Published: April 01, 2013
by Steffen Diel, Head of Treasury Finance, SAP AG, and Simon Regenauer, Director Capital Markets, Merck KGaAThis article provides a discussion on capital structure, cost of capital and financial flexibility considerations focused on large software companies such as SAP as part of their strategic task to establish and maintain an effective financing framework. The discussed topics are relevant for treasurers mainly from two perspectives: they form an important part of the treasurer’s curriculum as part of recurring strategic funding discussions with senior management; and the discussion broadens the scope of capital structure considerations with regard to the growth and increased importance of intangible businesses (e.g., knowledge based industries) in the global economy during the last two decades versus the role of traditional, i.e., tangible, business models.
How important are capital structure considerations when trying to determine its optimum for a given company? In doing so, we purely take the practitioner’s perspective and abstract from the academic literature around capital structure and enterprise value. We refer to generally accepted models where suitable for this purpose.
The determination and management of the capital structure is a key component of a company’s strategy. The capital structure strongly influences the weighted average cost of capital (WACC) which is the most relevant benchmark for the creation of shareholder value (SV).
The WACC constitutes the basis for determining the discount rate in a discounted cash flow model, the most widely used business valuation method. In addition, the capital structure and several key financial ratios derived from it form an important basis for the analysis of the creditworthiness of a company by third parties (e.g., rating agencies) and debt investors (e.g., banks or bondholders). The determination of a target capital structure by senior management could serve as a starting point for setting up an appropriate framework for financing decisions. This target capital structure and the accompanying financing decisions have to be well understood by investors if deemed to be successfully implemented.
The relatively recent history of enterprise software companies has been characterised by low financial leverage compared to other industries (e.g., discussion and examples can be found in an analyst report by Merrill Lynch). During the last few years, a trend towards more aggressive financial policies, i.e., a higher proportion of debt financing in corporate capital structures (higher financial leverage), has been fuelled by shareholders and analysts with the goal of increasing shareholder returns at the potential expense of debt investors.
In the years prior to the financial market crisis companies with low financial leverage were partly criticised for conducting their business based on an under-levered balance sheet. It has been argued that the WACC of those companies might be too high as a consequence of its high reliance on equity (instead of financial debt) and value could be unlocked by leveraging up, lowering WACC and potentially return cash to shareholders.
The financial market crisis since 2008 has considerably changed that view with investors putting much more focus on corporate cash balances and low financial leverage (‘cash is king’) given a volatile environment of uncertain funding opportunities and rising refinancing costs. This renaissance of a generally more conservative sentiment towards financial policy peaked, for instance, in a cash position that more than doubled between 2006 and 2011 in major US technology companies according to Moody’s.[[[PAGE]]]
Equity and debt investors expect different rates of return based on their diverging risk profile. While equity investors bear a higher risk and as a consequence expect a higher return, the cost of debt is further reduced by the tax shield (tax-deductibility of interest expenses). Therefore WACC might be reduced by replacing equity with debt. However, the increase in the company’s leverage will simultaneously increase the required cost of equity since more debt leads to even more risk for the shareholders.
At low debt levels the effects from replacing ‘expensive’ equity by additional debt (including tax shield) will over-compensate the increase in the cost of equity resulting in an overall decreasing WACC. Plugged into a discounted cash flow valuation (DCF) model, the reduced WACC will yield a higher net present value (NPV) of the relevant cash flows and consequently a higher enterprise value (EV).
With an increasing leverage and a higher dependence on debt investors the company not only loses financial flexibility, but its costs of financial distress rise. Bankruptcy costs are a common example of direct costs of financial distress (e.g., out-of-pocket costs such as auditors’ fees, legal and other fees). But significant costs of financial distress can also occur even if bankruptcy is avoided (so-called indirect costs, e.g., higher refinancing costs).
Additional debt puts stress to the company’s cash flow as a defined part of it has to be used for interest and redemption payments. If cash flows decrease due to an economic downturn, the company might get into trouble. Debt investors start to worry that repayments could be endangered and, just like the equity investors, are likely to defend themselves through higher compensation requirements for their risk-taking, i.e., by demanding higher credit spreads which increases the cost of debt.
Taking these effects into consideration, at a certain level of financial leverage the rising costs of equity and debt just offset the positive effect from replacing equity through debt capital. This level marks the theoretically optimal leverage with the lowest WACC. If the leverage is increased beyond that point, WACC starts to increase again. In practice, this point is not easily found and depends also on other, rather qualitative variables, such as business risk and financial policy.
Figure 1 illustrates graphically the theoretically optimal leverage; it plots the cost of equity and debt as well as the WACC against the range of rating categories displaying an increase in financial leverage when moving from left to right. For most companies, the WACC curve reaches its minimum at a rating category of BBB/BB which is often stated to be the optimal rating from a cost of capital point of view. This optimal leverage certainly varies depending on the industry the company operates in and other company-specific characteristics.
This raises the question whether a company should aim for a theoretically optimal rating of BBB/BB as a starting point for capital structure considerations? Does it make sense for companies to pursue that rating range to achieve optimal leverage and implicitly the WACC minimising capital structure? In addition to the minimum WACC paradigm, companies have to consider further parameters when deciding on the target capital structure than merely heading for the optimal leverage.
The following list of parameters should be taken additionally into account:
Financial policy is a question of finding an overall alignment of capital structure (financing), liquidity needs (investing), and dividends / share buybacks (distributing) while at the same time maintaining consistency with corporate strategy and market expectations. Companies need to trade off the benefits of debt against its costs. This trade-off involves the effective use of debt capacity while safeguarding the company’s ability to execute its business strategy without disruption.
Large software companies’ business risk profiles provide positive elements of mature companies (for SAP e.g., market leadership, broad and well-diversified customer base, and a high proportion of stable maintenance cash flows) while, at the same time, showing a high growth and innovative profile as a precondition for long-term survival in the highly dynamic and disruptive IT industry. Business risk can be measured as the volatility of a company’s earnings (e.g., EBIT). Following the strong business risk profile of SAP as a single example for a software company there would be no need to restrict financial leverage to a low level.
However, the software sector as a whole provides some unique features which reflect on the assessment of creditworthiness and the strategic liquidity needs.
The majority of the enterprise value of companies in the software sector consists of intangible assets and future prospects of its innovation strength and business growth potential as estimated by the net present values of growth opportunities (e.g., per end of 2012, SAP’s market capitalisation amounted to €75bn compared to an equity position of €14bn). Consequently, financial flexibility, strategic liquidity and continuous access to debt capital markets are key value drivers.[[[PAGE]]]
These factors are indispensable to the ability to seize value-enhancing growth opportunities through investments in innovation and mergers & acquisitions as they arise. Any risk that materially reduces financial flexibility (e.g., lower target credit rating) to the point of impairing access to additional capital potentially endangers strategic business plan execution which in turn could diminish Enterprise Value. Higher growth expectations generally imply a greater need for, and value of, financial flexibility. Thus, a more conservative capital structure, with a low or no financial leverage, can be of vital importance to optimally support the corporate strategy. In addition to a low financial leverage profile, a considerable cash level contributes to financial flexibility.
The opportunity cost of a strong liquidity position (cash holdings represent a negative NPV investment as the after-tax return on cash does not meet the required return on capital, the WACC) can be a fraction of the economic value it supports. Liquidity reduces the risks that stem from markets closing to the issuer, i.e., refinancing risk. Rating agencies are particularly sensitive to liquidity for companies in the software sector inherent to the nature of the industry and the associated technology risk.
The heavy reliance on intangible assets can be viewed negatively in case of debt funding through banks. The value of intangible assets, which often are not even recognised on the balance sheet, is difficult to assess for such debt providers and therefore they often cannot use them for collateral purposes. Thus, in times of a severe downturn in the operating business, external financing can be very expensive or simply unavailable for software companies. Consequently, their cost of debt curve (i.e., cost of debt corresponding to different rating categories) might be steeper (compare Figure 2) due to higher costs of financial distress compared to other industries. Sector specific pace and dynamics can lead to severe materialisation of business risks in case growth opportunities cannot be realised by way of acquisition or internal development of innovative products. Thus an appropriate financial flexibility is a necessary foundation for future revenues.
Customer relationships of enterprise resource planning (ERP) software providers like SAP are mutually long-term oriented. Customers have to be sure about the long-term ability of their partner to continuously develop and maintain the delivered software solutions. Again, a conservative capital structure with sufficient equity cushion to allow for additional debt capacity, if required, constitutes an important sign to a software company’s customers since they demand a high solvency on their supplier side. Too much debt might reduce customer confidence and in turn negatively impact the company’s sales performance.
Should SAP (as one example for a large software company) or a company from an industry with similar business characteristics focus on the theoretically optimal rating of BBB/BB in order to minimise WACC? The sections above make clear that treasurers must determine their optimal capital structure by balancing business and financial risk with the need to access debt capital markets at reasonable costs. Low financial leverage increases financial flexibility and creditworthiness which not only drives the cost and availability of debt, but also serves as a positive signal to the markets, customers, and suppliers of overall financial viability.
As a consequence, large software companies should target a rating category offering a higher financial flexibility than offered by their theoretically optimal rating. Figure 2 illustrates that exactly such a move towards a higher rating category can optimise enterprise value.
Graph I follows the theoretically optimal leverage approach where value is maximised at the WACC minimum since it is assumed that financial flexibility has no significant impact on future cash flows. In contrast graph II shows its value maximum at a much lower leverage ratio. This constitutes a more appropriate mapping for large software companies as an increased leverage might impair future investments, revenues and cash flows.
To provide for a prudent and risk-oriented approach, it is important to determine a target and a fallback rating category. If business environment worsens and cash flows deteriorate, management is prepared to allow its financial leverage ratio to move to a temporarily higher level (corresponding to the lower fallback rating) in order to fund necessary capital expenditure. The target rating determines the long-term debt capacity while the fallback rating determines the optimal amount of cost-effective reserve debt capacity that the company can draw upon when needed. A gap of at least one rating notch between target and fallback rating adds significant value as compared to an inflexible capital structure.[[[PAGE]]]
The article shows that treasurers, as part of their strategic task to establish and maintain an effective financing framework, can add significant value as a business partner to the senior management by constantly providing advice on capital structure and financial flexibility. This value-add can be broken down into four aspects.
1. Enhance the awareness for the importance of the treasurer’s advisory role to senior management with regard to capital structure considerations
2. Proactively provide a valid foundation for future financing decisions
3. Increase the company’s financial flexibility as it directly corresponds to the realisation of business opportunities and the financial support of corporate strategy
4. Develop a financing framework which sets the stage for a strategic dialogue with your company’s core banking group in order to optimally prepare for future financing needs (‘strategic funding partnership’).
Diel, Steffen /Wiemer, Joerg: Strategies for share buybacks (2008)
Merrill Lynch: Unlocking Value to optimal capital structure (2006/2007)
Moody’s : Technology Company Cash Cache Likely to Have Extended Overseas Vacation (2011)
Passov, Richard: How Much Cash Does Your Company Need? (2003)
Pettit, Justin: Strategic Corporate Finance: Applications in Valuation and Capital Structure (2011)
Ross, Stephen A. et al.: Corporate Finance (2008)
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