C O S T O F C A P I TA L

AND
C A P I TA L S T R U C T U R E
 PROBLEM-
LEVERAGE

• Consider the following information for Kaunark Enterprise:

• (hint estimate DOL, DCL and DTL)

CRITICAL QUESTIONS
• Where to invest? What type of projects should be considered?
• How to finance capital investment requirements? Whether manager should rely more on
borrowings or equity?
• Implication of financing choices? How it impacts value of firm?
• How finance manager should raise capital for future investment requirements?
Understanding firm value
C A P I TA L S T R U C T U R E
• A firm’s choice of how much debt it should have relative to equity is known as a capital
structure decision.
• A firm’s capital structure is really just a reflection of its borrowing policy.
W H Y C O S T O F C A P I TA L I S
I M P O R TA N T
• The return earned on assets depends on the risk of those assets.

• Knowing cost of capital can also help to determine the required return for capital
budgeting projects.

• The cost of capital provides us with an indication of how the market views the risk of our
assets.
C O S T O F C A P I TA L
• Sources of fund for corporation
• Debt- bank term loan and bond/debentures
• Equity
• Preference shares
C O S T O F E Q U I T Y E S T I M AT I O N
• The cost of equity is the return required by equity investors given the risk of the cash
flows from the firm.
 Business risk
 Financial risk
• Approaches
• The dividend growth model approach and
• the security market line (SML) approach or CAPM
DIVIDEND GROWTH MODEL APPROACH
• the firm’s dividend will grow at a constant rate, g, the price per share of the stock, P0, can
be written as:
EXAMPLE: DIVIDEND
GROWTH MODEL
• Suppose that your company is expected to pay a dividend of $1.50 per share next year.
There has been a steady growth in dividends of 5.1% per year and the market expects
that to continue.
• The current price is $25. What is the cost of equity?

1 . 50
RE   . 051  . 111  11 . 1 %
25
 E X A M P L E : E S T I M AT I N G T H E
D I V I D E N D G R O W T H R AT E
• One method for estimating the growth rate is to use the
historical average.
Year Dividend Percent Change
2014 1.23 -
2015 1.30 (1.30 – 1.23) / 1.23 = 5.7%
2016 1.36 (1.36 – 1.30) / 1.30 = 4.6%
2017 1.43 (1.43 – 1.36) / 1.36 = 5.1%
2018 1.50 (1.50 – 1.43) / 1.43 = 4.9%
Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%
EXAMPLE
• Greater States Public Service, a large public utility, paid a dividend of $4 per share last
year. The stock currently sells for $60 per share. You estimate that the dividend will grow
steadily at a rate of 6 percent per year into the indefinite future. What is the cost of equity
capital for Greater States?

g = Retention ratio (b) x Return on Equity (ROE)

b = (1- Dividend payout ratio)
A D VA N TA G E S A N D D I S A D VA N TA G E S
OF DIVIDEND GROWTH MODEL
• Advantage – easy to understand and use

• Disadvantages
 Only applicable to companies currently paying dividends
 Not applicable if dividends aren’t growing at a reasonably constant
rate
 Extremely sensitive to the estimated growth rate – an increase in g of
1% increases the cost of equity by 1%
 Does not explicitly consider risk
SML APPROACH

RE  R f   E (E (RM )  R f )
 EXERCISE
• Suppose stock in Alpha Air Freight has a beta of 1.2. The market risk
premium is 7 percent, and the risk-free rate is 6 percent. Alpha’s last
dividend was $2 per share, and the dividend is expected to grow at 8
percent indefinitely. The stock currently sells for $30. What is Alpha’s cost
of equity capital?
SOLUTION

we can average them to find that Alpha’s cost of equity is approximately 14.8 percent.
PROBLEM FOR STUDENTS
• Suppose your company has an equity beta of .58, and the current risk-free rate is 6.1%.
If the expected market risk premium is 8.6%, what is your cost of equity capital?

• RE = 6.1 + .58(8.6) = 11.1%

 A D VA N TA G E S A N D
D I S A D VA N TA G E S O F S M L
• Advantages
 Explicitly adjusts for systematic risk
 Applicable to all companies, as long as we can estimate beta

• Disadvantages
 Have to estimate the expected market risk premium, which does vary
over time
 Have to estimate beta, which also varies over time
 We are using the past to predict the future, which is not always
reliable.
PROBLEM – COST OF EQUITY
• Suppose our company has a beta of 1.5. The market risk premium is expected to be 9%,
and the current risk-free rate is 6%.
• We have used analysts’ estimates to determine that the market believes our dividends
will grow at 6% per year and our last dividend was $2.
• Our stock is currently selling for $15.65. What is our cost of equity?

 Using SML: RE = 6% + 1.5(9%) = 19.5%

 Using DGM: RE = [2(1.06) / 15.65] + .06 = 19.55%
E S T I M AT I N G B E TA
• The SML shows the relationship between return and risk.
• CAPM uses beta as a proxy for risk.
• Other methods can be employed to determine the slope of the SML
and thus beta.

29
U.S. STEEL
• U.S. Steel Mar. 2010- Feb. 2015 • U.S. Steel Mar. 2015-Feb. 2020

30
EXXON MOBIL
• Exxon Mobil Mar. 2010- Feb. • Exxon Mobil Mar. 2015-Feb. 2020
2015

31
COST OF DEBT
• The cost of debt is the required return on our company’s debt.
• Usually focus on the cost of long-term debt or bonds.
• The required return is best estimated by computing the yield-to-maturity on the existing
debt.
• The cost of debt is NOT the coupon rate.
• Types of debt
• Term loan
• Bond/debenture
EXAMPLE: COST OF DEBT
• Suppose we have a bond issue currently outstanding that has 25 years left to maturity.
• The coupon rate is 9%, and coupons are paid semiannually.
• The bond is currently selling for $908.72 per $1,000 bond.
• What is the cost of debt?

• Ans: YTM = 5(2) = 10% (** 5% semiannual)

EXERCISE
• Suppose the General Tool Company issued a 30-year, 7 percent bond 8 years ago. The bond is
currently selling for 96 percent of its face value, or $960. What is General Tool’s cost of debt?

Cost of debt
r= 7.373%
COST OF PREFERENCE SHARE
• Preference capital carries a fixed rate of dividend and is redeemable in nature.
EXAMPLE
WA C C C O N C E P T
• We can use the individual costs of capital that we have computed to get our “average”
cost of capital for the firm.

• This “average” is the required return on the firm’s assets, based on the market’s
perception of the risk of those assets.

• The weights are determined by how much of each type of financing is used.
C A P I TA L S T R U C T U R E W E I G H T S
• Notation
 E = market value of equity = # of outstanding shares times price per share
 D = market value of debt = # of outstanding bonds times bond price
 P = Market value of preferred stocks
 V = market value of the firm = D + E + P

• Weights (if P=0)

 wE = E/V = percent financed with equity
 wD = D/V = percent financed with debt
W E I G H T E D AV E R A G E C O S T O F
C A P I TA L ( WA C C )
We are concerned with aftertax cash flows, so we also need to consider the effect
of taxes on the various costs of capital.

Interest expense reduces our tax liability (subject to limitation).

This reduction in taxes reduces our cost of debt.
After-tax cost of debt = RD(1-TC)

Dividends are not tax deductible, so there is no tax impact on the cost of equity.

WACC = wERE + wDRD(1-TC)

V=E+D+P
EXAMPLE:
C A P I TA L S T R U C T U R E W E I G H T S
• Suppose you have a market value of equity equal to $500
million and a market value of debt equal to $475 million.

 What are the capital structure weights?

• V = 500 million + 475 million = 975 million
• wE = E/V = 500 / 975 = .5128 = 51.28%
• wD = D/V = 475 / 975 = .4872 = 48.72%
 E X T E N D E D E X A M P L E : WA C C - I
• Equity Information • Debt Information
 50 million shares  $1 billion in outstanding debt (face
 $80 per share value $100)
 Beta = 1.15  Current quote = 110 (current level)
 Market risk premium = 9%  Coupon rate = 9%, semiannual
 Risk-free rate = 5% coupons
 15 years to maturity
• Tax rate = 21%
E X T E N D E D E X A M P L E : WA C C - I I
• What is the cost of equity?
 RE = 5 + 1.15(9) = 15.35%

• What is the cost of debt?

 YTM
 RD = 3.927(2) = 7.854%

• What is the after-tax cost of debt?

 RD(1-TC) = 7.854(1-.21) = 6.205%
E X T E N D E D E X A M P L E : WA C C - I I I
• What are the capital structure weights?
 E = 50 million (80) = 4 billion
 D = 1 billion (1.10) = 1.1 billion
 V = 4 + 1.1 = 5.1 billion
 wE = E/V = 4 / 5.1 = .7843
 wD = D/V = 1.1 / 5.1 = .2157

• What is the WACC?

 WACC = .7843(15.35%) + .2157(6.205%) = 13.38%
EXAMPLE
• The FarmTrack Co. has 1.4 million shares of stock outstanding. The stock
currently sells for $20 per share. The firm’s debt is publicly traded and
was recently quoted at 93 percent of face value. It has a total face value
of $5 million, and it is currently priced to yield 11 percent. The risk-free
rate is 8 percent, and the market risk premium is 7 percent. You’ve
estimated that FarmTrack Co. has a beta of 0.74. If the corporate tax rate
is 21 percent, what is the WACC of FarmTrack Co.?
SOLUTION
• Cost of equity, using SML
RE = 8% + .74 . 7% = 13.18%.

• Total value of the equity (E) = 1.4 million × $20 = $28 million.
• The debt sells for 93 percent of its face value,
• Total current market value (D)= 0.93 × $5 million = $4.65 million.
• total market value (V)=equity and debt together =$28 + 4.65 = $32.65 million.
C O M PA N Y VA L U AT I O N W I T H T H E
WA C C
• The WACC can be useful for investment analysts when trying to measure the value of a
company.
• If an analyst can predict future Cash flow from assets (CFFA) for the entire firm, WACC
becomes the firm’s discount rate.
• To separate financing costs from the cash flows, the tax amount should be the amount
that would be paid if the firm used no debt.
• With no debt, Adjusted CFFA, or CFA*:
CFA* = EBIT × (1 – TC) + Depreciation – Change in NWC – Capital spending (CAPEX)
• If these cash flows continue to grow at growth rate g perpetually, the firm value today is:
V0 = CFA*1 / (WACC – g); CFA*1 is next year’s projected value
F L O TAT I O N C O S T S
• However, the cost of issuing new securities should not just be
ignored either.

• Basic Approach
 Compute the weighted average flotation cost.
 Use the target weights, because the firm will issue securities in these
percentages over the long term.
EXAMPLE: NPV AND
F L O TAT I O N C O S T S
• Your company is considering a project that will cost $1 million. The project will generate
aftertax cash flows of $250,000 per year for 7 years. The WACC is 15%, and the firm’s
target D/E ratio is 0.60. The flotation cost for equity is 5%, and the flotation cost for debt
is 3%. What is the NPV for the project after adjusting for flotation costs?

D/E = .6; Let E = 1; then D = .6

 fA = (.375)(3%) + (.625)(5%) = 4.25% V = .6 + 1 = 1.6
 PV of future cash flows = 1,040,105 D/V = .6 / 1.6 = .375; E/V = 1/1.6
 NPV = 1,040,105 - 1,000,000/(1-.0425) = .625
 = 1,040,105 - 1,044,386 = -4,281
Using TVM
PMT = 250,000; N = 7; I/y = 15%;
CPT PV = 1,040,105
C A P I TA L S T R U C T U R E
EFFECT OF FINANCIAL LEVERAGE
• Relationship Financial Leverage, EPS, and ROE
Capital Structure Scenarios (+/- 50%)
FINANCIAL LEVERAGE: EPS VS EBIT

EBIT (break even)

EXERCISE FOR STUDENTS
The MPD Corporation has decided in favor of a capital restructuring. Currently,
MPD uses no debt financing. Following the restructuring, debt will be $1 million.
The interest rate on the debt will be 9 percent. MPD currently has 200,000 shares
outstanding, and the price per share is $20. If the restructuring is expected to
increase EPS, what is the minimum level for EBIT that MPD’s management must
be expecting? Ignore taxes in answering.
SOLUTION
Under the old capital structure, EPS is EBIT/200,000. Under the new capital
structure, the interest expense will be $1 million × .09 = $90,000.
C A P I TA L S T R U C T U R E T H E O R I E S
• Net Income Approach
• Net Operating Income Approach
• Tradition Approach
• Modigliani and Miller (M&M)Theory of Capital Structure
 Proposition I – firm value
 Proposition II – WACC
1. NET INCOME APPROACH
The Net Income Approach suggests that a company can enhance its value
and lower its weighted average cost of capital (WACC) by increasing the
proportion of debt in its capital structure.
This approach is based on several assumptions:
1.The cost of debt is lower than the cost of equity.
2.There are no taxes.
3.The use of debt does not change investors' perception of risk.
According to this theory, as a firm increases its debt financing, it can take
advantage of the tax deductibility of interest expenses, which lowers its
overall cost of capital. This, in turn, increases the value of the firm.
1. NET INCOME APPROACH
2 . N E T O P E R AT I N G I N C O M E
APPROACH
• The Net Operating Income Approach, proposed by Durand, takes an opposing stance. It
argues that changes in capital structure do not affect the market value of a firm, and the
overall cost of capital remains constant, regardless of the financing method used.
This approach is based on several assumptions:
1. The market values the entire firm.
2. Business risk remains constant at every debt-equity mix.
2 . N E T O P E R AT I N G I N C O M E
APPROACH
EXAMPLE
TRADITIONAL APPROACH
MM PROPOSITIONS
• M&M PROPOSITION I: THE PIE MODEL
• M&M Proposition I: The proposition that the value of the firm is independent of the firm’s capital
structure.
• Their assets and operations are exactly the same.
W H Y M M T H E O R Y I S R E L E VA N T ?

• Ideal world, the total market value of all the securities issued by a firm would be
governed by the earning power and risk of its underlying real assets and would be
independent of how the mix of securities issued to finance it was divided between debt
instruments and equity capital.
MM: BUSINESS AND FINANCIAL RISK

Business risk: The equity risk that comes from the nature of the firm’s operating activities.
Financial risk: The equity risk that comes from the financial policy (the capital structure) of
the firm.

The first component, RA, is The second component in the cost of equity, (RA −
the required return on the RD) × (D/E), is determined by the firm’s financial
firm’s assets overall, and it structure. For an all-equity firm, this component is
depends on the nature of zero. As the firm begins to rely on debt financing, the
the firm’s operating required return on equity rises. This occurs because
activities. The risk inherent the debt financing increases the risks borne by the
in a firm’s operations is stockholders. This extra risk that arises from the use
called the business risk of of debt financing is called the financial risk of the
the firm’s equity. firm’s equity.
HOMEMADE LEVERAGE & MM
THEORY
• The shareholders can adjust the amount of financial leverage by borrowing and lending
on their own. This use of personal borrowing to alter the degree of financial leverage is
called homemade leverage.
• “The use of personal borrowing to change the overall amount of financial leverage to
which the individual is exposed.”
EFFECT OF:
HOME MADE LEVERAGE
• When investors sell their equity in firm L and buy the equity in firm U with personal
leverage, the market value of firm L tends to decline and the market value of firm U tends
to rise. This process continues until the market values of both the firms become equal
because only then the possibility of earning a higher income, for a given level of
investment and leverage, by arbitraging is eliminated. As a result, the cost of capital for
both the firms becomes the same.
THE COST OF EQUITY AND
FINANCIAL LEVERAGE
• M&M PROPOSITION II

• The proposition that a firm’s cost of equity capital is a positive linear function of the firm’s
capital structure.
• Although changing the capital structure of the firm does not change the firm’s total value,
it does cause important changes in the firm’s debt and equity.
M&M PROPOSITIONS I AND II
W I T H C O R P O R AT E TA X E S
• Debt two distinguishing features
• interest paid on debt is tax deductible (good for the firm)
• failure to meet debt obligations can result in bankruptcy (not good for the firm)

• Assumption relaxed: all interest paid is tax deductible

EXERCISE
• The Ricardo Corporation has a weighted average cost of capital (ignoring taxes) of 12
percent. It can borrow at 8 percent. Assuming that Ricardo has a target capital structure
of 80 percent equity and 20 percent debt, what is its cost of equity? What is the cost of
equity if the target capital structure is 50 percent equity? Calculate the WACC using your
answers to verify that it is the same.
SOLUTION
EXERCISE
SOLUTION
MM THEORY
• Value of firm with taxes
• EBIT to be $1,000 every year forever.

• Firm L has issued $1,000 worth of

perpetual bonds on which it pays 8 percent
interest each year. The interest bill is .08 ×
$1,000 = $80 every year forever.
• Also, the corporate tax rate is 21 %.
 I N T E R E S T TA X S H I E L D

• assume that depreciation is zero

• capital spending is zero

• there are no changes in NWC.

The fact that interest is deductible for Total cash flow to firm L is $16.80
tax purposes has generated a tax more.
savings equal to the interest payment
($80) multiplied by the corporate tax Interest tax shield
rate (21 percent): $80 x 0.21 = The tax savings attained by a firm
$16.80. from interest expense.
VA L U E O F TA X S H I E L D
• TAXES AND M&M PROPOSITION I

• Firm L is worth more than Firm U, the difference being the value of this $16.80 perpetuity.
TA X E F F E C T
EXAMPLE
• Suppose that the cost of capital for Firm U is 10 percent. We can call this the unlevered
cost of capital, and we will use the symbol RU to represent it. We can think of RU as the
cost of capital a firm would have if it had no debt. Firm U’s cash flow is $790 every year
forever, and, because U has no debt, the appropriate discount rate is RU = 10%. The
value of the unlevered firm, VU, is:

Firm L
Debt= $1000
(perpetual bond)

Tax= 21%
MM PROPOSITION II
• TAXES, THE WACC, AND PROPOSITION II

M&M Proposition II with corporate taxes states that the cost of equity is:
EXAMPLE
• To illustrate, recall that we saw a moment ago that Firm L is worth $8,110 total. Because
the debt is worth $1,000, the equity must be worth $8,110 − 1,000 = $7,110. For Firm L,
the cost of equity is:
PROPOSITION II
SUMMARY MM - THEORY
EXERCISE
SOLUTION
BANKRUPTCY COST AND FIRM
VA L U E
• When the value of a firm’s assets equals the value of its debt, then the firm is economically
bankrupt in the sense that the equity has no value.
• DIRECT BANKRUPTCY COSTS
• The costs that are directly associated with bankruptcy, such as legal and administrative
expenses.
• Example: legal and administrative costs to bankruptcy
• INDIRECT BANKRUPTCY COSTS
• The costs of avoiding a bankruptcy filing incurred by a financially distressed firm are called
indirect bankruptcy costs.
• The term financial distress costs to refer generally to the direct and indirect costs associated with
going bankrupt or avoiding a bankruptcy filing.
O P T I M A L C A P I TA L S T R U C T U R E
• STATIC THEORY OF CAPITAL STRUCTURE

• It says that firms borrow up to the point where the tax benefit from an extra dollar in debt
is exactly equal to the cost that comes from the increased probability of financial distress.
We call this the static theory because it assumes that the firm is fixed in terms of its
assets and operations and it considers only possible changes in the debt-equity ratio.
 S TAT I C T H E O RY O F C A P I TA L
STRUCTURE

The Static Theory of

Capital Structure: The
Optimal Capital
Structure and the Value
of the Firm
O P T I M A L C A P I TA L S T R U C T U R E A N D T H E
C O S T O F C A P I TA L
S U M M A RY- M M T H E O RY
EXTENDED PIE MODEL
• Bankruptcy costs are also a claim on the cash flows of the firm. The extended pie model holds that
all of these claims can be paid from only one source: The cash flows (CF) of the firm.
PIE MODEL: CLAIM ON CASH FLOW
PECKING ORDER THEORY
• The pecking-order theory is an alternative to the static theory. A key element in the pecking-order
theory is that firms prefer to use internal financing whenever possible.
• The pecking order theory suggests- Companies will use
• internal financing first. Then, they will
• issue debt if necessary.
• Equity will be sold pretty much as a last resort.
I M P L I C AT I O N S OF THE PECKING ORDER
• No target capital structure: Under the pecking-order theory, there is no target or
optimal debt-equity ratio.
• Profitable firms use less debt: Because profitable firms have greater internal cash flow,
they will need less external financing and will therefore have less debt. As we mentioned
earlier, this is a pattern that we seem to observe, at least for some companies.
• Companies will want financial slack: To avoid selling new equity, companies will want
to stockpile internally generated cash. Such a cash reserve is known as financial slack.
BANKRUPTCY PROCESS
SUMMARY
T R A D E - O F F T H E O R Y O F C A P I TA L
STRUCTURE
• The trade-off theory of capital structure is the idea that a company chooses how much
debt finance and how much equity finance to use by balancing the costs and benefits
• The classical version of the hypothesis goes
back to Kraus and Litzenberger. who
considered a balance between the dead-
weight costs of bankruptcy and the tax
saving benefits of debt. Often agency
costs are also included in the balance. This
theory is often set up as a competitor theory
to the pecking order theory of capital
structure
COST BENEFIT- TRADE OFF THEORY
PECKING ORDER THEORY