Whats the true cost of capital? The case of Afren

In my first blog I discussed shareholder wealth maximisation, I will now look into how a company’s capital structure can affect shareholder wealth, to what extent can a mixture of equity and debt increase shareholder wealth, or in some cases.. destroy it?

It’s obvious when running a business that reducing your costs would improve your profit, seems only logical that the cost of finance should be considered in those costs doesn’t it? This is where the debate of capital structure arises, can a company actually minimise its cost of capital by taking on a mixture of debt and equity.  The WACC acts as a ‘hurdle rate’ or the discount rate which companies can use in investment appraisal decisions (Watson and Head, 2013), therefore it influences a company’s investment options thus having a knock on effect on company profit.

African oil producer, Afren is currently reviewing its capital structure (Mann, 2015) in order to improve shareholder wealth; this is due to Afren’s share price plummeting over the past year (shown below).  A 59% decrease in net profit was reported in  the second quarter of 2014, falling from $309m to $127m (Afren, 2014) as a result of lower oil production in its primary Nigerian fields coupled with falling oil prices (Telegraph, 2014).

Afren admitted in February of defaulting on interest payments of $15m and as a result of a funding crisis want to review their capital structure to allow for a cash injection of $132m (Morris, 2015). Afren management suggested an equity funding that could double its current market capitalisation, diluting its current shares by 50% (Mann, 2015), clearly shareholders weren’t happy at that idea and share prices tanked even more (surprise, surprise!)  Afren finally decided to load up on debt, agreeing $300m and in loans before June as well as equity, issuing $321m high yield bonds (Morris, 2015).

(Source:London Stock Exchange)

We can see from shareholder’s reaction to Afren’s new capital structure proposal that both debt and equity have their gains and losses.  Equity in itself can be very costly; issuing shares on the stock exchange can result in high transaction costs and can be viewed as more risky by shareholders as there is no guarantee of dividends being paid.  The London Stock Exchange (2015) released a statement commenting on Afren’s new capital structure stating ‘existing shareholders would be unlikely to see any return on their current investments’.  If Afren can’t improve their financial situation and end up going into liquidation it should be noted that investors are ranked lowest on the creditor hierarchy (Watson and Head, 2013) therefore this increased risk results in a higher cost of equity capital.

However, Ebok, the creditor who is lending Afren $300m will require a significantly lower rate of return than shareholders due to the interest repayments they have arranged (Arnold, 2013).  As debt has a much lower transactional cost and tax benefits it is a cheaper source of finance than equity ( Watson and Head, 2013).

Seems pretty obvious company’s should just finance themselves through debt and forget all about equity right? Well, wrong, despite it seeming slightly simple and obvious, a lot of companies continue to raise capital through issuing shares.  US oil producers are issuing new shares at the fastest pace in over a decade (Bloomberg, 2015) in order to raise cash to reduce debt.  RSP Permian Inc, aims to raise $232m by selling additional shares, with Encana Corp, Noble Energy Inc and Carrizo Oil and Gas all issuing shares in a bid to reduce debt (Bloomberg, 2015).

Whilst some may argue it seems obvious that companies should just load up on debt, debt is not without its risks also.  It may reduce the WACC because it’s a cheaper source of finance, however the cost of equity increases due to shareholders demanding a higher return for the increased level of risks they are taking (Watson and Head, 2013).  Whilst taking on debt increases gearing, it can be argued that a company’s level of gearing can only go so far before it causes financial distress.  The financial risks a company take are intensified by a higher level of debt due to the risk of liquidation increasing, therefore WACC increases hence reducing shareholder wealth (Arnold, 2013).

I think the US oil producers mentioned above were justified in trying to reduce their level of debt, as the level of risks in the oil market have increased significantly due to the uncertainty surrounding oil prices.   ‘Equity does not have to be paid back and requires no disbursements of revenue and net profit’ a comment made by Troy Eckard who owns Eckard Global LLC when asked why large oil companies choose equity over debt. (Bloomberg, 2015).  

Miller and Modigliani (1958) argued that a company’s capital structure had no influence on the WACC or the value of a firm, concluding that an optimal capital structure doesn’t exist.  They highlighted that as the cost of debt is lower and normally a larger proportion of capital structure, therfore it offsets any increase in the cost of equity that rises with gearing.   However the theory makes a number of assumptions that seem unrealistic and cannot be applied in today’s market, such as perfect market efficiency, no costs of financial distress and no tax.

After making modifications to their theory in order to take into consideration tax (1963) and financial distress (1971) they changed their theory to suggest it may be possible to achieve an optimal capital structure.

I believe an optimal capital structure does exist, however it may be difficult to find it and I don’t believe that ‘one size fits all’ in this case.  Each firm’s capital structure will be significantly different.  The oil companies I have mentioned earlier are extensively impacted by economic influences, such as oil prices, drilling expenses and even conflict with Islamic State Militants! Therefore I would agree with these oil companies decision to increase equity rather than debt.

References:

Afren Plc. (2014). Afren Plc 2014 Half- Yearly Results. Retrieved from Afren Plc website: http://www.afren.com/investor_relations/financial_calendar/
Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson.

Bloomberg. (2015, March 20). Shale Producers Have Found Another Lifeline: Shareholders. Retrieved from http://www.bloomberg.com/news/articles/2015-03-20/shale-producers-have-found-another-lifeline-shareholders

London Stock Exchange. (2015). AFR AFREN PLC ORD 1P. Retrieved from www.londonstockexchange.com/exchange/prices-and-markets/stocks/summary/company-summary.html?fourWayKey=GB00B0672758GBGBXSSMM&lang=en

Mann, H. (2015, January 27). Afren plummets 50% after reviewing capital structure. Retrieved from http://www.iii.co.uk/articles/219772/afren-plummets-50-after-reviewing-capital-structure

Morris, J. (2015, March 13). Afren share price falls as much as 30 per cent after refinancing agreement | City A.M. Retrieved from http://www.cityam.com/211545/afren-share-price-falls-much-16-cent-despite-refinancing-agreement

The Telegraph. (2014, August 24). Profits half at scandal-hit oil company Afren. Retrieved from http://www.telegraph.co.uk/finance/newsbysector/energy/oilandgas/11062902/Profits-half-at-scandal-hit-oil-company-Afren.html

The Telegraph. (2015, March 13). Afren shares plummet as it unveils $300m rescue plan - Telegraph. Retrieved from http://www.telegraph.co.uk/finance/newsbysector/energy/oilandgas/11469139/Afren-urges-shareholders-to-support-300m-rescue-plan.htm
Watson, D. & Head, A. (2013). Corporate Finance: Principles and Practice. (6^TH ed.), Harlow: Pearson.