Question

In April 1997, Telstra, then a telecommunications company wholly owned by the Australian Government, announced a capital restructuring ahead of its proposed partial privatisation through a share market float during the second half of 1997. The capital restructuring involved payment of a special dividend of $3 billion to the government and the borrowing of $3 billion by Telstra. Its finance director reportedly said that ‘the restructuring would lower the average cost of capital and enable greater financial flexibility’. Similarly, one journalist noted that ‘debt financing is cheaper than equity raising’. His article also stated that ‘debt interest payments are also tax deductible, while dividends are not’. Critically evaluate these comments on the effects of, and reasons for, the restructuring.

Answer 1

Since the company takes on debt, it will lower its WACC.

A special dividend paid to the government also helps to fund the government to operate without having to balance its books. The issue of special dividend to the government also safeguards the government against a potential failed public offering.

Taking on debt would also improve the return on equity for the firm thus making it a more attractive option for the shareholders.

However, taking on debt would mean the company needs to make fixed payments. It will become more leveraged. Telecom is also a capital intensive sector so the company may have gone for debt financing only if it believes that the chances of increasing its revenue growth are fairly high. Hence by reducing its cost of capital it will increase its profits.

Answer 2

The first two comments are similar and will be discussed together. While the interest cost of debt is less than the rate of return expected by shareholders (cost of equity), this difference is consistent with the fact that the returns to lenders are less risky than those to shareholders. Raising more debt will increase financial risk and increase the cost of equity. The Modigliani and Miller (MM) analysis shows that in a perfect market there would be no effect on company value. When the MM assumptions are relaxed, any favourable effects must involve lower taxes, reduced agency costs or the impact of the financing change on the company’s investment decisions. While such effects are possible, the relevant factors have not been mentioned in the comments. Conversely, higher debt would be expected to increase the expected costs of financial distress, which would decrease company value. Finally, it is very difficult to see how using more debt finance can provide greater financial flexibility. Debt, with its obligations to pay interest and to repay principal when it is due, is usually regarded as reducing the borrower’s financial flexibility.

The third comment relating to taxes is, of itself, correct, but this does not establish that debt has an overall tax advantage compared to equity. The tax deductibility of interest means that cash flow paid out as interest escapes any company tax, but interest is taxable in the hands of investors who receive it. Under the imputation system, profits distributed as franked dividends are taxed only once at the shareholder’s personal tax rate. Therefore, for a given investor, the total tax burden on debt and equity can be the same.