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FINANCINGASSIGNMENT

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Table of Contents Executive summary..........................................................................................................................2 Cost of Capital Calculation................................................................................................................3 How does the observed data influence the estimation of a cost of capital?......................................4 Cost of Capital Calculation Methodology..........................................................................................4 Capital Transaction Recommendation..............................................................................................5 References........................................................................................................................................7

Executive summary Metcashshouldeitherinitiateanequityofferingatadiscountorinitiateasharerepurchaseplanto reduceitscostofcapital.AsharerepurchaseplanincreasestheweightingofMetcash’sdebtintheir capitalstructure,whichwouldreducetheirWACCinthelongrun.Offeringequityatadiscount createsasharedilution,whichwouldreduceMetcash’scostofequityandcostofcapitalintheshort runduetotheheavyweightofequityintheircapitalstructure.

Metcash Funding 4,000.00 3,500.00 3,000.00 2,500.00 2,000.00 1,500.00 1,000.00 500.00 0.00 2011 -500.00

2012

2013

2014

2015

2016

2017

2018

2019

2020

-1,000.00 Marketvalueofequity

netdebt

RetainedEarnings

Figure 1

Overthelasttenyears,Metcash’sobserveddebtandequitylevelshaven’tpreciselyfollowedany capitalstructuretheory.However,thecapitalstructuretheorythatperhapsexplainstheobserved trendsisthe“Trade-offTheory. Modigliani–Miller’sfirstpropositionsuggeststhatintheadventofaperfectcapitalmarketwithno taxes,costs,andinformationsymmetry,afirm’scapitalstructuredoesnotaffectitsvalue,andas such,leveragedoesn’tprovideanyadvantagetoafirm.Metcash’soperationwithinan“imperfect “capitalmarketaccountsforthelackofcorrelationbetweenModigliani–Miller’sfirstpropositionand itsleveragedcapitalstructureobservedinfigure1.Inarevisionoftheirfirstproposition,toinclude taxesandtheassumptionofpermanentdebt,ModiglianiandMillerchampioneddebtasamore valuablefundingsourcethanequity.However,thelimittothebenefitofdebtasitincreasesisoneof manyfactorswhichaccountforMetcash’shistoricallackofdebtcomparedtoequitywith2014-2016 FYasanexception.Assuch,Metcash’scapitalstructuredoesn’trelatewithModigliani–Miller’s theorem. ThePeckingOrderHypothesisdevelopedbyMyerandMaljufstemsfromtheassumptionthe informationasymmetrybetweenfirmsandexternalinvestorstranslatesintohighercostsforfirms whenissuingexternalfinancing.Thus,thehypothesisstatesthatfirmsprefertofundinvestments internallyviaretainedearnings,andiftheyrequireexternalfunding,theyfirstchoosedebtandthen equityasalastresortduetothelowercostofdebt.AsdepictedbyFigure1,Metcashhasalways preferredtofunditsoperationsthroughexternalfinancing,especiallyequity.Thelackofcorrelation betweenthepeckingorderhypothesisandMetcash’scapitalstructureisemphasisedbyMetcash’s

preferencetoraise300millioninequityand180millionindebtfacilitiesoverutilisingretained profitstofundnewacquisitionsin2020.

AninnovationofModiglianiandMillers’proposition,thetrade-offtheoryimpliestheoptimalcapital structurehasamoderatedebtratiothatoffsetsthecostsofdebt(agency,financialdistress)withthe benefitsofdebtthefirm(taxshields)[CITATIONMye01\l3081].AsdepictedbyFigure1,Metcash’s debtwasmaintainedatamoderatelevelcomparedtoequityovertenyearsexceptduringthe20142016FYS.However,thehighdebt-to-equityratiosfrom2014-16canbeexplainedbyMetcash’sshare price,whichdecreasedfrom3.96in2013to2.78,1.32,1.76andsubsequentlyreducedthevalueof Metcash’sequityinconsecutiveyears.Thedropinsharepricewasaby-productofMetcash’s reducedprofitabilityduring2014-2016,createdbyMetcash’sheavyinvestmentina“transformation plan”in2014.Evenafterconsideringthehighdebttoequityratiooutliers,Metcashmaintainedanet gearingaveraging36.8%overtenyears,belowtheindustryaverageof63.4%.Thus,Metcash’s sustainabledebtstructuredrawsparallelstothetrade-offtheory.

Cost of Capital Calculation Table 1 2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

7.97%

6.74%

5.97%

5.95%

4.87%

4.85%

5.26%

5.36%

5.05%

4.14%

Cost of equity

8.80%

7.61%

6.57%

6.90%

6.35%

5.30%

5.51%

5.46%

5.24%

5.08%

Cost of debt

6.98%

5.80%

4.73%

4.53%

3.91%

3.67%

3.59%

3.68%

3.49%

2.73%

D/E

27%

32%

22%

34%

69%

19%

9%

3%

7%

42%

Beta

0.52

0.53

0.50

0.54

0.61

0.50

0.46

0.45

0.46

0.57

Risk free rate

5.7%

4.4%

3.54%

3.66%

2.71%

2.33%

2.73%

2.78%

2.5%

1.69%

Market risk premium

6%

6%

6%

6%

6%

6%

6%

6%

6%

6%

WACC

How does the observed data influence the estimation of a cost of capital? TwocrucialfactorsthatinfluenceMetcash’scostofcapitalaretheoverallweightandthecostsof debtandequitywithinafirm’scapitalstructure.AsshownbyFigure1andTable1,it’sclearthat Metcash’scapitalstructureisdominatedbyequityandMetcash’scostofequityismoreexpensive thantheircostofdebt.ThisdeterminesthataslightincreaseintheMetcashcostofequitycanbea keydriverinincreasingtheircostofcapitalwhichisshowninthe2016-2017FYs.Conversely,thecost ofdebtwillhavetoinflateconsiderablytomakeasimilarimpact,asshownin2017-2018FYs.An increaseinthecostofdebt,asseenin2018FY,usuallyresultsinareducedcostofcapital,butTable 1showsthatthecostofcapitalincreasesasthesheerweightingofequitydampenstheimpactofa firm’sdebtwhenestimatingthecostofcapital. OtherfactorsthatinfluencecapitalcostincludethefirmsBeta,therisk-freerate,andthefirm’s financialperformance. Thefirm’sBetaandtherisk-freeratesarecriticaldeterminantsofafirm’scostofequitywhen calculatedusingtheCAPMformula.ThisisshowninTable1,whereasignificantdecreaseintheriskfreeratecorrelateswithalowercostofequityandcostofcapital2011onwards.TheBetafluctuated between0.46-0.65between2011-2020.However,itsimpactonthecostofcapitalwasdampened duetothevolatilityoftherisk-freerate. TheAltmanZscore,whichassignscreditratingstoafirmwithnopubliclytradeddebt,isdependent onafirm’sfinancialperformance.Usually,afirm’ssubparfinancialperformanceleadstoalower creditrating,makingthefirmsriskierintheinvestor’seyesandincreasingitscostofdebt.However, asshownbyAPPENDIX1,thesubstantialreductionoftherisk-freeratefrom2011-2020have accountedforalowercostofdebt,despiteMetcash’ssubparfinancialperformanceassigningthema lowercreditratingduringthe2016-2019FYS.

Cost of Capital Calculation Methodology Themarketrateofreturn TheAllOrdinariesmarketindexcomprises500ofthebiggestcompanieslistedontheAustralian SecuritiesExchange(ASX),whichisthelargestamalgamationofsharesintheASX,makingtheindex themostaccuratesubstituteforthemarket. Risk-Freerate Therisk-freerateiscalculatedastheaveragerateofreturnofa“risk-free“Governmentbond”for thecalendaryear(Bishop,Carlton,&Pan,2018).Forexample,1.69%wasanappropriaterisk-free ratein2021 MarketRiskPremium

ResearchbymultipleacademicsourceshasdeterminedAustralia’sMarketriskpremiumis6% relativetotheten-yearGovernmentBondRate[CITATIONBis18\p19\l3081]. Beta Metcash’sβwascalculatedwiththeLeveredBetaformulabyutilisingWoolworth’sasaproxy. WoolworthsleveredBetawasunleveredandreleveredtocalculateMetcash’sBetafrom2011-2020. WoolworthsisanappropriateproxyforMetcashbecauseitoperatesinAustralia’sLiquorandretail divisionsandisthusexposedtosimilarriskfactorsfacedbyMetcash.Moreover,Woolworth’sstable historicalpriceissufficienttoestimateacompanyβaccurately. Costofequity TheCAPMformulawasusedtocalculatethecostofequity. Costofdebt ThecostofMetcash’sdebtwascalculatedusingtheAltmanZscore[CITATIONAlt94\l3081]and creditratingriskspreadsourcedfromtheRBA[CITATIONRes21\l3081]. DebttoEquityratio TheDebttoEquityratiowascalculatedastotaldebt/equity.ThebookvalueofMetcash’stotaldebt wasasubstituteforthemarketvalueofdebt.Metcash’smarketcapitalisationwasusedasthe Marketvalueofequity.

Capital Transaction Recommendation ThesourceoffundingthathasthemostsignificantimpactonMetcash’scostofcapitalisequity,as showninTable1.Thus,toreduceitscostofcapital,Metcashhastoreduceitscostofequity. Metcashshouldoffersharesatadiscountofitscurrentmarketpricetoexistingshareholdersand potentialinvestorstoreduceitscostofequity.Thiswouldreducethecostofequityastheincreased numberofsharesincirculationwouldreducethecurrentmarketvalueofMetcash’ssharesbasedon thelawsofsupplyanddemand.Thedividendcapitalisationmodelcalculatesthecostofequityby dividingthecompany’sdividendpershareratewiththecompany’scurrentmarketvalueofshares andsummingtheproductwiththedividendgrowthrate.Thus,ifMetcashmaintainsitscurrent dividendpayout,whichwassuggestedinthe2020annualreport,andkeepsitsdividendgrowth constant,implementingthiscapitaltransactionwillreduceitscostofequity[CITATIONMet20\l 3081].Metcashalsoincreasesitsconsiderableequitytovalueratiobyimplementingthis transaction,whichcanstifletheeffectsofanincreaseinthecostsofdebtandreduceitscostof capital,asdepictedinTable1. Thepotentialrisksofthistransactionarethatpotentialinvestorswillinterprettheequityofferingas asignofbusinesstroublewhilstexistingshareholderswillbeunhappythatnewshareholdersmay undercuttheircapitalgains. However,theprospectsoffutureinvestorsacquiringdiscountedequityisincrediblylikely,basedon thelemonprinciple.Thelemonprinciplestatesthatinvestorswillbemorelikelytopurchasenew equityifofferedatadiscountpriceasinvestorsareuncertainoftheactualvalueofacompanydue totheinformationasymmetrypresentincapitaltransactions[CITATIONMye01\l3081].Moreover, Metcashachievedstrongfinancialresultsattheendofthe2020FY,withsalesincreasingby20%,

encouragingexternalinvestorstoinvestinMetcashatadiscountduetotheexcellentprofit potential[CITATIONMet21\l3081]. Despitebeingundercutbythiscapitaltransaction,existingshareholderswillstillbewillingtoinvest inthistransaction.Metcashissettomaintainaconstantdividendin2021[CITATIONMet20\l 3081],thusincreasingexistingshareholders’dividendpayoutiftheypurchasethenewshares, marginallyoffsettingthelossofvalueabsorbedbytheshareholderswiththeissueofdiscounted equity.Moreover,accordingtoMorningstar,existingshareholderswerewillingtopurchasesharesat $2.28inMay2020,whenthemarketpricewas$2.50duetoMetcash’sgrowthin2019[CITATION Dat21\l3081].ThecontinuedincreaseinMetcashprofitabilityreportedin2020intheirfinancial resultswillencourageexistingshareholderstopurchasethenewequityagain[CITATIONMet21\l 3081]. ThiscapitaltransactionisjustifiedbyadecreaseinMetcash’scostofequityfrom(5.24)to(5.08) during2019-2020afterMetcashimplementedashareissuein2020. Asharebuybackiswhenapubliclylistedcompanyusescashtopurchaseitssharesbackfromthe market.InthecontextofMetcash,theyshouldinitiateasharebuybacktoincreasedebtasa percentageofthetotalcapitalstructureandreducetheirWACC. Implementingasharebuybackreducesthesizeofequity,resultingintheequity-to-totalassets decreasingandthedebt-to-totalassetsincreasing;figuresusedasweightstodeterminetheWACC. Inthelongrun,ifthecostofdebthasamoresignificantimpactindeterminingthecostofcapital andifthecostofequityiskeptrelativelyconstantwithoutinflatingmassively,whichisobservedin Table1,asharebuybackleadstoalowerWACC.Asempiricalresearchandgeneralfinancial standardshavedetermined,thecostofafirm’sdebtisgenerallylowerthanequity,whichisthecase withMetcash,asshowninTable1. Potentialrisksofthisstrategyarethenegativeimplicationsofincreasedleverage.However,Metcash isuniquelypositionedtodealwiththeriskasMetcash’sinterestcoverratioin2010wasextremely strongat9.6[CITATIONDat21\l3081],whichwasinflatedbyimpressivesalesgrowththat amplifiedMetcash’sEBDITAinthesameperiodasreportedinMetcash’s2021interimfinancial results[CITATIONMet21\l3081].ThisportraysMetcashashavingastrongmarginofsafetywhen dealingwiththerisksofthistransaction. ThistransactionwillbeeffectiveasafterMetcashpurchased66,385,128ordinarysharesin2018 [CITATIONDat21\l3081],theircostofcapitalreducedfrom5.36to5.06accordingly.

References Altman,E.I.(1994).TheUseofCreditScoringModels.Stern School of Business,9. Bishop,S.,Carlton,T.,&Pan,T.(2018).Market Risk Premium.MacquarieUniversity,Departmentof AppliedFinance. Datanalysis via Morningstar. (2021). Retrieved from Morningstar: https://datanalysis-morningstarcom-au.ezproxy.library.sydney.edu.au/ftl/company/ratio?xtmlicensee=datpremium&ASXCode=MTS&sy=2011-01-01&ey=2021-12-31&rt=A Metcash.  (2020). Metcash Annual report. Retrieved  from  Metcash:  https://mars-metcdncom.global.ssl.fastly.net/content/uploads/sites/101/2020/08/05171507/Metcash-AnnualReport-2020.pdf Metcash.  (2021). Metcash Financial results. Retrieved  from  Metcash:  https://mars-metcdncom.global.ssl.fastly.net/content/uploads/sites/101/2020/12/07095220/2152667.pdf Myers,S.C.(2001).CapitalStructure.Journal of Economic Perspectives,82. Reserve  Bank  of  Australia.  (2021). Statistical Tables.  Retrieved  from  Reserve  Bank  of  Australia: https://www.rba.gov.au/statistics/tables/#interest-rates

APPENDIX APPENDIX 1 - Cost of Debt

APPENDIX 2-WACC Calculation...