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REPORT TO DIRECTORS 500550049

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I: Capital Structure Capital structure refers to the mix of securities and financing sources used by a company to finance investments (Meyers, 2001). The study of capital structure allows financial managers to maximise firm value through finding the combination of securities to appeal to investors greatest (Meyers, 2009). A study of ten years (2011-2020) showed a general trend of declining debt until 2019 depicted below.

Modigliani and Miller’s Proposition 1 states that no combination of capital structure is superior over another and that a firm’s overall market value is independent of such institution. Under this assumption, a firm’s WACC should not fluctuate regardless of its capital structure model when funding expenditure. However, objections to this theory exist, including the assumption of a perfectly competitive market with no tax, financial distress, or symmetry information, which is unrealistic. This section will rationalise Metcash’s financing decisions through capital structure theories.

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2012 Under the Trade-off Theory, firms should increase their leverage until it reaches the level for which firm value is maximised, as tax savings resultant from increasing leverage are perfectly offset by the increased probability of incurring costs of financial distress. As depicted in the diagram below, marginal benefit of increasing debt declines as debt increases, while marginal cost increases. This implies that a company must have a optimal value by allowing financial distress to offset the benefit of using debt as tax shield.

Within a dynamic trade-off strategy, Metcash should elect the levels of debt and equity accordingly so that the accumulation of earnings and losses is offset, and the resulting debt ratio is close to the target (Hovakimian, 2003). However, Metcash’s 2012 strategy of raising equity (to the sum of $325 million) to finance their Share Purchase Plans is inconsistent with the

500550049 trade-off theory as they could not realise interest tax gains by financial capital through the preferential forms of internal funding, or debt. This further reflects an inconsistency with Pecking Order Theory, whereby firm prefers internal to external financing and debt to equity if securities

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2015 During the 2015 financial year, Metcash’s stock price crashed with earnings per share fell 19.6% and gearing rising to 62.98% seen below.

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In response, the firm ventured to create a strong financial base to, resetting the balance sheet to reflect current difficult trading conditions. Such actions were permitted by the $1.5 billion available through debt facilities. Further, dividend payments were suspended to ensure access to capital to invest in future growth. Funds were also sourced through the sale of Metcash’s Automotive Holdings, and proceeds were invested into the balance sheet. Gearing decreased to 16.8% the following year, conveying the success of such actions. This is consistent with the pecking theory whereby retained earnings are preferential. Limitations of pecking order theory should be noted, including its failure to account for the fact that many firms operate successfully with little debt (Brealey et al., 2016). This observation contradicts trade-off theory, that higher profits imply a higher debt-servicing capacity and thus a higher income tax shield (Brealey et al. 2016).

2020 In the face of the COVID-19 pandemic characterised by economic uncertainty, Metcash sought to attain strong financial footing, resorting to equity financing. The $30 million equity raising and

500550049 additional $180 million in short-term debt facilities allowed for the continued investment in growth opportunities across Metcash’s three industries. Such funds were used in the acquisition of two bolt-on firms, Liquor Centre and Kollaras, in their liquor and hardware industries (Metcash, 2020). This aligns with the pecking order theory, whereby only in times of extreme financial distress, such as in the face of a pandemic, should firms resort to equity financing. This can be reasoned through the ‘Lemons Problem’, where investors draw negative inferences from a company’s announcement of share offerings as a result of information asymmetries (Benner & Zenger, 2016).

AASB It should be noted that the dramatic spike occurring in 2020, depicted in fig.1 was not as a result to change in capital structure, but simply an amendment to the AASB which necessitated lease liabilities to be receded on firms’ balance sheets. This change can be quantified in Metcash’s balance sheet through a $900bn debt impact on liabilities and a similar effect on assets.

Conclusion Overall, pecking order theory can be applied more successfully to Metcash’s capital structure decisions as opposed to other theories, however this is still not entirely accurate.

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II: Influence on WACC Effect Modigliani and Miller’s proposition 2 discusses the impact on WACCC as decreasing as proportion of debt increases. However, this notion is weakened through its failure to account for the increased risk of borrowing as firms borrow more. Accordingly, heightened levels of risk are place upon investors reducing the cost of equity when leverage sits at high levels. MMII was used utilised loosely in calculating WACC.

Calculation Data was retrieved over the period of FY2011 to FY2020. Net debt was used as opposed to total debt so as to exclude cash and cash equivalents, as these can be used to pay off debt immediately. Book value of net debt was used as Metcash’s debt is not publicly traded. Book value is a reflection of a point in time and is a backwards-looking measure, whereas market value reflects the company's equity incorporates the expectations of growth and highlights the actual amount of equity that is being supplied to the company at any given point in time. Market values are limited through the fact that its susceptible to changes with market sentiment and occasionally irrational pricing mechanisms and can become unstable over time. Since capital structure decisions are considered forward-thinking, through analysing the market value of the capital structure, we can analyse Metcash’s decisions. Australia’s company taxation rate of 30% and the convention market risk premium of 6% were also used (Bishop et. al., 2018).

500550049 Return on Debt Government bonds function as the best proxy representing risk-free rate (Villadsen et al., 2017). Accordingly, annual data for the Australian Government’s 10-year bond was used to depict the risk-free rate of each year. Altman’s Z-Score model has been used to predict financial distress through multiple discriminant analysis. A firm is deemed to be in the ‘safe’ zone for investors if it has a z-score greater than 2.99, indicative of a ‘safe’ investment.

At all material times, Metcash has satisfied such condition and thus would serve as a reasonable investment Based upon the Z-Scores, a credit rating of approximately A can be concluded, within one standard deviation (2.29) of the average Z-score (3.74) in its upper and lower bounds during the course of 2011-2020. In determining Metcash’s credit rating as that of ‘A’, we can thus identify the spread to be 1.08% (Damodran, 2020). rd was thus found through the summation of each year’s respective risk-free rate, and the spread of 1.08%.

500550049 Return on Equity Markowitz’s Capital Asset Pricing Model assists in quantifying risk and translates such risk into an estimation on the expected return of equity (re) (Mullins, 1982). The following formula was utilised to calculate re:

E(r i )=r f ❑ +E(r m−r f )ß i

This led to the results shown below:

Beta Calculation Metcash’s official levered beta of 0.77 (Morningstar, 2021), was unleveraged using the formula:

β u=

β1 [ 1+(1−t c )ϕ ]

Unlevered beta was thus found to be 0.892312742. This figure was then re-levered using

1+(1−t c )ϕ β 1= β u ¿ utilising the rf found for each respective year.

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Weightings D/V was found by dividing net debt by the sum of net debt and market cap. This figure was then subtracted from 1 to find E/V.

WACC Finally, the cost of capital for each year was found using the formula

After −taxWACC =(1−T c )r D D /V +r E E/ V This led to the results as depicted below.

500550049 Distress Costs

Such calculations employed above represent a naive standing, which expects full benefit from tax shields, however this may not be the reality practically.

Limitations To overcome inaccuracies in WACC calculation, Metcash should employ the APV method in place of the WACC calculation, as it calculates the unlevered value of a firm and makes adjustments to maintain integrity of calculations, such as the addition of tax shields in the determination of NPV.

Trends In drawing a comparison between WACC and debt-to-equity ratios, it can be concluded that these two concepts are inversely correlated. As the price of equity increases, an increased taking of debt cannot offset the notion that cost of debt is lower than equity with the tax shield

500550049 that is generated from taking more debt. Trends can be drawn upon to explain this relationship, depicted in the graph below, in practice.

The sudden drop in share price in 2015, resulted in low market capitalisation, is consistent with the inverse relationship between WACC and debt-to-equity, as WACC reached a low of 6.83% in this period when leverage increased to 62.98%.

See Appendix for full working.

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III: Recommendation Current Environment Metcash’s FY2020 raised $300 million in equity raising which allowed the company to face the uncertainties associated with COVID-19. However, inefficiencies in Metcash’s capital structure supports moderate levels of debt financing in the future which will allow the company to finance future growth opportunities as macroeconomic conditions improve in coming years. These inefficiencies are in reference ot high levels of equity, which is more expensive for firms. However, it is important that Metcash finance debt cautiously as to limit financial distress costs associated with debt financing per Trade-off theory. Further, given the current economic climate of a low cash rate of 0.1%, and resultant low interest rates, alongside low inflation, it can also be accorded that this would be an optimal time to raise debt, which will allow for optimisation of Metcash’s cost of capital in coming years (RBA, 2021).

Recommendation As cost of equity reflects the risk associated with generating future cashflow, lowering a company’s risk characteristics will lower such cost. Accordingly, to reduce their cost of capital, Metcash should utilise debt for financing going forward, through actions such as increased debt issue of $200 million. Further, to increase their leverage, Metcash may also repurchase their

equity through the form of debt, to further align with the pecking order theory whereby debt is preferential to equity in the case that external funding is required. However, the preference for debt issue over equity buy-back will be explained below.

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Rationale The increase in leverage through debt issue is preferred over buy-back of equity, to allow ofr increased liquidity within functions, such as future investment. This flexibility is necessitated through Metcash’s MFuture Strategy which requires high levels of investment to foster growth in the company overall. High levels of investment now, in ideal economic conditions will transition to high levels of growth as macroeconomic conditions improve in the future.

Shareholders & Goals Such actions also uphold Metcash’s shareholder commitments and strategic goals of expanding current initiatives such as their MFuture program which is currently underway. Per signalling theory, significant increases in leverage signals confidence to investors. In increasing debt levels, they are further able to provide shareholders with dividends (12.5c/ share in 2020). Further, debt raising is also in line with Metcash’s goal of “prudent approach towards capital management” as per the 2019 Annual Report.

Proven Success A similar strategy of raising debt was executed by Metcash in FY2015 following the share price crash. This strategy was largely successful, and thus speaks to the credibility of success being viable once again.

Competitive Perspective A brief analysis was performed in regards to competitors’ capital structure. As a conglomerate, numerous industries were analysed. Per Damodoran, average market debt to capital (adjusted for lease liabilities) for food wholesalers 35.90%, and beverage (alcoholic) firms sat at 23.97%. The retail and grocery food industry sat at a high of 86.32%. Competitor Woolworths was

500550049 analysed as having a debt-to-market cap. ratio of 35.23%, sitting slightly higher than Metcash at 22.77% in the first half of the 2021 financial year. In reference to these figures, it can be concluded that a higher level of leverage is viable for a profitable firm such as Metcash, as supported by Rajan and Zingales (1995) who considered that trade-off theory suggests large firms with tangible assets tend to have higher debt ratio.

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IV: Appendix

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IV: References ●

Altman, E.I. (2003). The Use of Credit Scoring Models and the Importance of a Credit Culture. Retrieved from http://pages.stern.nyu.edu/~ealtman/3%20CopCrScoringModels.pdf

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Altman, E. I., Iwanicz, D. M., Laitinen, E. K., & Suvas, A. (2017). Financial Distress Prediction in an International Context: A Review and Empirical Analysis of Altman’s ZScore Model. Journal of International Financial Management & Accounting, 28(2), 131– 171.

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Damodaran, A. (2021). Debt Fundamentals by Sector. Retrieved from http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/dbtfund.html

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Damodaran, A. (2020). Ratings, Interest Coverage Ratios and Default Spread. Retrieved from http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ratings.htm

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DeAngelo, H., & Roll, R. (2016). Capital structure instability. Journal of Applied Corporate Finance, 28(4), 38-52.

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Metcash. (2020). Metcash Annual Report 2020. Retrieved from https://mars-metcdncom.global.ssl.fastly.net/content/uploads/sites/101/2020/08/05171507/Metcash-AnnualReport-2020.pdf

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Morningstar Datanalysis Premium. (2021). Metcash Limited. Retrieved from https://datanalysis-morningstar-comau.ezproxy.library.sydney.edu.au/af/company/corpdetails?ASXCode=MTS&xtmlicensee=datpremium

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Morningstar Datanalysis Premium. (2021). Woolworths Limited. Retrieved from https://datanalysis-morningstar-com-

500550049 au.ezproxy.library.sydney.edu.au/af/company/corpdetails?ASXCode=WOW&xtmlicensee=datpremium ●

Myers, S. C. (2001). Capital structure. Journal of Economic perspectives, 15(2), 81-102.

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Ratings and Coverage Ratios. (n.d.). Retrieved 21 May 2021, from http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ratings.htm

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Trading Economics. (2021). Australian Government Bond 10Y. Retrieved from https://tradingeconomics.com/australia/government-bond-yield...