WACC: Practical Guide for Strategic Decision- Making - Part 2: Creating Shareholder Value - Towards an Optimal Credit Rating!

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WACC: Practical Guide for Strategic Decision-
Making - Part 2: Creating Shareholder Value
- Towards an Optimal Credit Rating!
The second article in this series on WACC discusses why 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. It elaborates on
managing the WACC and creating shareholder value, which is the main focus
of strategic decision-making. The article describes the relationship between
the WACC, shareholder value and the existence of an optimal credit rating.
Laurens Tijdhof - Senior Consultant, Zanders, Treasury & Finance Solutions
The second article in this series on WACC discusses Market evidence shows that, in recent years, fewer
why the credit rating should not be a goal in itself, companies have received a triple-A credit rating and
but the result of the corporate objective to maximize there are several reasons for this:
value for shareholders and other stakeholders. It
elaborates on managing the WACC and creating • More tolerance of risk
shareholder value, which is the main focus of • Company-specific challenges
strategic decision-making. The article describes the • Mergers and acquisitions
relationship between the WACC, shareholder value • Regulatory concerns
and the existence of an optimal credit rating.
• New industry dynamics
Credit Rating Policy
This article discusses the concept that the optimal
credit rating for companies is not always the highest
Newton’s first law of motion states that objects ‘tend rating. Credit ratings give information about the
to keep on doing what they are doing’. In fact, it is probability of default and the size of loss when
the natural tendency of objects to resist changes in a company defaults (recovery ratio). Therefore a
their state of motion. This resistance to change is credit rating gives an indication about the downside
also known as inertia. Many companies have the risk of debt and not about the upside potential of
tendency to maximize their credit rating towards a equity. There is a great misunderstanding about
triple-A rating in order to minimize their cost of debt. the corporate’s objective with respect to credit
Generally, however, this policy does not minimize the ratings. The table below provides insight into the
weighted average cost of capital (WACC). Therefore, relationship between business risk, financial risk and
these companies have the opportunity to stop this credit ratings.
inertia and increase shareholder value as a result.
Financial Risk Profile
Business Risk Profile
Source: Standard & Poor's
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A triple-A credit rating might seem ideal but it Designing such a capital structure is based on a
actually indicates that a company bears relatively combination of two elements:
low risk. For a company that does not invest in high-
risk projects, or for a company with low leverage, it 1. The level of debt-to-equity.
is relatively easy to get a triple-A rating. Is this an 2. The mixture of financing instruments.
indication of good performance? Not really, maybe a
triple-A credit rating is the result of a lack of creativity. Optimal Level of Debt-to-Equity
Risk is inherent in running a company therefore the
credit rating should not be a goal in itself but the Companies should focus on the optimal level of
result of the corporate objective to maximize value debt-to-equity, also known as leverage. Best market
for shareholders and other stakeholders.
practice is to define a target capital structure and to
combine this objective with maintaining sufficient
Corporate Finance Dilemma
financial flexibility to cope with adverse scenarios.
Companies with stable cash flows and low risk profiles
For most companies, corporate finance is a trade-
can generally absorb more debt into their balance
off process between raising debt, common equity sheets than other types of companies. To define
and hybrid capital. The availability of different types the optimal capital structure, however, an analysis
of capital creates a dilemma for these companies. is required that examines how the perceptions of
In general terms, debt is advantageous because investors, rating agencies and financial markets in
of its low costs and tax deductibility but it can be general are affected by capital structure changes. In
disadvantageous where bankruptcy costs are assessing an optimal capital structure it is important
concerned. More debt increases the default risk of a to focus not only on base case scenarios but also on
company and therefore shareholders will require a downside scenarios, which means that an optimal
higher return on equity. Furthermore, a company can capital structure will allow for unused borrowing
also raise hybrid capital, which contains elements of capacity. This enables the corporate to increase debt
both debt and equity. But the impact of hybrids on in adverse circumstances, e.g. the possibility that
the WACC and shareholder value differs, depending capital expenditure may be substantially above base
on the treatment by tax authorities, accountants case scenarios. An example of unused borrowing
and rating agencies. Ultimately, the optimal capital capacity could be contingent capital, such as a
structure of a company will normally consist of a standby credit facility.
mixture of debt, common equity and hybrid capital.
The graph shows the progress of the WACC as that every company has its own optimal range. The
well as the market value of a company. The flat definition of an optimal credit rating is based on the
bottom of the WACC graph clearly shows that there following considerations:
is a relatively large range where the level of debt-
to-equity is maximizing shareholder value. This 1. Minimum WACC: The credit rating should not
indicates that the optimal credit rating of a company be a goal in itself, but the result of the corporate
exists within this area. It is important to mention objective to maximize value for shareholders and
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other stakeholders. Therefore an optimal credit line drawn by tax authorities though. It is a waste
rating is located in the range where the level of debt-
of effort if the instrument that is designed does not
to-equity minimizes the WACC. This is also displayed deliver the tax benefits intended.
in the graph above.
The overall objective when designing the optimal
2. Meeting financial covenants: Financial covenants mixture of financing instruments is to keep
provide creditors with a warning about deteriorating investors, rating agencies and financial markets
financial conditions and give them the ability to satisfied. Bondholders and ratings agencies want
influence the borrower under these conditions. A companies to issue equity because it makes them
number of companies have financial covenants to safer. Shareholders do not want companies to issue
maintain investment grade status. It is likely that more equity because it dilutes earnings per share.
these covenants will increase the credit spread on Financial covenants ensure that companies meet
debt when the credit rating is close to minimum their requirements in terms of capital ratios, usually
investment grade.
defined in book value. Financing that leaves all
stakeholders happy is the ultimate goal.
3. Protection against adverse scenarios: An optimal
credit rating will allow a company enough unused Best market practice is not to lock in market ‘mistakes’
borrowing capacity so that during times of adversity that work against a company. For example, rating
it can use this capacity. In particular, it is important agencies could under-rate a company (credit rating
that financial projections under adverse scenarios gap), or financial markets could under-price stocks or
remain consistent with investment grade status and bonds (value gap). If this occurs, companies should
hence continue to allow a company to finance its not lock in these gaps by issuing financing instruments
for the long-term. In particular, when equity is under-
priced, issuing equity or equity-based products
4. Protection against turbulent market conditions: (including convertibles) would transfer wealth from
Access to capital markets may be difficult during existing to new shareholders. Furthermore, issuing
turbulent market conditions if companies are rated long-term debt when a company is under-rated locks
at BBB and below. Credit spreads typically widen in interest rates at levels that are too high, given the
under adverse economic conditions as investor actual default risk. Therefore solving potential gaps
quality consciousness and ‘flight to quality’ increase. requires good communication with investors or
Maintenance of an optimal credit rating will reduce rating agencies. This can be done based on in-depth
the risk that companies will be unable to attract financial analysis that examines how the perceptions
necessary finance at reasonable rates.
of investors, rating agencies and financial markets
in general are affected by capital structure changes.
Optimal Mixture of Financing Instruments
In assessing a capital structure it is important to
focus not only on base case scenarios but also on
When the optimal level of debt-to-equity is defined, downside scenarios.
companies should focus on the optimal mixture of
financing instruments, including:
Corporate Case Studies on Capital Structure and
Credit Rating
1. Interest-bearing debt: When raising interest-
bearing debt, a company can generally choose The following section contains case studies on the
between bank debt, private debt and public debt. policy of two companies, KPN Telecom and Nestlé,
Best market practice is to match cash flows on with respect to their capital structure and credit
debt as closely as possible with cash flows that rating.
the company makes on its assets. By doing so, a
company reduces default risk and it increases the KPN Telecom: Series of Downgradings
debt capacity. Furthermore, it increases shareholder
value because of lower earnings volatility.
Highly leveraged companies could face a series of
downgradings. A good example is the situation that
2. Common equity: A popular statement is ‘equity occurred several years ago with the Dutch listed
is a cushion, debt is a sword’. While debt with its company, KPN Telecom. The telecoms market was
fixed payment character disciplines managers, bullish for a long time but expectations had started
equity should give them more flexibility because of to diminish. It was doubtful whether the expected
the lack of a fixed return. However, stock markets can growth could be realized or whether the high capital
discipline managers as well. A good example is the expenditures for UMTS (the 3G mobile system)
recent trend of hostile takeovers of underperforming could provide a profitable return. Rating agencies,
public companies by private equity firms.
such as Standard & Poor’s and Moody’s, picked
up on this market signal and downgraded several
3. Hybrid capital: Hybrids contain elements of telecom companies and, as a consequence, the
debt and equity, e.g. preferred equity, convertible interest expenses of those companies increased. The
bonds and subordinated debt. The perfect hybrid highly leveraged companies, such as KPN Telecom,
instrument will have all of the tax advantages of debt, directly faced financial problems and therefore rating
while preserving the flexibility offered by equity. A agencies further downgraded these companies. The
company must ensure that it has not crossed the interest expenses further increased and so did the
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financial problems.
specific factors that determine the cash flows. For
companies with substantial operating history, it
In just three years, KPN Telecom was downgraded can be quantified how sensitive company value
several times. From AA in September 2000, its and operating income have been to changes in
rating reached the lowest level of BBB- at the end macroeconomic variables, such as inflation, interest
of 2002. This was also the end of the series of rates and exchange rates.
downgradings. From September 2002, KPN Telecom
was able to improve its credit rating from BBB- to 2. Best market practice is to define a target
A- by reducing its debt level and by divesting non-
capital structure and to combine this objective with
core activities. At the beginning of February 2006, maintaining sufficient financial flexibility to cope
it decided to increase its leverage again because it with adverse scenarios. When the optimal level of
felt the pressure of a potential hostile take over by a debt-to-equity is defined, companies should focus
group of private equity firms. In this group’s opinion, on the optimal mixture of financing instruments,
KPN Telecom was too conservatively financed. The including debt, equity and hybrid capital.
additional debt that was raised would be used to
finance share repurchases and potential acquisitions. 3. The optimal capital structure and credit rating
After the announcement of increasing leverage, KPN is achieved when the WACC is minimized. However,
Telecom was immediately downgraded from A- to it is relevant to combine this objective with meeting
BBB+. Shareholders did reward the revised financing financial covenants and by protecting against
policy with an increase of the stock price by 6.4 per adverse scenarios and turbulent market conditions.
cent though.
Companies located at the right side of the optimal
Nestlé: Highest or Optimal Credit Rating?
range should be focusing on reducing their
debt position and therefore avoiding a series of
In September 2005, Swiss company Nestlé considered downgradings. For example, KPN Telecom mainly
whether it should go for the highest or optimal improved its credit rating from BBB- to A- by reducing
credit rating. The triple-A rated company, therefore, its debt level and by divesting non-core activities.
performed an analysis of its capital structure and
concluded that the WACC could be decreased from Companies located at the left side of the optimal
7.6 to 7.4 per cent by changing the level of debt-to-
range could increase their leverage by raising more
equity from 10 towards 30 to 35 per cent.1 However, debt or reducing their equity position. The latter can
Nestlé decided not to change its capital structure be realized with share repurchases or distribution
and it is interesting to find out what influenced this of super dividends. Furthermore, these companies
decision. One of the main reasons Nestlé gave was could reduce the WACC by investing in more risky
that with a triple-A rating debt can be raised on better projects that add shareholder value.
terms and conditions. Furthermore, Nestlé wanted to
maintain maximum financial flexibility for potential The highest possible credit rating is not always the
acquisitions. Of course, the cost of debt is lower with best option. Maximizing value for shareholders and
a triple-A rating, however, in this situation it is likely other stakeholders can be realized with an optimal
that the company does not optimally benefit from level of debt-to-equity, including a mixture of debt,
the tax deductibility of debt financing. It is also likely common equity and hybrid capital. As a result, the
that some interesting investment projects would credit rating will be optimal.
be declined because of a too low risk tolerance.
Nestlé chose not to change its credit rating policy, Conclusion
although it acknowledged the potential benefits of a
lower, optimal credit rating. These potential benefits This article has elaborated on the relationship
can be quantified. Nestlé could add about €1.5bn between the WACC, shareholder value and credit
shareholder value if it further optimize its capital ratings. Some companies may have valid reasons
structure.2 This can be assumed as its accepted costs to choose a triple-A rating. Nestlé, for example, has
for maintaining maximum financial flexibility.
clearly thought about the issue and has chosen a
sub-optimal WACC. It is important, however, that
Roadmap to an Optimal Credit Rating
companies understand and think about the trade-
off between the WACC, shareholder value and credit
The roadmap to an optimal capital structure and ratings. In that way, a rational decision can be made
credit rating can be defined as follows:
about the optimal capital structure of a company.
This decision should be made with an open mind
1. Start with a scenario analysis of the cash flows with regard to changes in the capital structure. If
through an intuitive or quantitative approach. there is any irrational resistance to change, then it’s
Intuitively, by analyzing the growth potential of time for the company to end this inertia.
a company, the cyclicality of the cash flows and
1Focusing on the drivers of value, www.ir.nestle.com
2This calculation is based on an operational cash flow of 4.3bn in 2004.
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Laurens Tijdhof is a senior consultant with Zanders, Treasury & Finance Solutions. He has several years of
experience in consulting and corporate treasury management. He has a broad understanding of treasury
issues, especially related to corporate financing. At Zanders, he is involved in the corporate finance practice.
The corporate finance team at Zanders offers quantitative analysis of financing structures for its clients and
is an independent advisor or arranger on debt, equity and hybrid structures.
Zanders, Treasury & Finance Solutions is a specialist in treasury management, treasury IT, corporate finance,
risk management and asset & liability management. Our field includes all activities aimed at the financing
and financial risks of a company and any future changes therein. Zanders was incorporated in 1994 and
employs approximately 50 specialised consultants to provide advice to a diverse range of companies and
government bodies, including banks, pension funds, multinational enterprises, municipalities, hospitals,
housing corporations.
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