Mpact a South African paper and packaging company has recently reported highly satisfactory results. It has a rare attribute for a SA based industrial company. It appears to have very good growth prospects linked to good export prospects for SA agriculture as highlighted in BD on May 2nd.
And Mpact seems very willing to invest in the growth opportunity and to raise capital from internal and external sources to fund the growth opportunities. It speaks of a 20% internal rate of return on these projects which would be well above the 15% p.a. that could be regarded as the opportunity cost of the capital it raises.
But the Mpact story is complicated by its shareholding. Caxton an apparently less than friendly shareholder unwilling to raise its 34.9% stake to the point where it has to make an offer to all other shareholders. It prefers to merge its operations with Mpact, a prospect the Mpact board is actively discouraging.
Caxton however argues that Mpact has raised too much debt for its comfort. It may have in mind using its own cash pile to fund the capex after a merger. It may nevertheless have a generally valid point. Mpact might be better advised to fund its growth raising more additional equity capital and less extra debt. This might not suit Caxton but would be a less risky strategy. And there is not good reason that SA pension funds with their typical 60% equity – 40% debt would not welcome the opportunity to contribute additional equity capital that promises good returns.
It is a strategy to be recommended to any growing company. Any equity capital raised that beats its cost of capital will very likely add value for its shareholders old and new. The value of the firm will increase by more than extra capital raised- adding wealth for shareholders with a smaller (diluted) share of what will have become a larger cake. Dilution can take place for good growth reasons- and not only to save off the bankruptcy – that always comes with too much debt.
The temptation always offered by interest rates below what prospective internal rates of return on capex is to raise debt to improve the return on shareholder’s equity. When the internal rates of return have in fact exceeded the costs of finance, hindsight tells us more debt, would and should have been the obviously preferred source of capital. But in an uncertain world such favourable outcomes cannot be known in advance.
The savings in taxes paid, because interest payments are deducted from taxable income, that is equal in value to the tax rate multiplied by the interest paid, may be presumed to reduce the “weighted average cost of capital’ – and so perhaps reduce the target internal rate of return required to justify an investment decision. I would counsel against such an approach. Expected return on all the capital put to work, however funded, should be the initial critical consideration independent of tax to be paid. If the expected returns are attractive, the appropriate financial structure can then be considered. Debt is not necessarily cheaper than equity – because it is more risky – and the firm may well have to pay up for the financial risk it has taken on, usually when it is least convenient to do so.
When the source of any reported growth in earnings appears to be financial engineering, and is largely debt financed, it should be treated with suspicion by actual or potential investors in the shares of such a company. Returns on all capital invested needs to be greater than the interest rate on debt raised and in addition need to at least meet the returns required by shareholders who have alternative investment opportunities. How best to fund the growth should be a secondary consideration after the favourable return on all capital invested can be assumed with confidence.
MPact should be strongly encouraged by its shareholders and South Africans more generally to realise all the projects that can confidently earn 20% p.a. And raising extra equity rather than only debt capital will help ease their way down their apparently long runway -should the 20% materialise.