In business, success and failure are never far apart. Among the many different options available, management has to select those initiatives that can be managed with (limited) corporate resources in terms of capital, people and time available. The aim of the game is to maximize shareholder or stakeholder value.

Estimating the potential for the creation of shareholder value or economic ‘value add’ of a project is not rocket science. Any project with a positive net present value (NPV), where the cash flow is discounted at the weighted average cost of capital (WACC), should increase shareholder or economic value. However, experienced business managers know that in reality this is not that easy.

Management has always tried to include some objectivity in project selection in order to avoid personal risk. There are a wide range of methods and models for calculating and ranking the NPVs of projects under review, but most models are a variation on discounted cash flow or real option methods. While many of these are complex and cumbersome to use, if not ineffective in day-to-day business, others in contrast are far too simple.

The model selected will affect the estimated shareholder value created as well as the ranking of projects. Without careful examination, a model or method could provide a false objective measure to determine the value created. This is not because the formulae are incorrect, but because the input assumptions applied by the analyst are often taken for granted and not properly understood.

This article examines to what extent input, assumptions and models used for project selection could create a biased opinion of the creation of shareholder value. Companies should also make sure that the investment proposals allow management to compare individual projects and select those that make the best contribution to the creation of shareholder value. Treasury, as a custodian of risk management, could be the internal consultant to management in preparing and substantiating decisions on the allocation of a company’s limited resources.

Scope of Projects

Projects are different from business operations because they require a team of (hand-picked) people to achieve pre-defined objectives within an agreed timeframe, as well as an (upfront) agreed investment.

Once the objectives are achieved and the output is handed back to the business, the project and its organization is dissolved.

Typically, projects are created to improve or expand business operations but the nature and effect of a project can vary widely. For instance, a project on the acquisition and integration of new business is different to a project to develop and introduce a new product. A calculation of the shareholder value created can, of course, help to prioritize all these projects but because the effort, scope and risk of each project are different, companies must make sure they make accurate and meaningful comparisons between projects.

1. Cash flow projections

Each model starts with a forecast of project cash inflow and outflow. By its very nature, the validity of a forecast is highly dependent on the underlying assumptions, and most models recognize that cash flow projections cannot be 100% accurate.

More complex models include a sensitivity testing function but this takes considerable effort to build.

Many companies take shortcuts by varying the net or gross cash flows as calculated for the base case. These shortcuts might give an inaccurate view because varying the value of (net) cash flow does not recognize the fact that delayed projects could incur not only higher cost but also costs over a prolonged period. As a result, revenues could be lower than anticipated or the expected cash inflows from that project may be delayed. In fact, any delay to the anticipated cash inflow can have a disproportionate effect on the NPV of the project.

A second issue related to cash flow projection is what elements should be included. Some companies include only ‘hard dollar savings’, ignoring ‘soft dollar savings’, such as unlocking partial full-time equivalents (FTEs) allowing staff to focus on (other) value adding activity, or existing cash flow that might be jeopardized if the project is not accepted.

Other benefits, such as security, market perception or quality of data, are even more difficult – if not impossible – to quantify. And, even if they were, it would still be difficult to quantify their contribution to individual projects.

The more companies focus on ‘hard dollar savings’, the more projects will need to focus on core business operations. As a result, projects that would significantly improve the quality of management information systems without reducing headcount might be overlooked. Short and low risk projects with a small upfront investment will be considered a higher priority than larger, more risky projects. For instance, projects building on existing infrastructure to create incremental benefits will typically be favoured above projects that result in a paradigm shift within the organisation.

A third issue is the horizon of the cash flow projection.

For comparison purposes, companies often have standard projection horizons of three or five years. However, the longer the project implementation takes, the longer it will take for the benefit to materialize.

Prefixed horizons favour projects with ‘quick wins’, low investments and short implementation. Important infrastructure projects might not return a significant positive NPV over a three-year period. On the other hand, projects with lasting ‘quick wins’ contribute a benefit after three, four or even 10 years – long after anybody would even remember the objectives!

If one sets the horizon of projections in a different way for each project, comparing the projects will not be straightforward. If one assumes that projects are considered only to the extent that they enhance shareholder or stakeholder value, the relevant horizon should be adjusted to the profile of stakeholders.

2. Discount factor

After the projections have been validated, the next step is to discount cash flows in order to make the NPV comparable. In theory, the WACC represents the rate at which projects will start generating shareholder value. The WACC is the weighted average cost of capital though and if a company is treated as a portfolio of projects, the WACC is a reflection of all activities and risks inherent in the company’s businesses.

Furthermore, the WACC is not constant over time. Among other factors, the WACC depends on the risk free rate, the company’s funding strategy (leverage) and risk profile. Each of these factors will change over time and can be different for each business line or project. The cost of capital should therefore be agreed individually for each project, and there are a number of issues that need attention.

Allocation of equity and debt

The allocation of equity and additional funding to projects is an important factor for the calculated NPV.
Using the current WACC for the calculation disregards the effect a project might have on company leverage when approved. Using the current WACC will also underestimate the shareholder value created by the project if additional (senior) funding is put in place.

However, in a similar case, the marginal approach to the project cost of capital would allocate all new (senior) funding disproportionately to the new project and thus overestimate the shareholder value to be created.

Another approach to this issue is to estimate the risk profile of an individual project and allocate equity accordingly. Depending on the magnitude and profile of projects in the portfolio, this might imply that a company could have a temporary or permanent equity surplus (or shortage). All projects should then compensate for this difference in order to satisfy stakeholders’ requirements.

A project cost of capital curve

The WACC will change over time as a result of market fluctuations and funding strategies. It is therefore not unreasonable to discount the first year cash flow at a different rate than that of the fourth or fifth year. The curve for the cost of capital for an individual project does not have to correlate to a risk-free yield curve.

The leverage strategy and change in the company’s risk profile will also affect this curve.

3. Identifying project risk

Each project will have a specific risk profile. The real option method tries to treat each risk component as a decision ‘option’ and estimates the value of each one using standard option calculation methods. The result of this approach to project risk is dependent on the predicted accuracy of the decisions, likelihood of each option available and timing of such occasions.

The more options involved in each decision, the more difficult it will be to verify the assumptions and thus validate the outcome.

Other simpler and widely used models will increase the discount factor with a risk premium. This approach will not favour projects with a high upfront investment and long impact horizon. Outsourcing projects that convert fixed investments into variable cost might also benefit disproportionately from this approach to project selection.

Risk is project specific and sometimes even option specific, i.e. two alternative approaches to the same project might have different risk profiles. The case for outsourcing a project to two different countries might have an identical cash flow; however, the market might see one as a higher risk than the other (e.g. as a result of additional country risk). Allocating additional equity to one project or adjusting the company WACC with a country specific outlook are alternative approaches for incorporation of such risk elements.

Individual projects can potentially affect the overall company risk profile. Acquisitions or major investments could affect the company beta and change the overall cost of capital. If these changes are not incorporated in the project NPV, the contribution to shareholder value can easily be misjudged. A marginal approach to allocating the cost (or benefit) of changing the company risk profile is tempting, especially when companies execute a diversification strategy. However, quite a few companies do feel the pressure of trying to capitalize on a break-up premium.

To address the element of risk, some methods will use a less complex approach by increasing the standard project discount factor. This risk factor might vary from project to project and this approach to risk favours projects with ‘quick wins’ early on in the project. This can be at the expense of projects with long-term structural impact because of the reduced NPV of cash flows over a long period of time. For the same reason, the method also favours projects with small upfront investments.

A Role for Treasury

In order to substantiate and motivate the value created by projects, companies need to ensure that cash flow projections and project risk are modelled in such a way that the outcome is comparable. Project support offices (if available) are hardly ever equipped for this task.

Treasury as the custodian of cash forecasting, risk management and fair value calculation, is ideal for this job. It would make perfect sense for treasury to develop useful models for project managers and evaluate the business case documents for executive management. In this way, treasury would be able to reinforce its role as an internal consultant on cash flow and risk management.

Conclusion

Many companies put a lot of effort into modelling the benefits of projects prior to approval. Allocating scarce resources in order to ensure a successful project is an important responsibility of management and they should understand how an adopted model is applied within a project.

Validating the motivation behind input and stress testing of cash flow projections is probably more important than the fact that, on paper, projects will return the value that makes them eligible for approval. Treasury can use its expertise to assist management and make sure the company chooses the best projects.

It is important to look beyond mere numbers and not focus on the difference of 1% or 2% in the NPV; remember there is always an element of art and ‘gut instinct’ in project selection. Management should therefore treat project analysis as a tool to support their strategic decision-making within the company.

Overview of WACC Estimation

The WACC is recognized as one of the most critical parameters in strategic decision-making. It is relevant for business valuation, capital budgeting, feasibility studies and corporate finance decisions. When estimating the WACC for a company, there is a clear trade-off between theoretical purity and actual circumstances faced by a company. The decision in this context should reflect the actual environment in which a company operates. In general, the WACC is estimated using the following equation:

D: Market value of interest-bearing debt
E: Market value of common equity
H: Market value of hybrid capital
R_D: Cost of interest-bearing debt
R_E: Cost of common equity
R_H: Cost of hybrid capital
Ô: Corporate tax rate

The estimation of the WACC is based on several key assumptions:

• It is market driven. It is the expected rate of return that the market requires to commit capital to an investment.
• It is a function of the investment, not the investor.
• It is forward looking, based on expected returns.
• The base against which the WACC is measured is market value, not book value.
• It is usually measured in nominal terms, which includes expected inflation.
• It is the link, called a discount rate, which equates expected future returns for the life of the investment with the present value of the investment at a given date.

The WACC seems easier to estimate than it really is. Just as two people will rarely interpret a piece of art the same way, neither will two people calculate the same WACC. Even if two people do reach the same WACC, all the other applied judgments and valuation methods are likely to ensure that each has a different opinion regarding the components that comprise the company value.

Therefore, the following sections of this article will discuss the different WACC components in more detail. Errors that are frequently encountered in practice will be highlighted as well as best market practice as a guide for estimating the WACC.

Capital Structure

The first step in developing an estimate of the WACC is to determine the capital structure for the company or project that is being valued. This provides the market value weights for the WACC formula. Best market practice is to define a target capital structure and this is for several reasons.

First, the current capital structure may not reflect the capital structure that is expected to prevail over the life of the business.

The second reason for using a target capital structure is that it solves the potential problem of circularity involved in estimating the WACC, which arises when calculating the WACC for private companies. For instance, we need to know market value weights to determine the WACC but we cannot know the market value weights without knowing what the market value is in the first place.

To develop a target capital structure, a combination of three approaches is suggested:

1. Estimate the current capital structure.

A capital structure can comprise three categories of financing: interest-bearing debt, common equity and hybrid capital. The best approach for estimating the current ‘market value-based’ capital structure is to identify the values of the capital structure elements directly from their prices in the marketplace, if available. For equity, market prices are available for public companies, but it is more difficult to identify the market value of equity for private companies, business units and also for illiquid stocks.

The same applies for public debt, such as bonds, where the market value can be identified from available market prices. In the case of private debt, however, such as bank loans and private placements, the current value needs to be calculated. (For discussion about the difficulties of calculating the market value of hybrid capital, please refer to the third article in this series on the WACC.) The conclusion is that estimating the current capital structure based on market values could be difficult when market prices are not available. The next approach could assist in solving this difficulty, by estimating a target capital structure based on information from comparable companies.

2. Review the capital structure of comparable companies.

In addition to estimating the market value-based capital structure currently and over time, it is useful to review the capital structures of comparable companies as well.

There are two reasons for this. First, comparing the capital structure of the company with those of similar companies will help to understand if the current estimate of the capital structure is unusual. It is perfectly acceptable that the company’s capital structure is different, but it is important to understand the reasons behind this.

The second reason is a more practical one because in some cases it is not possible to estimate the current financing mix for the company. For privately held companies, a market-based estimate of the current value of equity is not available.

3. Review senior management’s approach to financing.

It is important to discuss the company’s capital structure policy with senior management to determine their explicit or implicit target capital structure for the company and its businesses.

This discussion could give an explanation why a company’s capital structure may be different from comparable companies. For instance, is the company by philosophy more aggressive or innovative in the use of debt financing? Or is the current capital structure only a temporary deviation from a more conservative target?

Often companies finance acquisitions with debt they plan to amortize rapidly or refinance with equity in the near future. Alternatively, there could be a difference in the company’s cash flow or asset intensity, which results in a target capital structure that is fundamentally different from comparable companies.

Corporate Tax Rate

The WACC is a calculation of the ‘after tax’ cost of capital. The tax treatment for the different capital components – such as interest-bearing debt, common equity and hybrid capital – is different. The corporate tax rate in the earlier mentioned WACC equation is applicable to debt financing because in most countries interest expense on debt is a tax-deductible expense to a company.

It is appropriate, however, to take into consideration the fact that several countries apply thin capitalization rules that may limit tax deductibility of interest expenses to a maximum leverage.

Furthermore, in some countries, expenses on hybrid capital could be tax deductible as well. In that case the corporate tax rate should also be applied to hybrid financing and the WACC equation should be changed accordingly. (For more information on hybrid capital please refer to the third article of this series on the WACC.)

Finally, corporate tax can also have a positive impact on the cost of equity. An example is Belgium, which recently introduced a system of notional interest deduction, providing a tax deduction for the cost of equity. This system will be further explained in the fifth article of this series, which elaborates on the impact of notional interest deduction on the WACC. In other words, the calculation of the WACC for Belgian financing structures needs to be revised.

The main conclusion is that the application of the corporate tax rate in the WACC equation will differ per country. As mentioned before, when estimating the WACC for a company, there is a clear trade-off between theoretical purity and actual circumstances faced by the company. Best market practice is to reflect the actual environment in which a company operates. Therefore the WACC equation needs to be revised accordingly.

Cost of Interest-bearing Debt

The cost of interest-bearing debt can be estimated using the following equation:

R_D = R_F + DRP

R_D: Cost of interest-bearing debt
R_F: Risk-free rate
DRP: Debt risk premium

The category of interest-bearing debt consists of short-term debt, long-term debt and leases. Many companies have floating-rate debt, as an original issue or artificially created by interest rate derivatives. If floating-rate debt has no cap or floor, then it is best market practice to use the long-term debt interest rate. This is because the short-term rate will be rolled over and the geometric average of the expected short-term rates is equal to the long-term rate.

The cost of debt is calculated using the marginal cost of debt, i.e. the cost the company would incur for additional borrowing, or refinancing its existing interest-bearing debt. This cost is a combination of the risk-free rate and a debt risk premium. Credit ratings are the primary determinants of the debt risk premium. (More information on the relationship between the WACC, shareholder value and credit ratings can be read in the second article of this series on the WACC.)

The risk-free rate is the theoretical rate of return attributed to an investment with zero risk. The risk-free rate represents the interest that an investor would expect from an absolutely risk-free investment over a specified period of time. In theory, the risk-free rate is the minimum return an investor should expect for any investment.

In practice, however, the risk-free rate does not technically exist, since even the safest investments carry a very small amount of risk. Therefore best market practice for WACC estimations is to use the yield on a 10-year government bond as a proxy for the risk-free rate.

Estimating the WACC can be a challenging exercise, however, because a risk-free government bond is not always available in emerging markets. (This will be discussed further in article seven of this series.)

The cost of debt is the yield-to-maturity on publicly traded bonds of the company. Failing availability of that, the rates of interest charged by banks on recent loans to the company would also serve as a good cost of debt. When using yield-to-maturity to estimate the cost of debt it is important to make a distinction between investment and non-investment grade debt. Investment grade debt has a credit rating greater than or equal to BBB- (Standard & Poor’s). For investment grade debt, the risk of bankruptcy is relatively low.

Therefore, yield-to-maturity is usually a reasonable estimate of the opportunity cost. The coupon rate, which is the historical cost of debt, is irrelevant for determining the current cost of debt. Best market practice is to use the most current market rate on debt of equivalent risk. A reasonable proxy for the risk of debt is a credit rating.

When dealing with debt that is less than investment grade, pay attention to the difference between the expected yield-to-maturity and the promised yield-to-maturity. The latter assumes that all payments (coupon and principal) will be made as promised by the issuer. Therefore it is necessary to compute the expected yield-to-maturity, not the quoted, promised yield. This can be done based on the current market price of a low-grade bond and estimates of its expected default rate and value in default.

If the necessary data is not available, use the yield-to-maturity of BBB-rated debt, which reduces most of the effects of the differences between promised and expected yields.
Leases, both capital and operating, are substitutes for other types of debt. In many cases it is reasonable to assume that their opportunity cost is the same as for the company’s other long-term debt. Since capital leases are already shown as debt on the balance sheet, their market value can be estimated just like other debt.

Operating leases should also be treated like other forms of debt. As a practical matter, if operating leases are not significant, it could be decided not to treat them as debt. They can be left out of the capital structure and the lease payments could be treated as an operating cost.

Cost of Common Equity

For estimating the opportunity cost of common equity, best market practice is to use the expanded version of the capital asset pricing model (CAPM). The equation for the cost of equity is as follows:

RE = RF + [βL * MRP] + SRP

RE: Cost of common equity
RF: Risk-free rate
βL: Levered beta of equity
MRP: Market risk premium
SRP: Specific risk premium

The market risk premium is the extra return that the stock market provides over the risk-free rate to compensate for market risk. The estimate of the historically derived market risk premium is about 5 per cent. This estimate depends on how much history is used. Structural changes in the economy and markets, however, suggest that more recent data provides a better basis for predicting the future. Therefore, best market practice is to use data from the second half of the last century. This is a sufficiently long period to achieve statistical reliability, while avoiding the potentially less relevant market returns.

The historically derived market risk premium can be benchmarked against the implied market risk premium of today’s market capitalization and earnings. This can be done under different assumptions for future earnings growth and reinvestment. Recent studies show an implied market risk premium of 5-5.5 per cent, which is comparable to the historical derived estimate.

Beta is the measurement for the systematic risk of a company and is typically the regression coefficient between historical dividend-adjusted stock returns and market returns. For decades, investors were only concerned with one factor, beta, in their portfolio selection. Beta was considered to explain most of a portfolio’s return.

This one-factor model, otherwise known as standard CAPM, implies that there is a linear relationship between a company’s expected return and its corresponding beta. Beta is not the only determinant of stock returns though so CAPM has been expanded to include two other key risk factors that together better explain stock performance: market capitalization and book-to-market (BtM) value.

Recent empirical studies indicate that three risk factors – market (beta), size (market capitalization) and price (BtM value) – explain 96 per cent of historical equity performance. These three-factor models go further than CAPM to include the fact that two particular types of stocks outperform markets on a regular basis: small caps and value stocks (high BtM value).

The approach to estimate beta depends on whether the company’s equity is traded or not. Therefore the beta of a company can be estimated in two ways. The first and preferred solution for public companies is to use direct estimation, based on historical returns for the company in question.

The second way is to use indirect estimation. This solution is mainly applicable to business units and private companies, but also for illiquid stocks or public companies with very little useful historical data. This estimation is based on betas from comparable companies, which are used to construct an industry beta. When constructing the industry beta, it is important to ‘unlever’ the company betas and then apply the leverage of the specific company.

Best market practice is to incorporate a specific risk premium for small caps and value stocks when estimating the cost of equity. As mentioned earlier, this premium may be applicable to a specific company, based on its market capitalization and BtM value.

Cost of Hybrid Capital

Hybrids are financial instruments that combine certain elements of debt and equity, such as preferred equity, convertible bonds and subordinated debt. WACC estimations are complicated by the introduction of hybrid capital into the capital structure.

This is most easily resolved through an effective split of the instrument’s value into debt and equity to reflect the true debt-equity mix. (The fifth article of this series describes how issuing hybrids can optimize the WACC. The article outlines how hybrids are analyzed on their impact on shareholder value, but they are also analyzed from the perspective of treatment by accountants/IFRS and rating agencies.)

Conclusion

There are many ways to make errors both in estimating the WACC and applying it in practice and this article discussed the different WACC components in more detail. Attention was given to some of the errors frequently encountered in practice. Best market practice was provided as a guide for estimating the WACC while more practical guidance on estimation and application of the WACC will be discussed in the rest of the articles in this series.
Let’s return to the analogy at the beginning of this article. Is estimating the WACC comparable to interpreting a piece of art?

Again, just as two people will rarely interpret a piece of art the same way, neither will two people calculate the same WACC. The key message of this article is that both are based on assumptions before reaching a final estimation or interpretation.

The more time you spend on defining good assumptions for estimating the WACC, the better the quality of business valuation, capital budgeting and other financial decision-making will be. It is like discovering the real value of art; it all starts with a good interpretation.

The article describes the relationship between the WACC, shareholder value and the existence of an optimal credit rating.

Credit Rating Policy

Newton’s first law of motion states that objects ‘tend to keep on doing what they are doing’. In fact, it is the natural tendency of objects to resist changes in their state of motion. This resistance to change is also known as inertia. Many companies have the tendency to maximize their credit rating towards a triple-A rating in order to minimize their cost of debt.

Generally, however, this policy does not minimize the weighted average cost of capital (WACC). Therefore, these companies have the opportunity to stop this inertia and increase shareholder value as a result.

Market evidence shows that, in recent years, fewer companies have received a triple-A credit rating and there are several reasons for this:

• More tolerance of risk
• Company-specific challenges
• Mergers and acquisitions
• Regulatory concerns
• New industry dynamics

This article discusses the concept that the optimal credit rating for companies is not always the highest rating. Credit ratings give information about the probability of default and the size of loss when a company defaults (recovery ratio). Therefore a credit rating gives an indication about the downside risk of debt and not about the upside potential of equity. There is a great misunderstanding about the corporate’s objective with respect to credit ratings. The table below provides insight into the relationship between business risk, financial risk and credit ratings.

A triple-A credit rating might seem ideal but it actually indicates that a company bears relatively low risk. For a company that does not invest in highrisk projects, or for a company with low leverage, it is relatively easy to get a triple-A rating. Is this an indication of good performance? Not really, maybe a triple-A credit rating is the result of a lack of creativity.

Risk is inherent in running a company therefore the credit rating should not be a goal in itself but the result of the corporate objective to maximize value for shareholders and other stakeholders.

Corporate Finance Dilemma

For most companies, corporate finance is a tradeoff process between raising debt, common equity and hybrid capital. The availability of different types of capital creates a dilemma for these companies.

In general terms, debt is advantageous because of its low costs and tax deductibility but it can be disadvantageous where bankruptcy costs are concerned. More debt increases the default risk of a company and therefore shareholders will require a higher return on equity. Furthermore, a company can also raise hybrid capital, which contains elements of both debt and equity. But the impact of hybrids on the WACC and shareholder value differs, depending on the treatment by tax authorities, accountants and rating agencies. Ultimately, the optimal capital structure of a company will normally consist of a mixture of debt, common equity and hybrid capital.

Designing such a capital structure is based on a combination of two elements:

1. The level of debt-to-equity.
2. The mixture of financing instruments.

Optimal Level of Debt-to-Equity

Companies should focus on the optimal level of debt-to-equity, also known as leverage. Best market practice is to define a target capital structure and to combine this objective with maintaining sufficient financial flexibility to cope with adverse scenarios.

Companies with stable cash flows and low risk profiles can generally absorb more debt into their balance sheets than other types of companies. To define the optimal capital structure, however, an analysis is required that examines how the perceptions of investors, rating agencies and financial markets in general are affected by capital structure changes. In assessing an optimal capital structure it is important to focus not only on base case scenarios but also on downside scenarios, which means that an optimal capital structure will allow for unused borrowing capacity. This enables the corporate to increase debt in adverse circumstances, e.g. the possibility that capital expenditure may be substantially above base case scenarios. An example of unused borrowing capacity could be contingent capital, such as a standby credit facility.

The graph shows the progress of the WACC as well as the market value of a company. The flat bottom of the WACC graph clearly shows that there is a relatively large range where the level of debt to- equity is maximizing shareholder value. This indicates that the optimal credit rating of a company exists within this area. It is important to mention that every company has its own optimal range. The definition of an optimal credit rating is based on the following considerations:

1. Minimum WACC: The credit rating should not be a goal in itself, but the result of the corporate objective to maximize value for shareholders and other stakeholders. Therefore an optimal credit rating is located in the range where the level of debtto- equity minimizes the WACC. This is also displayed in the graph above.
2. Meeting financial covenants: Financial covenants provide creditors with a warning about deteriorating financial conditions and give them the ability to influence the borrower under these conditions. A number of companies have financial covenants to maintain investment grade status. It is likely that these covenants will increase the credit spread on debt when the credit rating is close to minimum investment grade.
3. Protection against adverse scenarios: An optimal credit rating will allow a company enough unused borrowing capacity so that during times of adversity it can use this capacity. In particular, it is important that financial projections under adverse scenarios remain consistent with investment grade status and hence continue to allow a company to finance its functions.
4. Protection against turbulent market conditions: Access to capital markets may be difficult during turbulent market conditions if companies are rated at BBB and below. Credit spreads typically widen under adverse economic conditions as investor quality consciousness and ‘flight to quality’ increase.

Maintenance of an optimal credit rating will reduce the risk that companies will be unable to attract necessary finance at reasonable rates.

Optimal Mixture of Financing Instruments

When the optimal level of debt-to-equity is defined, companies should focus on the optimal mixture of financing instruments, including:

1. Interest-bearing debt: When raising interestbearing debt, a company can generally choose between bank debt, private debt and public debt. Best market practice is to match cash flows on debt as closely as possible with cash flows that the company makes on its assets. By doing so, a company reduces default risk and it increases the debt capacity. Furthermore, it increases shareholder value because of lower earnings volatility.
2. Common equity: A popular statement is ‘equity is a cushion, debt is a sword’. While debt with its fixed payment character disciplines managers, equity should give them more flexibility because of the lack of a fixed return. However, stock markets can discipline managers as well. A good example is the recent trend of hostile takeovers of underperforming public companies by private equity firms.
3. Hybrid capital: Hybrids contain elements of debt and equity, e.g. preferred equity, convertible bonds and subordinated debt. The perfect hybrid instrument will have all of the tax advantages of debt, while preserving the flexibility offered by equity. A company must ensure that it has not crossed the line drawn by tax authorities though. It is a waste of effort if the instrument that is designed does not deliver the tax benefits intended.

The overall objective when designing the optimal mixture of financing instruments is to keep investors, rating agencies and financial markets satisfied. Bondholders and ratings agencies want companies to issue equity because it makes them safer. Shareholders do not want companies to issue more equity because it dilutes earnings per share.

Financial covenants ensure that companies meet their requirements in terms of capital ratios, usually defined in book value. Financing that leaves all stakeholders happy is the ultimate goal.

Best market practice is not to lock in market ‘mistakes’ that work against a company. For example, rating agencies could under-rate a company (credit rating gap), or financial markets could under-price stocks or bonds (value gap). If this occurs, companies should not lock in these gaps by issuing financing instruments for the long-term. In particular, when equity is underpriced, issuing equity or equity-based products (including convertibles) would transfer wealth from existing to new shareholders.

Furthermore, issuing long-term debt when a company is under-rated locks in interest rates at levels that are too high, given the actual default risk. Therefore solving potential gaps requires good communication with investors or rating agencies. This can be done based on in-depth financial analysis that examines how the perceptions of investors, rating agencies and financial markets in general are affected by capital structure changes.

In assessing a capital structure it is important to focus not only on base case scenarios but also on downside scenarios.

Corporate Case Studies on Capital Structure and Credit Rating

The following section contains case studies on the policy of two companies, KPN Telecom and Nestlé, with respect to their capital structure and credit rating.

KPN Telecom: Series of Downgradings

Highly leveraged companies could face a series of downgradings. A good example is the situation that occurred several years ago with the Dutch listed company, KPN Telecom. The telecoms market was bullish for a long time but expectations had started to diminish. It was doubtful whether the expected growth could be realized or whether the high capital expenditures for UMTS (the 3G mobile system) could provide a profitable return.

Rating agencies, such as Standard & Poor’s and Moody’s, picked up on this market signal and downgraded several telecom companies and, as a consequence, the interest expenses of those companies increased. The highly leveraged companies, such as KPN Telecom, directly faced financial problems and therefore rating agencies further downgraded these companies. The interest expenses further increased and so did the financial problems.

In just three years, KPN Telecom was downgraded several times. From AA in September 2000, its rating reached the lowest level of BBB- at the end of 2002. This was also the end of the series of downgradings. From September 2002, KPN Telecom was able to improve its credit rating from BBB- to A- by reducing its debt level and by divesting noncore activities.

At the beginning of February 2006, it decided to increase its leverage again because it felt the pressure of a potential hostile take over by a group of private equity firms. In this group’s opinion, KPN Telecom was too conservatively financed. The additional debt that was raised would be used to finance share repurchases and potential acquisitions.

After the announcement of increasing leverage, KPN Telecom was immediately downgraded from A- to BBB+. Shareholders did reward the revised financing policy with an increase of the stock price by 6.4 per cent though.

Nestlé: Highest or Optimal Credit Rating?

In September 2005, Swiss company Nestlé considered whether it should go for the highest or optimal credit rating. The triple-A rated company, therefore, performed an analysis of its capital structure and concluded that the WACC could be decreased from 7.6 to 7.4 per cent by changing the level of debt-toequity from 10 towards 30 to 35 per cent.1 However, Nestlé decided not to change its capital structure and it is interesting to find out what influenced this decision.

One of the main reasons Nestlé gave was that with a triple-A rating debt can be raised on better terms and conditions. Furthermore, Nestlé wanted to maintain maximum financial flexibility for potential acquisitions. Of course, the cost of debt is lower with a triple-A rating, however, in this situation it is likely that the company does not optimally benefit from the tax deductibility of debt financing. It is also likely that some interesting investment projects would be declined because of a too low risk tolerance.

Nestlé chose not to change its credit rating policy, although it acknowledged the potential benefits of a lower, optimal credit rating. These potential benefits can be quantified. Nestlé could add about €1.5bn shareholder value if it further optimize its capital structure.2 This can be assumed as its accepted costs for maintaining maximum financial flexibility.

Roadmap to an Optimal Credit Rating

The roadmap to an optimal capital structure and credit rating can be defined as follows:

1. Start with a scenario analysis of the cash flows through an intuitive or quantitative approach. Intuitively, by analyzing the growth potential of a company, the cyclicality of the cash flows and specific factors that determine the cash flows. For companies with substantial operating history, it can be quantified how sensitive company value and operating income have been to changes in macroeconomic variables, such as inflation, interest rates and exchange rates.
2. Best market practice is to define a target capital structure and to combine this objective with maintaining sufficient financial flexibility to cope with adverse scenarios. When the optimal level of debt-to-equity is defined, companies should focus on the optimal mixture of financing instruments, including debt, equity and hybrid capital.
3. The optimal capital structure and credit rating is achieved when the WACC is minimized. However, it is relevant to combine this objective with meeting financial covenants and by protecting against adverse scenarios and turbulent market conditions.

Companies located at the right side of the optimal range should be focusing on reducing their debt position and therefore avoiding a series of downgradings. For example, KPN Telecom mainly improved its credit rating from BBB- to A- by reducing its debt level and by divesting non-core activities.

Companies located at the left side of the optimal range could increase their leverage by raising more debt or reducing their equity position. The latter can be realized with share repurchases or distribution of super dividends. Furthermore, these companies could reduce the WACC by investing in more risky projects that add shareholder value.

The highest possible credit rating is not always the best option. Maximizing value for shareholders and other stakeholders can be realized with an optimal level of debt-to-equity, including a mixture of debt, common equity and hybrid capital. As a result, the credit rating will be optimal.

Conclusion

This article has elaborated on the relationship between the WACC, shareholder value and credit ratings. Some companies may have valid reasons to choose a triple-A rating. Nestlé, for example, has clearly thought about the issue and has chosen a sub-optimal WACC. It is important, however, that companies understand and think about the tradeoff between the WACC, shareholder value and credit ratings. In that way, a rational decision can be made about the optimal capital structure of a company.

This decision should be made with an open mind with regard to changes in the capital structure. If there is any irrational resistance to change, then it’s time for the company to end this inertia.

¹ Focusing on the drivers of value, www.ir.nestle.com
² This calculation is based on an operational cash flow of €4.3bn in 2004.