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6.4. The Impact of Issue Costs

The introduction of a tax bias into our analysis of the cost of debt is our first example of a barrier to trade that runs counter to the Fisherian world of perfect competition outlined in Chapter One. But in the real world there are others, one of which we must now consider, namely issue costs.

In Chapter Five we hypothesized that dividends and earnings are perfect economic substitutes. At the beginning of this chapter we also stated that the cost of retained earnings is best measured by an opportunity cost, namely the shareholders' return foregone. But even if we ignore the dividend-earnings debate, how do we measure this?

In imperfect markets, a fundamental difference between a new issue of ordinary shares (like any other financial security) and retained earnings are the issue costs associated with the former. As a consequence, the marginal cost of equity issues is more expensive than retentions, which explains why management hold back earnings for reinvestment

To prove the point, using previous notation and our knowledge of equity valuation for a constant dividend stream (D) in perpetuity, let us introduce issue costs (C) into the constant dividend valuation model.

The marginal cost of an ordinary share Po issued by a company is now given by:

(11) Ke = D / Po (1 - C)

By definition, this is higher than the cost of retained earnings, since the latter do not incur issue costs. The cost of retained earnings is simply equivalent to the current dividend yield forgone by existing shareholders, namely their opportunity cost of capital:

(12) K = D / P

Note that also, that if we substituted earnings (E) for dividends (E) into both of the previous equations; management's preference for retentions, rather than dividend distributions, would still prevail in the presence of transaction costs.

Returning to the cost of loan stock, issue costs also increase the marginal cost of capital. This is best understood if we first substitute issue costs (C) into the cost of irredeemable debt in a tax less world. Like the equity model, the denominator of Equation (3) is reduced by issue costs.

(13) Kd = I / P0(1-C)

If we now assume that debt interest is tax deductible, the post-tax cost of debt originally given by Equation (7) also rises.

(14) Kdt = I (1-t) / P0(1-C)

Review Activity

In preparation for Chapter Seven and the data required to derive a weighted average cost of capital (WACC) as a cut-off rate for investment, use the information below to calculate:

- The total market value of the company's equity plus debt,

- The marginal cost of each fund source.

- 5 million ordinary £1 shares currently quoted at £1.20, £6 million in retained earnings, 4 million preference shares currently quoted at 60 pence and £2 million debentures trading below par at £80,

- Ordinary and preference shares currently yielding 20 per cent and 10 per cent, respectively,

- Ordinary dividend growth of 5 per cent per annum,

- New issues costs of 20 pence per share for ordinary and preference shares,

- A 10 per cent pre-tax debt yield.

- A 20 per cent rate of corporation tax

Total market value is the summation of ordinary shares, retained earnings, preference shares and debentures. With the exception of retained earnings derived from historical cost based accounts, all capital issues are valued at their market price as follows:

(5m x £1.20) + £6m + (4m x £0.60) + (£2m x 0.80) = £16m

Marginal Component Costs are based on market values, not book (nominal or par) values because management require today's yields to vet new projects. Component costs should therefore be underpinned by current returns for each category of investor who may finance projects. However, the company's ultimate concern, (rather than investors) is its own break-even income stream that may differ from the multiplicity of views held by proprietors and creditors. Consequently, the firm's component costs not only incorporate any tax effects, but also the costs of capital issues as follows:

Issue of ordinary shares = Dividend / Net proceeds of issue, plus the growth rate = [(£0.24 / £1.00] + 5% = 29%

Retained earnings = Dividend yield, plus the growth rate = 20% + 5% = 25%

Preference share issue = Dividend / Net proceeds of issue = £0.06 / £0.40 = 15%

Debentures (after tax) = (interest /net proceeds of issue) multiplied by (1-tax rate) = (£10.00 / £80.00) x (1- 0.20) = 10%

6.5. Summary and Conclusions

In Chapter One our study of strategic financial management began with a hypothetical explanation of a company's overall cost of capital as an investment criterion designed to maximise shareholder wealth. By Chapter Five we demonstrated that an all equity company should accept capital projects using the marginal cost of equity as a discount rate, because the market value of ordinary shares will increase by the project's NPV.

In this chapter we considered the implications for a project discount rate if funds were obtained from a variety of sources other than the equity market, each of which requires a rate of return that may be unique.

For the purpose of exposition, we analysed the most significant alternative to ordinary shares as an external source of funding, namely redeemable and irredeemable loan stock. We observed that corporate borrowing is attractive to management because interest rates on debt are typically lower than equity yields. The impact of corporate tax relief on debenture interest widens the gap further, although the tax-deductibility of debt is partially offset by the costs of issuing new capital, which are common to all financial securities.

In this newly leveraged situation, the company's overall cost of capital (rather than its cost of equity) measured by a weighted average cost of capital (WACC) would seem to be a more appropriate investment criterion. So, given the solution to your latest Review Activity, let us formally analyse how management can combine the component capital costs from various fund sources to derive a WACC as a discount rate for project appraisal.

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