COST OF CAPITAL AND CAPITAL STRUCTURE POLICY

Cost of Capital

 Suppose we say that the required return on investment is 10%, what does that
imply?
 The firm must earn 10% on the investment just to compensate its investors for the
use of the capital needed to finance the project.
 In such a case, 10% is the cost of capital of the investment. If the investment is
risk-free than the cost of capital is the risk-free rate of return.

Capital Structure

 Capital structure of the firm is the debt-to-equity ratio (debt/equity).

 Debt of a firm is the borrowing by the firm. This is mostly done by means of
bonds and loans from banks.
 Equity of a firm is the ownership of the firm. This is mostly done by means of
selling shares or based on savings.

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Cost of Equity (Re)

 Cost of equity is the return that equity investors require on their investment in the
firm.
 What is the main problem with cost of equity?
 Return on equity investment cannot be observed directly. There is no coupon rate
on shares.
 Cost of equity has to be estimated.

Two methods of estimation cost of equity

(i) Dividend growth model approach

P0 = {D0 x (1 + g)}/Re- g (Equation 1)

P0 = Price of share today

D0 = Dividend today
g = Growth rate of the share
Re = Required return on the share

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From equation 1

Re = ({D0 x (1 + g)}/P0) + g (Equation 2)

 How does one estimate the growth rate g?

 From historical growth rate.
 From statistical analyst’s forecast of future growth.
 Equation 2 has few disadvantages.
 Applies only to companies that pay dividends.
 Cost of equity is sensitive to the growth rate.
 Does not consider risk.

(ii) Security Market Line (SML) approach.

SML is

E(Re) = Rf + βe x (E(Rm) – Rf) (Equation 3)

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E(Re) = Expected cost of equity.
Rf = Risk-free rate of return.
βe = Beta of the equity.
E(Rm) = Expected cost of equity on the market portfolio.

Dropping the expected sign from the equation 3

Re = Rf + βe x (Rm – Rf) (Equation 4)

Everything required for equation 4 is available for estimation.

 Equation 4 includes and adjusts for risk.

 Applicable for all companies.

Cost of Debt (Rd)

 The returns that lenders require on the firm’s debt.

 The cost of debt can normally be observed.

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 Coupon rate is usually the cost of debt.

Weighted Average Cost of Capital (WACC)

 Weighted average cost of capital is the weighted average of the cost of debt and
equity.
 It is a discount rate.
 WACC assumes a constant debt/equity ratio.

E = market value of the firm’s equity.

E = number of shares outstanding x price per share.

D = market value of the firm’s debt.

D = number of bonds outstanding x price per bond.

V = combined market value of the debt and equity.

V=E +D (Equation 5)

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 Divide equation 5 by V

1 = (E/V) + (D/V)
E/V and D/V are capital structure weights.

For example:

E = £200 million
D = £50 million
V = E + D = £250 million

E/V = 200/250 = 0.8 or 80%

D/V = 50/250 = 0.2 or 20%

The sum of the weights should be equal to one or 100%.

 Given the structure weights, what does the weighted average cost of capital
(WACC) looks like?

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 WACC = Rw = (E/V) x Re + (D/V) x Rd (Equation 6)

Re = Required return on equity.

Rd = Required return on debt.

 As stated earlier, WACC is the weighted average of the cost of debt and equity.

For example:

E = £200 million
D = £50 million
V = E + D = £250 million

E/V = 200/250 = 0.8 or 80%

D/V = 50/250 = 0.2 or 20%

Re = 10% or 0.1
Rd = 7% or 0.07

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WACC = Rw = 0.8 x 0.1 + 0.2 x 0.07 = 0.08 + 0.014 = 0.094 or 9.4%.

Adjusted Weighted Average Cost of Capital

 Equation 6 presents the unadjusted weighted average cost of capital.

 Equation 6 does not take in consideration taxes of any type.
 Since businesses are concerned with after tax cash flows. Discount rate needs to
be expressed in after tax bases.
 In most countries (not all) the interest paid on debt held by firms is deductible for
tax purposes. Payments to shareholders, such as dividend are not tax deductible.
 Pre tax and post tax cost of debt has to be determined.

WACC = Rw = (E/V) x Re + (D/V) x Rd x (1-T) (Equation 7)

T = corporate tax rate.

 Equation 7 is the tax-adjusted WACC.

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What is the purpose of the WACC?

 The WACC for the firm reflects the risk and the target capital structure of the
firm’s existing asset as a whole.
 The WACC can be applied as a discount rate and may be applied in the
evaluating investment opportunities.

NPV = - C0 + C1/(1 + Rw) + C2/(1 + Rw)2 + C3/(1 + Rw)3 + …. + Cn/(1 + Rw)n

Rw = WACC

 The WACC is the proper discount rate only if the proposed investment is a
replicate of the firm’s existing operating activities. For example, if an
automobile company wants to start a new model of a car then WACC may be
applied as a discount rate. But, if the automobile firm wants to start its own
finance company then WACC is not the proper discount rate.

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Example:

Company X has 1.4 million shares outstanding.

Current price of share = £20 per share.
Debt value = 93% of the face value.
Face value = £5 million.
Current bond yield = 11%
Risk-free rate = 8%
Market risk premium = 7%
Beta of X = 0.74
Tax rate = 34%
WACC = ?

Solutions

First find the value of Re and Rd.

Based on SML

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Re = 0.08 + 0.74 x 0.07 = 0.1318 or 13.18%

Total value of equity = 1.4 x £20 = £28 million

Total value of debt = 0.93 x 5 = £4.65 million
Total market value = 28 + 4.65 = £32.65 million

E/V = 28/32.65 = 0.8576 or 85.76%

D/V = 4.65/32.64 = 0.1424 or 14.24%

Cost of debt = 11% or 0.11

WACC = 0.8576 x 0.1318 + 0.1424 x 0.11 x (1 – 0.34) = 0.1234 or 12.34%

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 The Capital Structure Policy
Choices in Financing

 There are two main ways in which a business can raise money. Debt and
equity.
 The equity can take different forms. For small business, it can be owners
investing their savings. For publicly traded firms, it is common shares.
 The debt can also take different forms. For private business, it is usually
bank loans. For publicly traded firms, it can take the form of long-term
bonds.
 Debt/equity ratio is known as the Capital Structure.

Optimal Mix of Debt and Equity.

Is there an optimal mix of debt and equity for a firm?

 Managers choose the capital structure that maximises the value of the firm.

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  Changing in the capital structure benefits the shareholders (owners) if and only if
the value of the firm increases.
 Firms that have no debt are known as an unlevered firm. Firms with debt are
levered firm.
 WACC assumes that debt/equity ratio is constant. In reality, debt/equity ratio is
not constant and often changes, thus WACC changes.

The Miller-Modigliani (MM) Theorem

The Miller-Modigliani Proposition I (MM I)

 According to MMI in an environment, where there are no taxes, default risk or

agency costs, capital structure is irrelevant.
 The value of the firm is independent of its capital structure.
 It is completely irrelevant how a firm chooses to arrange its finances.
 According to MMI leverage is irrelevant.
 A firm’s value will be determined by its project cash flow.

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 Assume two firms X and Y. The assets and operations are the same for both firms.
Thus, X and Y are identical on the left side of the balance sheet. The right hand side
of the sheet is different because the two firms finance their operation differently.

Firm X Firm Y
Equity 40% 60%
Debt 60% 40%

Debt/Equity ratio for X = 6/4 = 3/2

Debt/Equity ratio for Y = 4/6 = 2/3

However the size of the pie is the same. This is because the value of the asset is the
same. The size of the pie does not depend upon how you slice it.

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The Miller-Modigliani Proposition II (MM II)

 A firm’s cost of equity is a positive linear function of its capital structure.

 The excepted rate of return on the common share of a levered firm increases in
proportion to the debt/equity (D/E) ratio.
 Changes in the firm’s capital structure do not change the firm’s total value but it
does change the firm’s debt and equity.

Ignoring taxes for the moment

WACC = Rw = (E/V) x Re + (D/V) x Rd

Rearranging

(E/V) x Re = Rw - (D/V) x Rd

Re = (V/E) x Rw - (D/E) x Rd

V=E+D

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Re = (E+D/E) x Rw - (D/E) x Rd

Re = (1 + (D/E)) x Rw - (D/E) x Rd

Re = Rw + (D/E) x Rw - (D/E) x Rd

Re = Rw + (Rw - Rd) x (D/E) (Equation 8)

 Equation 8 is an equation for a line and presents the relationship between the cost
of equity (Re) and the debt-to-equity (D/E) ratio.
 As debt-to-equity ratio (D/E) increases, the cost of equity (Re) increases and vice
versa.
 As D/E increases, the increase in leverage raises the risk of equity and therefore
the required return on equity. Why?
 According to MMI WACC stays the same no matter what the value of D/E. The
firm’s overall cost of capital is unaffected by its capital structure.

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Miller-Modigliani Proportions I and II with Taxes

 Two main features of debt that has been ignored till now.

(i) Interest paid on debt is tax-deductible. This is a benefit for the firm.

(ii) Failure to meet debt obligation can result in bankruptcy. This is not a benefit
for the firm.

MM Proposition I with Taxes.

Interest Tax Shield

 The tax savings attainted by a firm from interest expense.

Value of the tax shield = (T x Rd x D)/Rd = T x D

T = Tax rate
D = Market value of debt

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Assume two firms X and Y.

X has no debt and Y has debt. In other words, Y is levered and X is un-levered. X has
no interest to pay and Y does. X has no tax shield but Y does.

VX = Value of the un-levered firm.

VY = Value of the levered firm.

VY = VX + (T x D) (Equation 9)

Equation 9 is also an equation of a line.

Slope = T
Intercept = VX

What does equation 9 show?

 It shows the positive relationship between the value of a levered firm (VY) and the
market value of the debt (D).
 As the D increases, the value of the levered firm increases. Why?

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  With the inclusion of taxes, MM proposition I changes. Now debt-to-equity ratio
makes a difference.
 Higher the debt, higher the tax shield, higher the value of the firm and vice versa.
Having debt will be advantageous.

MM Proposition II with Taxes.

WACC = Rw = (E/V) x Re + (D/V) x Rd x (1-T) (Equation 7)

 Equation 7 is the tax adjusted WACC.

MM II with taxes becomes

Re = Rw + (Rw - Rd) x (D/E) x (1 – T) (Equation 10)

 Equation 10 (like equation 8) still presents a linear and a positive relationship

between the debt-to-equity ratio and the cost of equity (Re).

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 As D/E increases, Re will rise and vice versa. Similarly, as (1 – T) increases, Re
will rise and vice versa.
 The MM proposition II does not change much with the inclusion of taxes.

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Bankruptcy Cost

 One limit to the amount of a debt a firm might use comes in the form of
bankruptcy cost.
 Bankruptcy cost consists of legal and administrative cost and the cost of
avoiding a bankruptcy cost.
 As D/E increases, the probability increases that the firm may not be able to pay
its bondholders.
 A firm is bankrupt when the value of its assets equals the value of its debt.
 At this moment the value of equity is zero and bondholders take over.
 When a firm is having problems meeting its debt obligation it is under financial
distress.
 Firms borrow up to the point where the tax benefit from an extra £ in debt is
exactly equal to the cost that comes from the increased probability of financial
distress.

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