An Example of a Primary Market Transaction is Woolworths Ltd - Accounting & Finance Assignment Help

Assignment Task

QUESTION 1

(a) An example of a primary market transaction is Woolworths Ltd issuing new shares.

An example of a secondary market transaction is my brother buying Woolworths Ltd shares on the market through a broker from a company in Timbuctoo selling Woolworths Ltd shares on the market through a broker.

In the case of a primary market transaction, Woolworths is involved in the transaction, receiving financing from the buyer (perhaps via an intermediary).

In the case of a secondary market transaction, Woolworths receives nothing and the transaction is between the seller and the buyer. The company in Timbuctoo selling Woolworths shares receives the money my brother paid for the shares and my brother receives the shares in exchange.

(b) The assumed goal is the maximisation of firm value, which in more restrictive forms is the maximisation of shareholder wealth or maximisation of share price.

An example would be decision making in project analysis using the NPV. We would accept a project with a positive NPV but reject it if the NPV is negative. A positive NPV project adds value to the company, whereas a negative NPV project reduces company value.

QUESTION 2

(a) A firm’s optimal capital structure is the mix of debt and equity that maximises share price and firm value. This also coincides with the point at which WACC is minimized. This is because the value of a firm is the PV of future cash flows and the lower the discount rate (WACC), the higher the PV. For Pound, WACC is minimised at a capital structure consisting of 40% debt and 60% equity. At that capital structure, the firm’s WACC is 11.04% and firm value should be maximised.

To answer this question, you need to recognise the factors that result in benefits or costs of financial leverage and which theory those factors relate to. You then need to tie these together to explain the U-shape of Pound Industries’ WACC.

The main factor that results in a benefit of financial leverage is the tax deductibility of debt for tax paying companies. As the debt level increases, the tax shield increases because of the tax deductibility of interest on debt. This initially reduces WACC because the cost of debt is cheaper than the cost of equity. This is MM’s theory of capital structure with corporate taxes.

There are also benefits of debt related to reductions in agency costs. Agency theory suggests that firms with large free cash flows or diverse ownership interests or both may face higher agency costs (lack of risk taking in investment decision making, managerial perquisites, “empire building” etc). Increasing the level of debt in the capital structure can act as a disciplinary mechanism on managerial decisions, therefore reducing agency costs. This would reduce the cost of equity and therefore WACC.

However, there are also increased costs as the level of debt in the capital structure increases, the main ones being insolvency and agency costs of debt. With greater financial leverage comes greater probability of financial distress and associated insolvency costs. Agency costs of debt also rise as debtholders become nervous that management will make decisions that benefit shareholders to bondholder detriment. The cost of debt will begin to rise and debtholders will place restrictions on what the firm can do. For example, loan contracts may contain very restrictive clauses that limit the dividend that can be paid out and limit investment in high-risk (but potentially profitable for shareholders) projects.

Therefore, trade-off theory states that as the debt level rises, the tax shield and agency cost reductions that come with increasing debt levels initially reduce WACC. However, at some point, these benefits are outweighed by increasing insolvency and agency costs of debt. The WACC then begins to increase as more debt is added.

The trade-off theory incorporates these opposing effects and states that an optimal capital structure exists where the benefits of debt are just equal to the costs. The WACC is minimised and firm value maximised with this capital structure.

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