Debt Vs Equity

Capital Structure Cost Of Equity Cost Of Debt Debt And Equity Weights Differences Between Debt And Equity Bonds Stocks

Capital Structure
Companies must decide how much to rely in debt and how much to rely on equity as sources of capital (capital structure) Remember that the total cost of capital of a company depends upon how it uses the money how risk is the business it operates The capital structure does not affect the risk of the business

How does capital structure effect the cost of capital?

Interest paid on debt is tax deductible, so as debt increases taxes paid by the company are reduced Debt creates the possibility of bankruptcy and financial distress, so as debt increases the firm incurs increased direct and indirect bankruptcy costs When these two offset, we get the financially optimal capital structure

Optimal Capital Structure

Maximizes the value of the company Capital structure does not impact the cash flows earned by the companys business Therefore, the capital structure that maximized the value of the company is the one that yields the lowest cost of capital and any other financing related costs

Cost of Capital
How the market requires at any time to provide capital to a company or business Cost of capital depends upon the risk of the business to which to money will be provided For this assessment we will assume that we know the percentages of debt and equity

Cost of Capital
Cost of capital is the weighted average of the cost of equity and the cost of debt Cost of Capital = R Cost of Equity = RE, Share of Equity = WE Cost of Debt = RD, Share of Debt = WD WE + WD = 1 RC = WE*RE + WD*RD

How to Determine Cost of Equity

Dividend Discount Model
Advantage: Simplicity Disadvantages
Companies may not pay dividends Need to make assumptions about dividend growth rate Does not directly consider risk

Capital Asset Pricing Model

RE = Rf + BetaE*(RM Rf) BetaE is measure of systematic risk of equity

Cost of Debt and Preferred Stock

Yield to maturity on debt and preferred stock Reduced for any tax benefits on deductibility of interest : RD = YTM*(1-T) Calculated using prices for actually debt and preferred stock already issued at the time Based upon current market value and returns

Debt and Equity Weights

ValueCompany = ValueEquity + ValueDebt 1 = VE/VC + VD/VC 1 = WE + WD Ideally weights are based upon market value of debt, equity and company book values of debt, equity and company are often used if market values are not available

Example Cost of Capital

Jones Company has $10000 of 10-year 6% coupon bonds outstanding currently trading at par. It has 1000 shares of stock outstanding currently trading at $30 per share. The Beta of the stock is estimated to be 1.5 and the risk free rate is 3% and the market risk premium is 8%. The tax rate is 33%. What is Jones Companys cost of capital?

Example Cost of Capital

VD = $10000, VE = 1000*$30 = $30000 WD = .25, WE = .75, T = 33% RD = 6%*(1-0.33) = 4% RE = 3% + 1.5*(8%) = 15% RC = WD*RD + WE*RE
= .25*4% + .75%*15% = 1% + 11.25% = 12.25%

Capital Structure and Cost of Capital

Differences Between Debt and Equity

Debt Not an ownership interest Lenders do not have voting rights Interest is considered a cost of doing business and is tax deductible Lenders have legal recourse if interest or principal payments are missed Inability to pay debt can lead to financial distress and bankruptcy Equity Ownership interest Common stockholders vote for the board of directors and other issues Dividends are not considered a cost of doing business and are not tax deductible Dividends are not a liability of the firm, and stockholders have no legal recourse if dividends are not paid An all equity firm can not go bankrupt

Bond Valuation and Interest Rates

Par Value or Face Value (typically $1000) Coupon Payment and Frequency Coupon Rate Coupon Yield Maturity Yield-to-Maturity (YTM)

Bond Cash Flows

Bond Cash Flows
Year 1 Coupon Year 2 Coupon Year 3 Coupon Year n Coupon and Principal 10 Year 6% Coupon Bond with $1000 Par Value Year 1 - $60 Year 2 - $60 Year 3 - $60 Year 10 - $60 + $1000 = $1060

Bond Valuation
Present Value of Bond Cash Flows Bond Cash Flows are
Coupon Payments Principal Repayment

Bond Value equals

Annuity: Present Value of Coupon Payments Lump Sum: Present Value of Principal

Bond Valuation Equation

BV = C*( (1 1/(1+r)n)/r) + ParV*(1/(1+r)n) Where: BV = Value or Price of the Bond C = coupon payments r = yield-to-maturity n = years-to-maturity

Example of an Bond with Annual Coupon Payments

A $1000 par value bond has 6% annual coupon payments. The yield to maturity is 8%. The bond matures in 5 years. BV = $60*(1-1/(1.08)5)/.08 + $1000/(1.08)5 BV = $60*3.9927 + $1000*.68058 BV = $920.15

Example of an Bond with Annual Coupon Payments

A $1000 par value bond has 6% annual coupon payments. The yield to maturity is 4%. The bond matures in 5 years. BV = $60*(1-1/(1.04)5)/.08 + $1000/(1.04)5 BV = $60*4.4518 + $1000*.8219 BV = $1089.04

Example of an Bond with Annual Coupon Payments

A $1000 par value bond has 6% annual coupon payments. The yield to maturity is 6%. The bond matures in 5 years. BV = $60*(1-1/(1.06)5)/.08 + $1000/(1.06)5 BV = $60*4.2124 + $1000*.7473 BV = $1000

Relationship Between Bond Price and Interest Rate

When yield-to-maturity (r) is above coupon rate then the bond price is below par value When yield-to-maturity (r) is equal to coupon rate then the bond price equals par value When yield-to-maturity (r) is below coupon rate then the bond price is above far value

Bond Risks
Inflation and Inflation Risk Default Risk Price or Interest Rate Risk
How bond price changes with interest rates Long-term bonds have more price risk than short-term bonds Low coupon rate bonds have more price risk than high coupon rate bonds

Reinvestment Risk
Uncertainty about return that can be achieved reinvesting cash flows Short-term bonds have more reinvestment rate risk than long-term bonds High coupon rate bonds have more reinvestment rate risk than low coupon rate bonds

Common Stock Features

Common Stock
Votes at shareholder meeting
Cumulative voting vs. Straight voting Proxy voting

Classes of common stock

Sometimes different voting rights Sometimes different rights to dividends

Rights to dividend Rights in liquidation

Preferred Stock Features

Often have no voting rights Stated value in liquidation Priority to common stockholders in liquidation Dividends
Fixed amount Priority to common dividends May be cummulative