, management should be aware of the disadvantages that
going public
implies, out of which we can mention the difficulty to estimate the
investors’ reaction
regarding company’s information, the uncontrollable variations of the
market price
etc.
To conclude, the management should keep in mind the existence of an
optimum
capital structure and try to reach to that equilibrium point. A good
evolution on the
stock market would give the company access to a cheaper debt, therefore
diminishing
the WACC of Transgaz.
Bibliography:
***, ACCA course notes – F9 Financial Management, BPP Learning Media, Londra,
2007
***, Price Waterhouse Coopers , Prospect Transgaz, 2007
Damodaran A., Applied Corporate Finance,John Wiley and Sons, 2002
Peter Helfert , Financial analysis-tools and techniques, McGraw-Hill, 2001
Ross-Westerfield-Jaffe, Corporate Finance, McGraw-Hill, 2002
Stancu I., Finante, Ed Economica, Bucuresti, 2002, pp 642-645
www.bvb.ro
www.ktd.ro
www.stern.nyu.edu/~adamodar/spreadsheets
www.transgaz.ro
www.zf.ro