Lowering the cost of capital

Accurately assessing and controlling the cost of capital is crucial for effective financial decision-making in any organization. That’s because determining the optimal capital structure in financial management is fundamental for a company to reduce its costs and increase its overall profitability.

The cost of capital represents the economic cost of financing a company’s assets, calculated using the Weighted Average Cost of Capital (WACC) formula. A company creates value when it generates a return on assets that is higher than the required return on the capital needed to fund those assets.

Calculating the cost of capital

The cost of capital is the weighted average of the cost of its components: debt and equity reflecting the right-hand side of the balance sheet. The WACC formula entails multiplying the percentage of debt by the after-tax cost of debt and the percentage of equity by the cost of equity.The after-tax cost of debt is the effective interest rate on the company’s debt after accounting for the tax deductibility of interest, while the cost of equity is the required return on the company’s stock. The latter can be estimated through the Capital Asset Pricing Model, the Dividend Discount Model, or bond yields plus risk premium.

Theoretical approaches to minimizing the cost of capital

Several theories explain how capital structure minimizes the cost of capital. In 1958, Professors Franco Modigliani and Merton Miller proposed that under a set of very restrictive assumptions – such as riskless borrowing and lending, perfectly competitive markets, no taxes, and no bankruptcy and agency costs – the company’s value is unaffected by its capital structure.

The 1963 extension to their theory proposed a linear relationship between the cost of debt and the cost of equity. Debt holders’ priority claim on assets and income makes the cost of debt lower than the cost of equity. Increasing debt raises the cost of equity due to the heightened financial risk to equity holders. The benefits of lower-cost debt are perfectly offset by the increased cost of equity, resulting in no change to the weighted-average cost of capital, and no change to the company’s value.

Removing the strict assumptions of Modigliani-Miller leads to more realistic theories:

1. As interest payments are tax-deductible in most markets, debt provides a tax shield equal to the marginal tax rate times the amount of debt. Lifting the assumption of no tax, the value of the company increases with increasing levels of debt, and the optimal capital structure is 100% debt.
2. Bankruptcy costs comprise direct costs such as legal and administrative fees and, more importantly, indirect costs such as the lost trust of customers, creditors, suppliers, and employees; and foregone investment opportunities. Removing the assumption of no bankruptcy costs, the static trade-off theory states that increasing the use of debt increases the cost of financial distress, which at some point will exceed the tax shield from using debt.
3. Agency costs refer to conflicts of interest between owners and managers who don’t have a stake in the company and tend to maximize their own compensation and benefit. According to agency theory, the use of debt forces managers to be disciplined about the use of cash because they have less free cash flow available for personal benefit.
4. Managers also have asymmetrical information about the company’s future performance compared to owners or creditors. The choice of debt versus equity financing sends signals to the market regarding management’s opinion of the company’s prospects. Issuing fixed debt is a signal of confidence in the company’s ability to meet future interest payments, while equity issuance signals that the company’s stock is overvalued. Higher use of debt tends to decrease the cost of asymmetrical information.

Optimizing capital structure in financial management

To account for all these factors, all corporations should have a target capital structure that reflects its cost of debt, cost of equity, probability of financial distress, and management’s opinion on future financial performance. The target capital structure can deviate from the optimal capital structure by using tactical opportunities in different financing sources.

Zero or negative short-term rates encourage the use of floating rate debt to minimize the cost of debt. Under flat yield curves, companies to use fixed-rate debt. Stock markets at historic highs create an opportunity to issue additional equity at a favorable market price. Volatility in stock markets presents an opportunity to issue convertible bonds as the embedded conversion option is positively correlated with the volatility of the company’s stock. These tactical opportunities should, however, not overshadow the strategic choices that determine the target capital structure.

How can a Treasury Management System help?

A Treasury Management System (TMS) is used to manage the whole lifecycle of debt and equity financing. The benefits can be summarized in a few key points.

1. A TMS is critical to enhancing the efficiency and accuracy of debt management processes. For bond issuance, a TMS automates the preparation of necessary documentation, ensuring that all legal and financial information is accurately included, thereby minimizing the risk of errors and omissions. It also ensures regulatory compliance by automatically validating that all activities adhere to relevant local and international financial regulations. Also, a TMS can build investor confidence by automating the distribution of relevant documents to improve transparency.When managing interest rate derivatives, a TMS continuously monitors and calculates interest rate exposures, providing real-time data on the company’s risk profile. This allows for timely identification and mitigation of potential risks. The system also automates the execution of hedging strategies by integrating with market data providers to fetch real-time interest rates and execute trades based on predefined risk management policies. For interest fixing, a TMS automates the process of locking in interest rates by monitoring market rates and executing rate locks under favorable conditions. It ensures compliance with internal policies and external regulations, and generates detailed reports for audit and compliance purposes. In terms of settlement, a TMS automates fund transfers, updates ledgers, reconciles transactions with bank statements, and generates comprehensive settlement reports, ensuring timely and accurate payments, maintaining financial records, and enhancing overall financial transparency.
2. A TMS automates equity management by preparing and ensuring compliance for equity issuance documents, facilitating investor relations, and optimizing market timing for issuances. A TMS can replace everyday corporate tasks such as dividend payments by automating calculations, processing, and tax compliance. It can also manage stock splits through updating records and regulatory filings. Also, a TMS monitors market conditions for share repurchases, executes buybacks, and generates detailed reports for compliance and internal review, which enhances overall efficiency and accuracy.
3. A TMS provides analytics on capital structure, cost of capital, and drill down to any of its component details. These analytics are available for any day and for a long-term trend, supporting strategic and tactical financing decisions. A TMS enhances capital structure analysis through detailed insights into the proportion of debt and equity, tracking issuance and repayment schedules, and generating maturity profiles for debt instruments. It continuously monitors interest rate exposures, calculates the WACC, and allows for scenario analysis and benchmarking against industry standards. A TMS can be used to show transaction-level details and historical trends, integrate real-time market data, and help support and inform strategic and tactical decision-making with insights into long-term trends and real-time market conditions. Finally, a TMS can support risk management through stress testing, scenario analysis, and hedging strategies.

In summary…

Lowering the cost of capital should be integral to any organization’s financial objectives. A TMS can help reduce the costs associated with manual processes, inefficiencies, errors, and fraud. It also helps save money by providing the visibility to optimize cash flow and minimize borrowing costs.