Hand notes on cost of capital and capital structure

Disclaimer: This hand note shall not in any time be regarded as a substitute for students not to visit library, text books and web for acquiring knowledge on this topic, where you find it is suitable then you can rely .

1st draft Composed by: H. B. Hamad
2010

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Introduction
You often hear corporate officers, professional investors, and analysts discuss a company's capital str ucture. You may not know what a capital structure is or why you should even concern yourself with it, but the concept is extremely important because it can influence not only the return a company earns for its shareholders, but whether or not a firm survives in a recession or depression. Sit back, relax, and prepare to learn everything you ever wanted to know about investments and the capital structure of the companies There are several types of value, of which we are concerned with four: 

Book Value ± The carrying value on the balance sheet of the firm¶s
equity (Total Assets less Total Liabilities) 

Tangible Book Value ± Book value minus intangible assets
(goodwill, patents, etc) 

Market Value - The price of an asset as determined in a
competitive marketplace 

Intrinsic Value - The present value of the expected future cash
flows discounted at the decision maker¶s required rate of return

Capital Structure - What It Is and Why It Matters The term capital structure refers to the percentage of capital (money) at work in a business by type. Broad ly speaking, there are two forms of capital: equity capital and debt capital. Each has its own benefits and drawbacks and a substantial part of wise corporate stewardship and management is attempting to find the perfect capital structure in terms of risk / reward payoff for shareholders. This is true for big companies and for small business owners trying to determine how much of their startup money should come from a bank loan without endangering the business. Let's look at each in detail: Equity Capital: This refers to money put up and owned by the shareholders (owners). Typically, equity capital consists of two types:

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1. Contributed capital, which is the money that was originally invested in the business in exchange for shares of stock or ownership and 2. Retained earnings, which represents profits from past years that have been kept by the company and used to strengthen the balance sheet or fund growth, acquisitions, or expansion. Many consider equity capital to be the most expensive type of capital a company can utilize because it¶s "cost" is the return the firm must earn to attract investment. A speculative mining company that is looking for silver in a remote region of Africa may require a much higher return on equity to get investors to purchase the stock than a firm such as Procter & Gamble, which sells everything from toothpaste and shampoo to

detergent and beauty products. Debt Capital: The debt capital in a company's capital structure refers to borrowed money that is at work in the business. Bonds are generally considered the safest type (long-term) because the company has years, if not decades, to come up with the principal, while paying interest only in the meantime. Other types of debt capital can include short-term commercial paper utilized by giants companies that amount to billions of shillings in 24 -hour loans from the capital markets to meet day -to-day working capital requirements such as payroll and utility bills. The cost of debt capital in the capital structure depends on the health of the company's balance sheet - a triple AAA rated firm is going to be able to borrow at extremely low rates versus a speculative company with tons of debt, which may have to pay 15% or more in exchange for debt capital.

Other Forms of Capital: There are actually other forms of capital, such as vendor financing where a company can sell goods before they have to pay the bill to the vendor, which can considerably increase return on equity but don't cost the company anything. In the case of an insurance company, the policyholder

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"float" represents money that doesn't belong to the firm but that it gets to use and earn an investment on until it has to pay it out for accidents or medical bills, in the case of an auto insurer. The cost of other forms of capital in the capital structure varies greatly on a case-by-case basis and often comes down to the talent and discipline of managers.

Seeking the Optimal Capital Structure Many middle class individuals believe that the goal in life is to be debt -free (see should I Pay Off My Debt or Invest?). When you reach the upper echelons of finance, however, that idea is almost anathema. Many of the most successful companies in the world base their capital structure on one simple consideration: the cost of capital. If you can borrow money at 7% for 30 years in a world of 3% inflation and reinvest it in core operations at 15%, you would be wise to consider at least 40% to 50% in debt capital in your overall capital structure. Do you agree with me? I can imagine you are not!!. Of course, how much debt you take on comes down to how secure the revenues your business generates are - if you sell an indispensable product that people simply must have, the debt will be much lower risk than if you operate a theme park in a tourist town at the height of a boom market. Again, this is where managerial talent, experience, and wisdom come into play. The great managers have ability for consistently lowering their weighted average cost of capital by increasing productivity, seeking out higher return products, and more. To truly understand the idea of capital structure, you need to take a few moments to read Return on Equity: The DuPont Model to understand how the capital structure represents one of the three components in

determining the rate of return a company will earn on the money its owners have invested in it. Whether you own a doughnut shop or are considering investing in publicly traded stocks, its knowledge you simply must have.

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Most investors assess a stock's promise by weighing common-sense factors about the prospects of the company: the quality of its products or services, its future demand and the nature and strength of the

competition. But this qualitative analysis often fails to answer the critical question of valuation: G iven the company's profit potential, is its stock a good investment at today's market price? Professional stock analysts use models to estimate a company's inherent worth and to determine whether the company's stock is a bargain. These models require many inputs. One of the most important to consider is the company's weighted average cost of capital. Companies are vehicles for the productive investment of capital. A typical clothing manufacturer, for instance, may use its cash to buy cotton, pay workers to sew the cotton into sweaters, and then pay a sales force to sell the sweaters for a profit. In this way, the company's ability to raise capital plays a crucial role in its ability to grow profitably.

Costs of Capital
Businesses can't make money. One choi ce is to borrow money, either from a bank or through a bond sale. Another option is to sell a piece of the business through an offering of stock, or equity. Both of these alternatives come at a cost. For debt, the company must make interest payments. For equity, it may make dividend payments, and shareholders will expect capital gains. The average of the costs of these two sources of capital, weighted for the proportion of each that the company uses to fund itself, is called the weighted average cost of cap ital. It is represented in the following formula: We can measure cost to equity in almost three ways. 1. Dividends valuation (dividend yield) method 2. Gordon¶s dividend growth model 3. risk measured analysis

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Pt ! 0 Hence the value of stock should be equal to present value (1  r ) t g of all future dividends Po = § (1  r ) t !1 Div t t In valuing the common stock. Div1 6 of 55 1st Draft to be improved   P1  PO PO .   2 3 1  r (1  r ) (1  r ) (1  r ) t Po = Whereby: t= horizon. when you move to time horizon (t) the present value of stock should not cha nge and assumed to be zero. we have made two assumptions:  We know the dividends that will be paid in the future.Thus expected return that an investor expects from an investment in a stock over a set period of time is equal to: Expected return on stock (r) = (r) = divident  Capital gain investment Div1 Whereby Div 1 and P1 denote the dividend and stock price in year1 when we isolate the current stock price P o in the expected price (Po) = return formula. It is clearly assumed that. the value to stock is equal to present value of all dividends out of the investment at time t and stock¶s present value at time t....Dividends valuation method the price of stock is equal to the present value of all future dividends the intuition behind this insight is that the cash payoff to owners of the stock is equal to cash dividends plus capital gain or losses . Div1  P1 1 r The equation then becomes what determines next years price P1 by changing the subscripts next year¶s price is equal to the discounted value of the sum of dividends and expected price in year 2 P1= Div 2  P2 1 r Div1 Div 2 Div 3  P2 Div t  Pt  ..

33% hence investor will run away with these investment rushing to other investment of similar risk in the market. So you agree with me? I can imagine your answer in NO. Is just a present value of future cash flow that investment is going to generate to its owner.  Both of these assumptions are unrealistic. they will start to sell their share hence price will drop of cause to shs. hence we should assume that 7 of 55 1st Draft to be improved . 75? Say shs. 75 a share (P o =75).70.. Then what is the expected return to stockholders? Expected rate of return (r) = Div1  P1  PO = (3+ 81-75)/75 = 12% PO So 12% is appropriate discounted rate that investor would be like to take on the investment other things constant. Two: assume the price of stock is little bit lower than shs. 75 ar e the right discounted rate and right price of stock respectively in any fair market. They also expect the stock to sell for Shs. 75.. g In concluding.. especially knowledge of the future selling price. this formula is unrealistic § (1  r ) t !1 Div t t as it is not easy to predict all future dividend going to be paid.. It is further assumed that.79.  Furthermore.. This will lead to many investors rushing in buying share forcing rise to shs.. what happen to rate? It definitely will rise above 12% i. 81 a y ear hence (P 1 = 81). ok buddy just follow me with these two scenarios: One: What happen when Po is above shs. We know how much you will be able to sell the stock for in the future.e 20%.. 3 cash dividend over the next year (Div 1=3). 75 which is market price. the calculations would be very tedious! Assume: a share or stock is selling for Shs. expected return would be lower than 12% i..e 6. suppose that you intend on holding on to the stock for twenty years. Investment expect a Shs. 75 say shs. this 12% and shs.

based on future dividends.constant dividend paid in perpetuity then our formula should be amended to r = Div1 where Div1 = Div0 +g and g is growth rate r Gordon¶s dividend growth model The Gordon Growth Model (or Constant Growth Model) is a financial model used to determine the ³intrinsic´ value of a stock. A Stock as Perpetuity Note that if the stock is never sold. infinite series of payments to the shareholder to arrive at the present value. which are assumed to grow at a constant rate. Gordon and originally published in 1959. Named after Myron J. current stock price. then it follows that the future sale price of the stock would equal the sum of the cash flows subsequent to the sale discounted by the required rate of return. Because the model considers the current price of the stock to be equal to its future cash flows. then it is essentially perpetuity to the investor and its price would equal the sum of the present value of its dividends. 8 of 55 1st Draft to be improved . It also assumes that the investor¶s required rate of return for the stock is held constant and is equal to the cost of equity for that company. The model sums this discounted. D 1 =future dividend= Do (1+g) whereby g is growth rate. Under the Gordon Model the investor holds the stock for the sole purpose of receiving income from company operations through dividend payments. Arriving at Present Value The Gordon Growth Model is the best known of a class of discounted dividend models and is a variation of the discounted cash flow valuation model. The Gordon approach assumes that the company pays a dividend that grows at a constant rate. the model values a business as the present value of all future dividends and leverages a required rate of return that the investor could receive on similar Po = alternative assets.

Summing the infinite series we get. K or r denotes expected return = yield + expected growth. It is common to use the next value of D given by: D1 = D0(1 + g).e g =0 . the size of the company. This corresponds to the terminal case of the discounted cash flow model. Write this as So the return k is the dividend divided by the price. .g. Gordon's model is thus applicable to the terminal case. Note that the model assumes that th e earnings growth is constant for perpetuity. In practice a very high growth rate cannot be sustained for a long time. that a company pays out all its earning as dividend and nothing retained for investment. 9 of 55 1st Draft to be improved . thus the Gordon's model can be stated as . In practice this P is then adjusted by various factors e. Often it is assumed that the high growth rate can be sustained for only a limited number of years. i. After that only a sustainable growth rate will be experienced. When the growth g is zero.Investors who look at stocks as if they were buying a private business may benefit from this valuation approach.

It incorporates both factors.When g is very close to k. But for many growth stocks.06/.1.01/. By replacing the (lack of) dividend with earnings. The model's equation recognizes the trade off between paying dividends and the growth realized by reinvested earnings. going to infinity when g is equal to k.7% So the price of the stock assuming 6% growth= shs. Cost of Newly Issued Stock Cost of Newly Issued Stock Cost of newly issued stock (k c) is the cost of external equity. In this case this model should not be used.107 = 1.02/.07) assuming 2% growth= shs.00 cost of capital = 8% Say the growth rate = 1% .00(1. b) If the stock does not currently pay a dividend. Now say the growth rate = 6% . you double count. Problems with the model a) The model requires one perpetual growth rate greater than (negative 1) and less than the cost of capital. c) Gordon's model is sensitive if k is close to g.14. and therefore replace the stock¶s dividend D with E earnings per share.17.53 = 1.01) The difference determined in valuation is large . the price is very high. One common technique is to assume that the Miller-Modigliani hypothesis of dividend irrelevance is true. and it is based on the cost of retained earnings increased for flotation costs (cost 10 of 55 1st Draft to be improved .00(1. But this has the effect of double counting the earnings.02) assuming 7% growth= shs.43 = 1. the current growth rate can vary with the cost of capital significantly year by year.00 = 1. if dividend = shs. more general versions of the discounted dividend model must be used to value the stock.2% So the price of the stock assuming 1% growth= shs.00(1.07/. like many growth stocks.06) The difference determined in valuation is relatively small.00(1. and multiplying by the growth from those earnings. For example.

the greater the risk. its expected ROE is 10%. this can be calculated as follows: R= D1 g Po (1  f ) where: f = the percentage flotation cost. as an alternative approach to the dividend valuation model. we can make the assumption that there are two basic functions associated with the CAPM:  Attempting to establish the µcorrect¶ equilibrium market value of a company¶s shares. 2 and the company expects to pay out 30% of its earnings. 40. RISK There is risk associated with investment in any security. For a constant -growth company.  Calculating the cost of a firm¶s equity (and thus the weighted average cost of capital). next year¶s dividend is shs. What is cost of new equity? Capital asset pricing model Capital asset pricing model (CAPM): This is an equation expressing the relationship between the degree of risk of an investment and the expected return on the investment. the cost of capital and gearing. the greater the required return from the investment. However. The model brings together aspects of share valuations. assume the company has a flotation cost of 5%. For our purposes. or (current stock price funds going to company) / current stock price Example: cost of newly issued stock assume the company¶s stock is selling for shs. Additionally. one 11 of 55 1st Draft to be improved .of issuing common stock).

a premium) as compensation for taking the systematic risk of the investment. is government stock y The only way for an investor to avoid risk altogether is to invest solely in government securities y Risk comprises financial and business risk. y The risk. Such risk may arise as a result of government legislation. from adverse trends in the economy or from other external factors over which the company has no control. y Systematic risk is unavoidable risk. CAPM is concerned with: The remainder is the relevant risk for appraising  How systematic risk is measured. Systematic risk may also vary between projects. y The risk related to the market. cannot be diversified and is known as systematic or market risk.  How systematic risk affects required returns and share prices.  Will expect a greater return from companies with greater systematic risk (as measured by their beta factors). investments.type of stock which has a low risk and which is assumed in portfolio theory to be risk-free.  Should not require a premium for unsystematic risk as this may be diversified and removed from the portfolio (as discussed earlier). MARKET RISK AND RETURN 12 of 55 1st Draft to be improved . which can be diversified away is known as unsystematic risk and is unique to a particular company. however. investors tend to diversify their portfolios to reduce their risk while maintaining their return. we use the beta factor The CAPM is based on the assumptions those investors:  In shares require a return in excess of the risk -free rate (i.e. MEASURING SYSTEMATIC RISK The CAPM splits the total risk of a security into the unsystematic risk and the remainder. To measure systematic risk.

13 of 55 1st Draft to be improved . The most commonly accepted method for calculating cost of equity comes from the Nobel Memorial Prize-winning capital asset pricing model (CAPM). ß . where: Cost of Equity (Re) = Rf + Beta (Rm-Rf).Rf) Where: Re = expected return from an individual investment Rf = the risk-free rate of return Rm = the market rate of return (the return on the all share index) = the beta factor of the investment Let's explain what the elements of this formula are: Rf . The interest rate of Treasury bills or the long term bond rate is frequently used as a proxy for the risk-free rate.Rf) (Rm . the cost of equity is basically what it costs the company to maintain a share price that is satisfactory (at least in theory) to investors. As the components of the market fluctuate constantly. also known as the characteristic line.Beta .The CAPM was formulated principally to evaluate investments in stocks and shares (µthe market¶ meaning the stock market) rather than in companies¶ investment projects. A measure of the relationship between the returns of the company and those of the market is given by the beta factor ( ) for that company. as it is based on the variability of the total market return.Rf) = or Re = Rf + (Rm .This is the amount obtained from investing in securities considered free from credit risk. so the systematic risk attached to shares will also change. The formula is expressed as: (Re . Market risk is almost impossible to determine accurately.Risk-Free Rate . Therefore.This measures how much a company's share price moves against the market as a whole. such as government bonds from developed countries. The line of best fit.

pending lawsuits. which may increase or decrease the risk profile of the company. the shares are described as defensive: they are less risky than the market generally. adjustments can be made to take account of risk factors specific to the company. (Rm ± Rf) = Equity Market Risk Premium .Where > 1. concentration of customer base and 14 of 55 1st Draft to be improved . If a company¶s beta factor is 2. which is unique to the company. Where = 1. It is a highly contentious figure.The equity market risk premium (EMRP) represents the returns investors expect. Where < 1. the shares are described as aggressive: they outperform the market. then the expected return for this company with a beta factor of 2 is 10 per cent above the risk-free rate of return. Once the cost of equity is calculated. The actual return for the company may differ from the expected return because of variations due to the company¶s unsystematic risk. to compensate them for taking extra risk by investing in the stock market. the shares are described as neutral: their returns are in line with the average return of the Stock Market. its return will vary twice as much as the return on the market as a whole. Many commentators argue that it has gone up due to the notion that holding shares has become riskier. If the market return (Rm) is 5 per cent above the risk-free rate of return. it is the difference between the risk-free rate and the market rate. the expected return for the company is 6 per cent below the risk-free return. In other words. If the market return is 3 per cent below the risk-free return. The market as a whole has a beta factor of 1. This means they give a bigger return than the market when the market return is positive and a bigger loss than the market when the market return is negative. over and above the risk-free rate. Such factors include the size of the company.

raising its overall cost of capital. to approximate the cost of bank borrowings the interest rate paid on the loan s hould be taken. With a lower rating. Cost of bank borrowings Bank borrowings do not have a market price with which to relate interest and payments to in order to calculate their cost as is the case with securitized debt. its cost of borrowing money falls. the company will have to pay higher interest to borrow capital. it¶s cost of bo rrowing money rises. The cost of debt explains the negative reaction that occurs when a company's bonds are downgraded by a ratings agency such as Standard & Poor's. 95 per share and pays a dividend of 4% of par value (shs. hence there is not tax adjustment For instance Zantel preferred stock is selling for shs. For companies that have issued bonds previously. Adjustments are entirely a mat ter of investor judgment and they vary from company to company. 100). it's possible to estimate the cost of debt by looking at the yield of those bonds. preferred stock dividends are viewed as a return to equity.4(100)/95 =4. The cost of preferred stock is kP = 0. making the appropriate calculation to allow for the tax deductibility of the interest payment Cost of preferred stock kP is the minimum required rate of return required on newly issued preference shares Is given by the equation k P= Dp/Pp Where: Dp = expected dividend per year and Pp = per share market price of the stock Note: the minimum required rate of return is based on the value of the stock as perpetuity Note: unlike interest expense on debt. When a company is considered risky.2% 15 of 55 1st Draft to be improved . Cost of Debt The cost of debt is simply the cost of borrowing money. or the interest rate that the company would pay on the borrowed amount. and when a company is considered stable.dependence on key employees. Thus.

3% + 0.The cost of debt capital which has already been issued is the rate of interest (the internal rate of return) which equates the current market price with the discounted future cash flow from the security. The market price is shs. I (1  t c ) I if tax rate is applied then P Po 0 The tax is included because interest on loan is allowable for tax purposes so if a company use borrowed capital there is always a saving due to tax relief on interest paid.(4. calculate the cost of this capital if the denture is: -Irredeemable. 3% (b) The cost of debt capital is 7. Ignoring taxation.9% of current market value. 100 ± shs. The best trial and error figure to try first is.75 ex interest. The cost of these debts will be found by using the internal rate of return. 4. therefore. 0. 7. The capital profit that will be made from now to the date of redemption is shs. y Irredeemable debt For redeemable debt the cost is calculated as the interest payable over the market value of debt. Solution (a) The cost of irredeemable debt capital is: 7.2% say 8% to the nearest. 95.3% if irredeemable. Example: Peet Ltd has 7% debentures in issue. 95.25 ( shs. -Redeemable at par after 5 years. This profit will be made over five years which gives an annualised profit of shs. y Cost of redeemable debt These are debts with a defined period or date of repayment.9% = 8.85.75).25/5) which is about 0. 16 of 55 1st Draft to be improved .

791 0.11 is therefore: 8. The WACC equation is the cost of each capital component multiplied by its proportional weight and then summing: Where: Re = cost of equity Rd = cost of debt E = market value of the firm's equity D = market value of the firm's debt 17 of 55 1st Draft to be i roved ¦ The approximate cost of debt capital ¥ Year 0 1-5 5 cash f 95.75 26.The cost of debt capital estimated above represents the cost of continuing to use the finance rather than redeeming the debt securities at their current market price.621 ¤ £¢¡ PV -95.common stock.are included in a WACC calculation.75 27.54 62. A company with no debt capital can make the calculations using the information of another company which is judged to be similar as regards to risk.1 . All capital sources .WACC ean A calculation of a firm's cost of capital in which each category of capital is proportionately weighted.WACC  © ¨ § What oes Weigh ed Average Cost Of Capital .993 0. as an increase in WACC notes a decrease in valuation and a higher risk. It would also represent the cost of raising additional finance if we assume that the cost of additional capital would be equal to the cost of that already issued. the WACC of a firm increases as the beta and rate of return on equity increases.10 0. bonds and any other long-term debt .75 7 100 discoun rate (8) 1 3.1 -7. preferred stock.95 68.681 PV -95. Weighted Average Cost of Capital .30 discount rate ( 0) 1 3. All else help equal.

new debentures or loans. including new share issues.  The weighted average cost of capital must reflect the long -term future capital structure of the company. using the formula: We should consider discount rate that is after tax. remember interest payable in the form of corporate tax is deductible and hence reduce the tax liabilities. ARGUMENTS AGAINST USING THE WACC  Businesses may have floating rate debt whose cost changes frequently  The business risk of individual projects may be different from that of the company and will thus require a different premium included in the cost of capital. but payment of dividends to shareholder is not allowable hence does not reduce the tax liability of company.  The finance used for the project may alter the company¶s gearing and thus its financial risk. ASSESSMENT OF RISK IN THE DEBT VERSE EQUITY 18 of 55 1st Draft to be improved .V=E+D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate Businesses often discount cash flows at WACC to determine the Net Present Value (NPV) of a project.  New investments must be financed from new sources of funds. for this case in the formula of WACC tax has to be included in debt part D/V * rd * (1-tc) ASSUMPTIONS WHEN USING WACC  The cost of capital used in project evaluation is the marginal cost of funds raised to finance the project.

and are paid dividends Where organisation does not make profit. whether the company makes profit or not If redeemable. 19 of 55 1st Draft to be improved .DEBT  Fixed interest payment in each period. dividends may not be paid. in interest payment the company may be forced into liquidation  Loans if secured is charged over fixed asset  Interest payments are tax deductible. nor do they have business or financial risk. where a company makes profit  Loan will increase the company¶s gearing level EQUITY  Ordinary shareholders are the owners of the organization. without forcing the organisation into liquidation  Dividends paid to shareholders are not tax deductible  Equity will reduce the gearing (risk) level COST OF CAPITAL FOR UNQUOTED COMPANIES To estimate an approximate cost of capital the firm can use the cost of equity of a similar quoted company and adjust it for difference in financial and business risk COST OF CAPITAL FOR NOT-FOR-PROFIT ORGANISATIONS Government departments do not have a market value. hence they cannot calculate the cost of capital. then loan amount will have to be paid in the future  In case of default. They therefore use the targeted µreal rate of return¶ set by the treasury as the cost of capital Factors Influencing Capital Structure Business risk Risk associated with the nature of the industry the business operates and if the business risk is higher the optimal capital structure is required.

Finance risk measured through gearing/leverages ratios. Conservative managers will usual try to keep the debt equity ratio low. Financial gearing Extent to which debt finances firms total capital structure Debt equity ratio: Total debt/Total assets Times interest earned Measures the firm¶s ability to meet its annual finance interest payments. and competition levels. depreciation tax shield as they already have an existing lower tax burden. variability of inputs. Advantage not much for businesses with unrelieved tax losses. Managerial style How much to borrow also depend on managers approach to finance risk. Financial flexibility Depends on how easy a business can arrange finance on reasonable terms under adverse conditions.Tax position Debt capital is regarded as cheaper because interest payable is deductible for tax purposes. Finance risk Additional variability in return that arises because the financial structure contains debt. Flexibility in raising finance will be influenced by the economic environment (availability of savers and interest rates) and the financial position of the business. TIE ratio = Earnings before interest and tax Interest charges Operational gearing Measures to what extent are fixed costs used in firms operations. 20 of 55 1st Draft to be improved . Business and Finance Risk Business risk The variability in operating income caused but inherent factors of the business other than debt financing can be influenced by changes in prices. sales volume.

y Restrictions on further borrowing might be contained in the denture trust deed for a company¶s current debenture stocks in issue. Financial gearing can reach very high levels. with companies preferring to raise additional capital for expansion by means of loans rather than issuing new equity. y Occasionally. Sales value equals costs. y Extra borrowing beyond a safe level will cost more interest. there are other side effects associated with high gearing which may include the following: Financial distress where obligations to the conditions are not met or they are Costs: y y y y y y Loss of key suppliers Uncertain customers Low asset value Loss of staff moral Legal costs Agency costs in trying to negotiate additional loan facilities through an agent. variable cost and the fixed costs.e. y y y High interest rates Need to sign loan covenants thereby loosing financial freedom Borrowing cap met with difficulties 21 of 55 1st Draft to be improved . there might be borrowing restriction in the articles of association. Companies might not be willing to borrow at these rates. Apart from the limitations stated above. but there are limits.Breakeven point analysis will measure the relationship between sales volume. y Lenders might want security for extra loan which the would be borrowers cannot provide. Breakeven point is the level of sales where the firm is neither making profits nor losses i. y Lenders might simply be unwilling to lend more to a company with high gearing or low interest cover.

For example. Apart from being cheaper than share capital the following attributes compels the company to use the debt capital. can the value of the firm be increased by financing new investments with debt rather than equity? In order to examine the effect of the firm's financing decisions (the firm's capital structure) on t he value of the firm. y High gearing might send bad signals on company¶s liquidity to employees as well as lenders y Loss of decision making on certain areas to lenders due to loan covenants Despite mentioning all the limitations and cost of high gearing mentioned above company¶s still uses debt capital. there are no transaction costs involved in either the purchase or sale of securities y Investors can borrow and lend at the same rate that corpora tions can borrow and lend.part 11 The purpose of this note is to examine how the value of the firm is affected (holding investment policy and dividend policy constant) by the way in which the firm finances its investments. y y y y Motivation ± Regarded as cheaper source of income New issue stocks may dilute holding Operational and strategic staff more cautious on utilization of funds Flexibility in arrangement than equity Capital Structure. assume that y y y the firm's investment decision is given.y y Limits set by lenders on amount available Financial slack ± Highly geared firms fail to seize opportunities as they arise due to unwillingness of lenders for more fund advancements. 22 of 55 1st Draft to be improved . the firm's dividend policy is given.

Value of Tax Shields from the Corporate Deduction for Interest Expense The capital investment projects undertaken by the firm are usually financed with some combination of debt and equity.. We will also assume that the firm's production capacity is already in place (i. Although firms do not issue perpetual debt in practice. The remainder would be paid to the shareholders. either in the form of a dividend or 23 of 55 1st Draft to be improved .e. consider the case where the firm is currently financed entirely (100 percent) by equity. the investment decision by the firm is a given) so that any changes in the firm's financing mix (such as replacing equity with debt financing) will have no impact on the cash flows from operations. the amount that is raised by The proceeds from the debt issue will be used to repurchase an equal Shilling amount of the firm's outstanding equity shares. the firm would have to pay corporate taxes on the Shilling in question at a rate of tc. In order to understand the effect of this choice on the value of the firm. If no debt had been issued. Assuming that the interest payments for the bond are risk-free and that the opportunity cost for riskfree cash flows (before personal tax) is r issuing this bond is shs 1 rd D . To see how the value of the firm changes if equity financing is replaced with debt financing. The implications of the ³recapitalization´ (change in financing mix) described above is to divert one Shilling of before -tax operating income (profit before financing charges and taxes) from stockholders to bondholders. suppose t hat the firm issues a perpetual bond that pays one shillings of interest each year. the consequences of using debt as a more or less permanent component of a firm's financing mix are virtually identical.

. the after-tax value of one Shilling of operating income directed toward the stockholders in the firm is (1 .(1 .to) . Since corporations are allowed to deduct interest expense prior to computing their corporate tax liability.tE) (1 . the interest income to the bondholders is equal to one Shilling.e.through reinvestment in the firm resulting in appreciation in the stock price.te ) ( 1 .tc) (1 . Since interest income is taxed at a rate of to .to ) rD . the after-tax cash flow received by the bondholders is (1 .to ) ( 1 . Since the dividend to the shareholders would have been taxed at a rate of te. then the value which is created by diverting one Shilling of beforetax operating income from the stockholders to the bondholders is (1 .to) rD shs1 Rearranging the expression above shows that the value created in a recapitalization that causes the firm to pay an additional one Shilling per year of interest expense (in perpetuity) is 24 of 55 1st Draft to be improved . ( 1 .tc ) ] shs1 .t e) (1 .to) shs 1 The value (if any) of diverting one Shilling of before -tax operating cash flow from the shareholders to the bondholders can be determined by comparing (subtracting) the after-tax cash flows that would have been received by the stockholders to (from) the after-tax payment received by the new bondholders. valued as a perpetuity) using the after-tax return required by the bondholders.tc ) shs1 . If these after-tax cash flows are capitalized in perpetuity (i. [ ( 1 . The net benefit created by corporate borrowing can be determined by comparing the after-tax cash flows to the stockholders with the after-tax cash flows which bondholders receive if the firm issues enough perpetual debt so that one Shilling is diverted to the payment of interest expense.

one that is 100 percent equity financed).to) For a firm having outstanding debt in the amount of D with yearly interest expense of r D D . D D) by the value per Shilling of yearly interest expense given Therefore.to) To illustrate the application of the formula.tc) ] . consider the following special cases.tE) (1 .. the total value created by replacing D Shillings of equity (starting from a point of relying solely on equity financing) with D Shillings of debt is obtained by simply multiplying the firm's yearly interest expense (r above.tE) (1 . the tax rate on interest income (to) is 40 percent and the tax rate on equity income (te) is equal to zero. Example 1 : Suppose that the corporate tax rate ( tc) is 50 percent.tc ) ].to) The incremental value of the tax shields generated by deb t financing is used as an adjustment to the value of an unlevered firm (i.e. the incremental value created by financing with debt rather than equity is given by D[1 - (1 . Then the value of the tax shields from one Shilling of debt (not one Shilling of interest expense) is 25 of 55 1st Draft to be improved .e. the value after debt has been added to the firm's financial structure) is equal to the value of the unlevered firm (V U ) plus the value of the tax shields from debt financing V L = V U + D [1 (1 . That is the value of the recapitalized or levered firm (i. (1 .tE) (1 .. (1 .1 rD [1 - (1 .tc) ] . (1 .

.80x0).tc) ]= (1 .40 + . the tax rate on equity income is approximately 8 percent (.50) ] =shs1[1] (1 . case..40) = shs1 [1 - ..to) shs1 [1 - (1 . Example 2: Assume that the corporate tax rate (tc) is 50 percent and that the tax rate on interest income (to) is 40 percent as in Example 1. the greater is the value of the tax shields from replacing equity with debt financing..00) (1 .tE) (1 .20x.40) = shs1 [1 - 5 ] 6 = shs .46 ] . the value of each Shilling of debt added to the firm's financial structure (up to some level consistent with sustained profitability for the firm) is shs.to) (1 . Note that the higher the tax rate on equity income..23.17 per Shilling of debt (not interest expense).tc) (1 .60 = shs .08) (1 . the value of the tax shields from one Shilling of debt is In this shs1 [1 - (1 . assume that the tax rate on equity income (tE) reflects the fact that 20 percent of the income to stockholders is in the form of dividend income taxed at 40 percent while 80 percent is in the form of capital gains having (according to many economists) an effective tax rate of zero. However. Therefore. 26 of 55 1st Draft to be improved .shs1 [1 - (1 . Therefore.tE) (1 ..17.50) ] (1 .

(1 . 1st Draft to be improved .tc) (1 . So long as the firm is consistently profitable.tE) (1 . What is moderate will depend critically on the nature of the For example.to) ] = shs1 [1 . = VU + tc D .A particularly important example is the case where the tax rate on interest income (to ) is equal to the tax rate on equity income (tE) . firm's engaged in heavy research and 27 of 55  Example : (1 . In this case the value of the tax shields from one Shilling of debt (not one Shilling of interest expense) is shs1 [1 - = This example shows that when equity income and interest income are taxed at identical rates the value of the tax shields from financial leverage is determined entirely by the corporate tax rate. the full value of the tax shields may be realized (without resorting to tax loss carry forwards). In other words. research and development activities have little assurance of utilizing the tax deductions for the interest expense on debt (in addition to providing poor collateral). the value each Shilling of debt is equal to tc so that the value of the levered firm is given by VL Note that the adjustment that has been used to the value of the unlevered firm (with no debt financing) to reflect the value of the tax shields from debt implicitly assumes that the firm holds the level of debt to a (³moderate´) level that allows the firm to sustain consistent (taxable) profitability. when (te) is equal to (to ) . firm's engaged in highly speculative industry in question. Therefore.tc) ] shs1 (tc). just as if the marketplace ignored the effects of personal income taxes.

10 + 5 8 . = .000 1/8 shs1..00 20% Given the three possible values for the Return on Equity.50 5% Shs 1.05 + 1 8 . Given this assumption.00 10% Shs 2. firms in mature industries (e. the expected (required) rate of return on Machinga's stock is rE = 1 4 . it is useful to examine the impact of a recapitalization (issue debt and buy back equity) on the value of the firm under the (artificial) assumption that all of the tax rates considered previously are equal to zero.15 (15 percent). The Impact of Financial Structure in a World with No Taxes To illustrate the important impact of taxes on the value of financing decisions. the resulting change in the risk profile of the remaining equity shares (including an increase in the expected dividend) precipitates an increase in the cost of equity capital.20 . tobacco or food products) that have relatively stable cash flows can often support rel atively high levels of debt.000 5/8 shs2.development activities will tend to rely primarily on equity financing.g. 28 of 55 1st Draft to be improved  State 1 State 2 State .000 Net Operating Income Probability Earnings per Share Return on Equity (ROE) shs500 1/4 shs . the example shows that even though a change in financial structure has no impact on the total value of the firm. Machinga Example: Number of Shares Price per Share Firm Value = 1000 = shs 10 = shs 10. On the other hand.

Then the new capital structure will be Number of Shares Price per Share Value of Shares Value of Debt = 500 = shs 10 = shs 5000 = shs 5000 29 of 55 1st Draft to be improved .15 shs 10. Given that the required rate of return on equity (the cost of equity capital) is 15 percent. Suppose now that the firm decides to a) sell shs5000 of debt b) Retire 500 shares of stock with the proceeds from the debt issue. Where rE is the required rate of return on equity.00 .00 + 5 8 shs2.50 = . it is easy to verify that the price of one share in the firm should be (as we have already assumed) P0 = ~ E(D ) rE = shs1. Then the expected dividend for the firm will be ~ E(D )= 1 4 shs.50 + 1 8 shs1.50.Assume that all earnings will be paid out as a dividend (in perpetuity). = shs1.

00 10% Shs 2. the increase in financial leverage has also increased the range (variability) for both dividends per share (from shs. Consider our projections for ROE and EPS for each of the possible outcomes for net operating income. since the required rate of return increases to 20 percent (you can show that the expected Return on Equity is 20 percent). the recapitalization has no The increase in the expected rate of return demanded by shareholders can be motivated by examining the respective payoff patterns for the unlevered (the original debt-free firm) and levered (recapitalized to include debt financing) firm. Although the recapitalization has increased the expected dividend per share. In other words.000 Shs 500 shs 1500 Shs 3. Therefore.00 30% It can be shown that the recapitalization of the firm has increased the expected dividend for the remaining shareholders of Machinga to shs 2.To see why this must be the case. financial leverage increases the risk associated with the expected returns promised to shareholders. consider the possible realizations of earnings per share and return on equity for the recapitalized or levered firm. However. (You should be able to compute the expected dividend for the recapitalized firm in the same way that we computed the expected dividend for the unlevered version of Machinga). effect on the total value of the firm.00 per share.00 to 0-shs3. the stock price remains unchanged at shs 10 per share.000 Shs 500 Shs 500 Shs 1. Operating Income Interest Expense Net Income Earnings Per Share (EPS) Return on Equity (ROE) shs500 Shs 500 shs 0 0 0 Shs 1.00) and Return on Equity (from 5%-20% to 0%-30%).50-shs2. Since we have assumed that there are no tax benefits 30 of 55 1st Draft to be improved  State 1 State 2 State .

00 Shs 1. the investor's income from these two shares would have had the following distributio n across states of the world Earnings per Share Income from 2 Shares of Stock shs .00 Shs 1.00 Shs 2. an investor with two shares prior to the recapitalization would now have one share of stock and shs 10 (from the sales of one of the shares of stock).associated with debt financing (these will be discussed later).00 The Table above shows that the total investment income for an investor with shs2 0 invested in a portfolio consisting of one share of stock in the 31 of 55 1st Draft to be improved  State 1 State 2 State  State 1 State 2 State . the value of the firm's equity shares will not change (this ³can be shown´).00 Shs 2.00 Shs 4.00 shs3.50 Shs 1. which could be invested at 10 percent interest by purchasing shs 10 of the bonds of the recapitalized firm. consider the position of an investor who initially owned two shares of stock. The total income to the investor from one share of stock (with a market price of shs 10) and one bond (also worth shs 10) paying interest at a rate of 10 percent would be Income from 1 Levered Share Income from shs10 in Bonds Total Investment Income 0 Shs 1. To see why the recapitalization has no impact on the total value of the firm. Prior to the recapitalization.00 Given our assumption that the firm is recapitalized by issuing debt to buy back one half of the firm's outstanding stock.00 Shs 4.00 shs1.00 Shs 2.00 1.00 1.

Therefore.00 Which is identical to the dividends from an investment of shs 10 in the shares of the recapitalized firm? In other words. The total market value of the debt and equity of a levered firm (using debt financing in addition to equity financing) must be equal 32 of 55 1st Draft to be improved  State 1 State 2 State .00 Shs 2. shareholders can replicate (match) the pattern of payoffs from the levered firm by financing one-half of an investment in 2 shares of stock in an all equity firm by borrowing shs 10 at an interest rate of 10 percent. the firm cannot create value for investors by recapitalizing an all equity firm since the shareholders are able to do this for themselves if they wish.00 1. is that the financing mix used by the firm (the capital structure) does not matter as long as investors are able to costlessly duplicate (or reverse) the financial implications of any financing decision which the firm might make. The implications of the analysis above.00 Shs 4. The distribution of payoffs from this portfolio is shown belo Income from 2 Levered Share Interest on Personal Debt of shs 10 Total Investment Income 0 Shs 1. Similarly.00 Shs 1. so long as an investor can borrow at the same interest rat e (roughly) as corporations.00 Shs 0. These implications can be summarized as 1. for which Merton Miller and Franco Modigliani received the Nobel Prize in Economics.00 Shs 3. the investor can undo the impact of the recapitalization by simply using the proceeds from selling stock back to the firm to purchase the newly issued bond.recapitalized firm and shs 10 in bonds is identical to the pattern of returns obtained from owning 2 shares in the all equity (unlevered) firm.00 1.

the weighted average cost of capital may be thought of as the required return on the portfolio of securities that has been issued to finance the firm's operations. Since VL is equal to VU. the two firms must have the same blended cost of funds or weighted average cost of capital. 2. In general.to the market value of an unlevered (all equity) firm having the same degree of operating risk. re is the cost of equity and td is the corporate tax rate. In other words. the value of the equity was shs 5. 33 of 55 1st Draft to be improved . VU = VL. After the firm was recapitalized to include debt financing.000. we assumed that the corporate tax rate (tc) was equal to zero. td is the before-tax cost of debt. the firm's WACC may be computed using the formula In WACC = D ( 1 .000. which requires that the cost of equity capital for the levered firm be greater than the cost of equity capital for the unlevered firm (since the cost of debt will always be less than the cost of risky equity capital). VL is the total value of the firm. S is the value of the firm's equity. Weighted Average Cost of Capital The weighted average cost of capital (WACC) is the firm's hurdle rate or opportunity cost of capital. general.tc ) rD VL + S VL rE Where D is the value of the firm's debt. the outstanding value of the firm's debt was shs 5. The WACC is used in capital budgeting to compute the net present value for projects which have the same risk and debt capacity as the firm as a whole. In the previous example.000 and the total value of the firm was shs 10.

10 shs10.000 + shs. in some instances.000 . Adjusted Present Value 2. which in this case was 15 percent. the three approaches give identical values for the firm and its component securities.15 (15 percent). However.20 shs10. Valuation There are three general approaches to valuation. Therefore.5.Since the before-tax cost of debt is 10 percent and the required rate of return on the equity in the recapitalized firm is 20 percent. Note that prior to the recapitalization (using debt financing). the weighted average cost of capital for an all equity firm must be equal to the cost of equity (which is also the required return on the firm's assets for an all equity firm).000 = . there is only one security in the financing portfolio of the all equity firm. Adjusted Discount Rate 3. Equity Capitalization For the relatively straightforward examples illustrated here. 1.000 . a firm cannot change it's weighted average cost of capital by altering the financing mix used to finance its operations. one or more of the valuation approaches 34 of 55 1st Draft to be improved . the firm relied solely on equity financing with a cost of 15 percent.5. The computations above show that when there is no tax deduction for corporate interest expense. In other words. the weighted average cost of capital is WACC = D VL rD + S VL rE = shs.

it is usually convenient to have more than one valuation technique at your disposal. 100 percent of EBIT can be used to pay dividends to the shareholders. Therefore. y Then add on the present value of any special benefits associated with the financing of the project. To simplify the discussion of the Adjusted Present Value (APV) approach to valuation. 35 of 55 1st Draft to be improved . the value of the all equity/unlevered firm (Vu) is equal to after-tax EBIT capitalized in perpetuity at the required return on assets Vu = ( 1 . the first step in the APV approach is to value the firm (or project) as if the financing were all equity. ra. then after paying corporate taxes at a rate of tc. consider the case where a firm generates perpetual before-tax operating cash flows denoted by EBIT. the value of subsidized financing which may be tied to undertaking the project (e. As noted above. if there were no debt financing. Therefore. Adjusted Present Value The adjusted present value approach to valuation is a two-step approach requiring that we y value the firm as if the project were to be financed entirely by equity.g. Note that if the financing for a project is 100 percent equity then the cost of equity capital r e is equal to the required return on assets.tc ) EBIT rA . y the flotation costs of issuing securities.. In other words.suggested above may be difficult to implement. Examples of special financing benefits whose value should be accounted for include y y the value of the tax shields from debt financing. industrial development bonds or below market loans from foreign governments).

. then the cash flow to the stockholders is (1 .000.000].000.000.000 0 Shs700.000 in debt at 15 percent.000.000 0 shs1. 36 of 55 1st Draft to be improved .000 Shs 835.000.000 Note that when the firm is financed entirely by equity.000.000. the firm pays no interest and the total after-tax payout from the firm is equal to (1 ..000.tc) EBIT = = (1 . For example.000 shs550. If the firm issues shs 3. shs 700.000 450.000 Post-Recapitalization (shs3.. if the firm issues D Shillings of debt then the value of the ³recapitalized´ firm will be VL = VU + tc D .000 300.tc) [EBIT .000. then the pre. Assume that the corporate tax (tc) rate is 46 percent and that the required return on assets (r A) is 20 percent.000 Shs700.000. consider a firm which has perpetual EBIT of shs 1.000. = shs 385.000 450.30) shs 1. To illustrate the application of the Adjusted Present Value approach.000.15 x shs 3. If the firm issues shs 3.The second step of the APV approach requires that we determine the value of any financing effects associated with a firm or project separately and then add the value of these benefits to the unlevered value of the project.000.000 .000 of Debt) shs1.rD D] = (1 .000 165.30 Equity Income Interest (to Bondholders) Total After-Tax Payout shs1.3) [shs 1.000 per year.000 Shs385.000 of perpetual debt at an interest rate of 15 percent.and postrecapitalization cash flows to the stockholders and bondholders will be Pre-Recapitalization (All Equity) EBIT Less: Interest Net Income Less: Tax@ .

000.000. the sum of the after-tax cash flow to the stockholders and bondholders is (1 .30 x shs 3. The example above raises an important fundamental question concerning the application of the formula for the value of the levered firm.400.000. Applying the formula for the value of the unlevered firm shows that Vu = = = ( 1 .000 of debt to repurchase equity is questionable given that the initial value of the all equity firm is only shs 3.000 .000.15). 500.000 = shs 4. If this amount is capitalized in perpetuity using the cos t of debt (note that we are ignoring personal taxes here). The example shows that adding debt to the financial structure of the firm increases the total after-tax cash flow paid out by shs 135.tc ) EBIT rA .15 x shs 3.tc) [EBIT .20 shs 3. then it is unlikely that the required debt financing can be obtained.rD D] + rD D = = ( 1 .000.e.000. the additional cash flow increases the value of the firm by shs 900. the tax savings attributable to the corporate deduction for interest expense. 000.500. 0. the value of the underlying assets).tc ) EBIT + tc rD D .000.30) shs 1.000 + shs 135.000 + . (1  ..000.000.30) shs 1.000/.The interest to the bondholders is equal to rD D or shs 450. = shs 700.30 x .000 + .000. If the primary security for the loan is the collateral (i. Therefore.000 (shs 135.500. Note however that the operating cash flow for the firm is more than twice as large as the required interest 37 of 55 1st Draft to be improved ..000. (1 . The assumption that the firm can issue shs 3. So that the total value of the levered firm is VL = = Vu + tc D shs 3.

an adjusted discount rate or weighted average cost of capital is defined by the identity. then bondholders may be willing to p urchase the debt of the firm based on the adequacy of the cash flows generated by the firm's assets. That is. This approach can be represented using the following formula for the value of the levered firm VL = ( 1 .. the value of the firm or project may also be determined by capitalizing the ³after-tax operating cash flows´ for the unlevered firm using a discount rate that is adjusted to reflect the tax shields associated with debt financing. In other words. the present value of the ³after-tax operating cash flows´ (i. Adjusted Discount Rate The most important alternative to the Adjusted Present Value method of valuation is the Adjusted Discount Rate approach.to B+ range. the initial willingness of fixed income investors to purchase the debt of the firm is in doubt given the fact firms in the BBB ratings category have great difficulty issuing debt in tight credit markets. Nevertheless. where WACC (sometimes referred to as the weighted average cost of capital) represents the adjusted discount rate.e. the after-tax profits if the project were financed entirely with equity) is determined using an ³adjusted discount rate´ which takes into account any benefits from the utilization of debt in the financing of the project. The adjusted discount rate is most easily defined by noting that the adjusted present value approach and the adjusted discount rate approach should suggest the same value for a firm with perpetual operating cash flow of EBIT and debt financing in the amount of D. Under the Adjusted Discount Rate approach. if the cash flow of the firm is stable.tc ) EBIT WACC . 38 of 55 1st Draft to be improved .payments on the debt. While this level of interest coverage would likely place the rating on the firm's debt in the BB .

which implies that the value of the tax shields from debt are equal to zero. In other words.t c ) rD + S VL rE The formula for the weighted where the weights of debt and equity in the capital structure are respectively D/V L and S/VL . when the tax shields from debt have no value. average cost of capital is WACC = D VL ( 1 . we don't know the cost of equity for the levered (or recapitalized) firm. which is the cost of equity for a firm with no debt in its financial structure. the cost of debt was 15 percent. we need to know both the cost of equity and the after-tax cost of debt.( 1 . the cost of financing the firm does not depend on the amount of debt in the firm's financial structure. then the WACC is a weighted average of the after-tax cost of debt (to account for the corporate deduction for interest expense) and the cost of equity. We have already shown that financial leverage 39 of 55 1st Draft to be improved . if the firm uses only debt and equity to finance its operations. To use the formula above to value the firm. Although we know that the required return on assets is 20 percent. For example. EBIT rA = EBIT WACC . In the previous example.tc ) EBIT rA + tc D = ( 1 .tc ) EBIT WACC . It is fairly easy to show that the weighted average cost of capital defined above is simply the average cost of the portfolio of securities used to finance the firm's operations. Note that when the corporate tax rate is equal to zero. which in turn implies that the weighted average cost of capital (the adjusted discount rate) is equal to the required rate of return on assets.

400. the cost of equity capital is rE = = .20 + shs 3.400 + 1. which implies that the value of the firm's equity is shs 1.15 4.5 percent) .1.increases the risk of the cash flows to the shareholder s.400 .000 (1  30) .5.000 of debt (D).27. It turns out that the cost of equity capital is related to the required return on assets (rA ) and the amount of debt in the firm's financial structure by the following formula rE = rA + D ( 1 .400 = 0. the total value of the firm was shs 4.5 percent) .400. a before-tax cost of debt of 15 percent.rD ) S . Given the cost of equity capital.15) shs.000.000 (1  .t c ) ( rA .2  . WACC = D VL ( 1 . Given a required return on assets of 20 percent. To show how this formula works. Further.000. consider the previous example. 40 of 55 1st Draft to be improved .000. 4. We saw that after the firm issued shs 3.275 (approximately 27. we know that the increase in risk increases the rate of return required by the shareholders.3)(. we can now determine the weighted average cost of capital. and a corporate tax rate of 46 percent.t c ) rD + S VL rE = 3. 400 27.

= = (1  . Recall that our estimates of the cash flows from capital investment projects have never included a charge for any financing costs associated with the project. In other words. without considering the costs associated with the financing of the project. Implicitly. the Adjusted Discount Rate approach (WACC) to valuation is very useful. With regard to the question of how we determine the relative weights of debt and equity in the capital structure. the costs of financing the project were always taken care of by making the appropriate adjustment to the discount rate used to compute the present value of the project. Firms usually have a 41 of 55 1st Draft to be improved . So what? Since we needed the value of the firm and the value of the equity (obtained using the APV approach) to determine the weights of debt and equity required to determine the WACC.000. The calculations above show that under ideal conditions. the Adjusted Discou nt Rate approach is typically used to value projects that will be financed with the same mix of securities as the firm's existing assets. isn't the logic above circular and therefore useless? The answer to the question above is clearly no. Wonderful you say.tc ) EBIT WACC .000. In fact.275 shs 4. the approach that we have followed has always been to estimate the after-tax cash flow from operations. the Adjusted Discount Rate approach to valuation and the Adjusted Present Value approach give the same value for the firm.000 0. VL = ( 1 .30)1.Once we know the weighted average cost of capital we can determine the value of the firm by discounting the after-tax operating cash flow of the firm using the weighted average cost of capital or adjusted discount rate. we have been using an Adjusted Discount Rate approach to valuation all semester.400.

Joint Ventures Since the debt associated with a joint venture is usually a liability of the venture itself rather than of the individual partners. The total value of the firm is then determined by adding the value of the firm's outstanding debt to the value of the equity. we value the stock by computing the present value of the after -tax cash flows (after paying interest to the bondholders) available for distribution to the shareholders using the cost of equity capital. each partner is concerned primarily with the value of their respective 42 of 55 1st Draft to be improved . The equity capitalization approach is most often used to value 1. the choice between the Adjusted Discount Rate approach and the Adjusted Present Value approach hinges on whether the financing benefits associated with a project take the form of the tax savings from issuing debt that will provide long-term financing for the project (use APV) or whether the financing benefits include short -term financing benefits such as subsidized financing or loan guarantees. computing the weighted average cost of capital is not usually a problem in practice. Since the corporation usually has a reasonable estimate of the weights of the various components of the financing mix. In other words. Real Estate Investments These projects are usually heavily leveraged. 2. The fact that the debt financing is often specific to the project makes the weighted average cost of capital difficult to determin e in some cases.reasonable estimate of the relative importance of debt and equity in both the mix of securities used to finance existing operations and the mix of securities that will be required to finance projects currently in the planning stage. Equity Capitalization Approach The equity capitalization approach to valuation calls for valuing the equity of the firm separately using the cost of equity capital. Therefore.

Foreign Investments Debt financing is often obtained in one or more foreign countries in order to hedge political and exchange rate risk.000.15 x shs 3.000 as before. If we discount the after-tax cash flows to the shareholders at the cost of equity capital. (1 . 43 of 55 1st Draft to be improved .3)[1..275 (27..5 percent). we continue the preceding example.000.rD D ] rE . we find that the value of the firm is shs 4.000.000.400. the value for the firm's outstanding equity shares is S = = = ( 1 .rD D]= (1 .000 ] = shs 385. which is shs 3.15 * 3. Other financing aspects as loan guarantees and subsidized interest rates make the computation of an adjusted discount rate or weighted average cost of capital difficult in such cases.30) [ shs 1. To illustrate the equity capitalization approach.000  .400.000.000. rather than with the value of the venture as a whole.equity shares.000.000.000 ] . . Since we have already determined that the cost of equity capital for the recapitalized firm is . all that remains is to determine the after-tax cash flows available for distribution to the shareholders.tc) [EBIT . 3.tc ) [EBIT .000. (1  . Adding the value of the firm's outstanding debt.275 shs 1.

the Modigliani-Miller theorem is also often called the capital structure irrelevance principle. The other (Firm L) is levered: it is financed partly by equity. bankruptcy costs. and partly by debt. the value of a firm is unaffected by how that firm is financed. Consider two firms which are identical except for their financial structures. Modigliani was awarded the 1985 Nobel Prize in Economics for this and other contributions.Modigliani-Miller theorem The Modigliani-Miller theorem (of Franco Modigliani. under a certain market price process (the classical random walk). The basic theorem states that. and in an efficient market. The first (Firm U) is unlevered: that is. and asymmetric information. The Modigliani-Miller theorem states that the value of the two firms is the same. Therefore. It does not matter if the firm's capital is raised by issuing stock or selling debt. it is financed by equity only. It is made up of two propositions which can also be extended to a situation with taxes. The theorem was originally proven under the assumption of no taxes. Merton Miller) forms the basis for modern thinking on capital structure. It does not matter what the firm's dividend policy is. 44 of 55 1st Draft to be improved . in the absence of taxes.

We have implicitly assumed that the investor's cost of borrowing money is the same as that of the firm. y return on equity. Therefore the price of L must be the same as the price o f U minus the money borrowed B. he could purchase the shares of firm U and borrow the same amount of money B that firm L does. or cost of equity. suppose an investor is considering buying one of the two firms U or L. To see why this should be true. y y y ke is the required rate of k0 is the cost of capital for an all equity firm. Proposition I: where VU is the value of an unlevered firm = price of buying a firm composed only of equity. Proposition II: Proposition II with risky debt. and VL is the value of a levered firm = price of buying a firm that is composed of some mix of debt and equity. because of the higher risk involved for equity-holders in a company with 45 of 55 1st Draft to be improved . the WACC (k0) stays constant.Without taxes. which is the value of L's debt. or cost of debt. The eventual returns to either of these investments would be the same. This discussion also clarifies the role of some of the theorem's assumptions. Instead of purchasing the shares of the levered firm L. kd is the required rate of return on borrowings. As leverage (D/E) increases. which need not be true in the presence of asymmetric information or in the absence of efficient markets. A higher debt-to-equity ratio leads to a higher required return on equity. D / E is the debt-to-equity ratio.

capital structure matters precisely because one or more of these assumptions is violated. Therefore leverage lowers tax payments. but the theorem is still taught and studied because it tells something very important. D / E is the debt-to-equity ratio.debt. rD is the required rate of return on borrowings. or cost of equity. Tc is the tax rate. Dividend payments are non-deductible. It tells where to look for determinants of optimal capital structure and how those factors might affect optimal capital structure. VU is the value of an unlevered firm. or cost of debt. and Individuals and corporations borrow at the same rates. 46 of 55 1st Draft to be improved . Proposition II: where y y y y y rE is the required rate of return on equity. none of the conditions is met in the real world). With taxes Proposition I: where y y y VL is the value of a levered firm. These propositions are true assuming the following assumptions: y y y no taxes exist. That is. r0 is the cost of capital for an all equity firm. no transaction costs exist. These results might seem irrelevant (after all. The formula is derived from the theory of weighted average cost of capital (WACC). since corporations can deduct interest payments. TCD is the tax rate (TC) x the value of debt (D) the term TCD assumes debt is perpetual This means that there are advantages for firms to be levered.

its application should be focused on understanding the implications that the relaxation of those assumptions bring. The formula however has implications for the difference with the WACC. that excessive leverage ratios bring. When misinterpreted in practice. Modigliani and M. Miller in 1958. and individuals and corporations borrow at the same rate Miller and Modigliani published a number of follow -up papers discussing some of these issues.The same relationship as earlier described stating that the cost of equity rises with leverage. It can also be misinterpreted to justify excess ive leverage in order to extend margins for trading operations. Since the value of the theorem primarily lies i n understanding the violation of the assumptions in practice. Their second attempt on capital structure included taxes has identified that as the level of gearing increases by replacing equity with cheap debt the level of the WACC drops and an optimal capital structure does indeed exist at a point where debt is 100% The following assumptions are made in the propositions with taxes: y y y corporations are taxed at the rate TC on earnings after interest. especially bankruptcy risk. rather than the result itself. because the risk to equity rises. 47 of 55 1st Draft to be improved . While it is difficult to determine the exact extent to which the ModiglianiMiller theorem has impacted the capital markets. the argument can be made that it has been used to promote and expand the use of leverage. no transaction costs exist. still holds. The theorem was first proposed by F. even though this action should not be directly comparable to the capital structure of a financial entity. the theorem can be used to justify near limitless financial leverage while not properly accounting for the increased risk.

What would be ZU¶s estimated cost of equity if it were to change its capital structure to 50 percent debt and 50 percent equity? Question no. It pays out all of its net income as dividends and has a zero growth rate. ZU Electronics currently has no debt. is 5 percent. so the company pays out all of its earnings as dividends (EPS = DPS). rM ± rRF. which is based on the CAPM. The consultant believes that if the company moves to a capital structure financed with 20 percent debt and 80 percent equity (based on m arket values) that the cost of equity will increase to 11 percent and that the pre-tax cost of debt will be 10 percent. Currently the company¶s cost of equity. 2.00 3.) The riskfree rate is 6 percent and the market risk premium. its investment bankers believe its weighted average cost of capital would be 10 percent. . ZU Software Co. 40 per share and it have 2. is trying to estimate its optimal capital structure.Review questions Question no. JAK Enterprises Co. If the company makes this change. In order to estimate the cost of debt. What would its stock price be if it changes to the new capital structure? Question no. Its operating income is shs.) Question no. The current stock price is shs.5 million shares of stock outstanding. 1 A consultant has collected the following information regarding Young Publishing: (m/=) Total assets Operating income (EBIT) Interest expense Net income Share price (not in millions) EPS = DPS (not in millions) 3. ZU has a capital structure that consists of 20 percent debt and 80 percent equity. 4. the company has produced the following table: 48 of 55  1st Draft to be improved . what would be the total market value of the firm? (The answers are in millions. 20 million and its tax rate is 40 percent.000 800 0 480 3.25. based on market values. (Its D/S ratio is 0. is 12 percent and its tax rate is 40 percent. The company¶s capital structure consists of debt and common stock. Ltd is trying to determine its optimal capital structure. Right now.20 Tax rate Debt/ ratio WAC M/B ratio 40% 0% 10% 1. If it moves to a capital structure that has 40 percent debt and 60 percent equity (based on market values).00× The company has no growth opportunities (g = 0).

43 0. The resulting capital structure would have a shs. J.90 0. 200 million of assets.´ bU.0.8 9.% financed With debt (wd) % financed With equity (wc ) Debt-to-equity ratio (D/S) Bond Beforetax rating (%) Cost of debt 0.80 0. Aaron estimates that if it had no debt its beta would be 1. 100.20/0.) On the basis of this information.0.30 0. What would be its new stock price per share? c) Now assume that AJC is considering changing from its original capital structure to a new capital structure that results in a stock price of shs.67 1.50/0.90 0. If it makes this change. How many shares would AJC repurchase in the recapitization? Question no.667 million for the year.10 0. The company has shs.70 0. 6 Your company has decided that its capital budget during the coming year will be shs. 60.6 The company¶s tax rate. The A. 336.10/0. T. AJC's current cost of equity is 8. The company uses the CAPM to estimate its cost of common equity.40 0. what is the company¶s optimal capital structure. 820.50 = = = = = 0. and its tax rate is 40 percent.00.50 0.25 0.000 and it is a zero-growth company. The firm has 10.8 percent. The risk-free rate is 5 percent and the market risk premium is 6 percent. its average interest rate on outstanding debt is 10 percent.20 0.70 0.0 8. is 40 percent. If the company follows the 49 of 55 1st Draft to be improved . 5. Its optimal capital structure is 60 percent equity and 40 percent debt.000 shares of common stock outstanding selling at a price per share of shs. equals 1.40/0.60 0. Its earnings b efore interest and taxes (EBIT) are projected to be shs. (Its ³unlevered beta. Its earnings before interest and taxes (EBIT) are shs. 34.30/0. 64 per share. 504. 200.11 0. r s. Croft Company (AJC) currently has shs . 20 million.000 market value of debt. and its tax rate is 40 percent. and what is the firm¶s cost of capital at this optimal capital structure? Question no. its resulting market value would be shs.000 total market value of equity and shs.50 0.60 0.000.000 market value (and book value) of perpetual debt outstanding carrying a coupon rate of 6 percent. a) What is AJC's current total market value and weighted average cost of capital? b) Now assume that AJC is considering changing from its original capital structure to a new capital structure with 50 percent debt and 50 percent equity.2 8.00 AA A A BB B 7 7.80 0.

0 percent of the gross amount. Chwaka Ltd. 11.000 of long term debt. 826. what is the absolute difference in Shillings saved by raising the needed debt all at once in a single issue rather than in three separate issues? 50 of 55   1st Draft to be improved . Yearly flotation costs for three separate issues of debt would be 3. shs. Machinga Corporation is financing an ongoing construction proje ct. How large (in millions of Shillings) will the capital budget be? Question no. Flotation costs for a single debt issue would be 1. what is its expected dividend payout ratio? Question no.45. Ignoring time value effects d ue to timing of the cash flows. If the firm follows a residual dividend policy and has no other projects. 500 million. 8 million of new capital during each of the next three years. The firm's capital structure is 40 percent debt and 60 percent equity.200. 40% 8%. 1 A 15-year zero coupon bond has a yield to maturity of 8 percent and a maturity value of shs.residual dividend policy and maintains the same capital structure. and will be sold at a price of shs. 1. The firm needs shs. One million shares of common stock are outstanding. The following facts apply to your company: Target capital structure EBIT: Assets Tax rate Cost of new and old debt: 50% debt. For the next year. 2. 50% equity shs.000.000. matures in 2 years. 1.000. the firm expects to fund one large positive NPV project costing shs. The firm¶s capital structure consists of 40 percent debt and 60 percent equity. the payout ratio is 60 percent. 5. The firm has a choice of issuing new debt and equity each year as the funds are needed.6 percent of the gross debt proceeds. and the company pays a 10 percent rate on its shs. 200 million. or issuing the debt now and the equity later. expects EBIT of shs. The firm's marginal tax rate is 40 percent. 9. What is the amount of tax that an investor in the 30 percent tax bracket would pay during the first year of owning the bond? Question no.000. what will its dividend payout ratio be? Question no. Based on the residual dividend policy. The bond has a par value of shs. and it will fund this project in accordance with its target capital structure.000 for the current year. and its marginal tax rate is 40 percent. . The cost of equity is 14 percent. S. What is the annual after-tax cost of debt to the company on this issue? Question no. 7.000. 1. S Bakhres & Company is planning a zero coupon bond issue.

000 par value quarterly payment bonds would sell at shs. 55 every six month s. a subsidiary of the Postal Service. and the average age of inventory is 72 days. For the Cook County Company. How low would the yield to maturity on the new bonds have to be. what is the interest tax shield each year? c) A firm has a WACC of 16%.000 shares of stock outstanding with a market price of shs.¶s stock? Question no. what is the "breakeven rate"?) Question no. 795. If the bonds are called.Question no.000 and a coupon rate of 12%. must decide whether to issue zero coupon bonds or quarterly payment bonds to fund construction of new facilities. have a 10 percent annual coupon rate. what is the length of the firm¶s cash conversion cycle? Question no. What is the firm¶s debt-to-equity ratio? Ignore taxes. 15 per share.060. At what price would the zero coupon bonds with a maturity of 10 years have to sell to earn the same effective annual rate as the quarterly payment bonds? Question no. what is the present value of the interest tax shield? b) A firm has 10. Each bond is now eligible to be called at a call price of shs. 5. Lady and Bros. 45 per bond. Question no. 1 .000 and a coupon payment of shs. If the firm is subject to a 40% tax rate and the appropriate discount rate is 10%. has 12 percent semiannual bonds outstanding which mature in 10 years. a cost of debt of 10% and a cost of equity of 22%. 15 A firm with no debt has 200. 1. 1. 155. The coupon rate would be 8% and the firm¶s tax rate is 34%. in order for it to be profitable to call the bonds today? (That is.000 bonds outstanding. The firm is considering adding shs. has 31. what is the dividend per share on BDJ Inc. The 1. seventeen 51 of 55  1st Draft to be improved .000 in debt to its capital structure. Assuming a 365-day year. 12 TTCL.000 shares outstanding valued at shs. 14.000 and the retention ratio is 80%. If the corporate tax rate is 34%. 16 BDJ Ltd Inc. each with a face value of shs. If net income for the year is shs. What would the firm be worth after adding the debt? a) Suppose a firm issues perpetual debt with a face value of shs. the company must replace the bonds with new 10-year bonds.54. Its cost of equity is 12%.000. The flotation cost of issuing new bonds is estimated to be shs. 1. the average age of accounts payable is 45 days. the average age of accounts receivable is 60 days. 20 each. and mature in ten years.

75. taxes or other market imperfections. which is financed with 100% equity. What will the market price of a share of Alex¶s stock be after the dividend? c) Assume the firm pays the shs. what is your total wealth? d) Assume the firm uses the shs.10 y Expected average annual growth rate of dividends 7% 52 of 55 1st Draft to be improved . 475. 25. 25. What will the firm¶s earnings per share be after the dividend? b) Assume the firm pays the shs.000(market value).150. what dividend will be paid? Question no. The firm has cash of shs. Total earnings for the most recent year are shs. a) Assume the firm pays the shs.000.000 excess cash to buy back stock at shs.000 and the firm needs shs.20 y Current annual gross dividend per share shs.000 shares of stock outstanding. has a target debt/equity ratio of . What will the firm¶s earnings per share be after the repurchase? e) Assume the firm uses the shs. 0. 1. 25. 25. 25. Inc.000 or to repurchase stock in the amount of shs.000 excess cash out in the form of a cash dividend.000 shares before the dividend was paid and that this was your total wealth. with a market price of shs. 25. 25. 850. If the company follows a residual dividend policy. including the evaluation of capital investment proposals is the cost o capital: required: explain in simple terms what is meant by the cost of equity capital for a particular company b) Calculate the cost of equity capital for X ltd from the data give below using two alternative methods y A dividend growth model y The capital asset pricing model Data for X Ltd y Current price per share on the stock exchange shs. 25. What will the market price of a share of Alex¶s stock be after the share repurchase? Question 1 a) It is commonly accepted that a crucial factor in the financial decisions of a company. 25. 5 per share. 5 per share. 5 per share. For each of the following 6 questio ns.000 in excess of what is necessary to fund i ts positive NPV projects. The firm has other assets worth shs.000 excess cash out in the form of a cash dividend. The firm is considering using the cash to pay an extra dividend of shs.000 for new investments. What will the firm¶s P/E ratio be after the share repurchase? f) Assume the firm uses the shs. 1. Inc.000 excess cash to buy back stock at shs. 17 Consider the firm. 5 per share.000 excess cash out in the form of a cash dividend.000. The firm has 100. 50.Lucky Mike¶s. assume that there are no transaction costs. Immediately after the dividend is paid. After-tax earnings for 1996 were shs. Also assume you owned 1. Alex.000 excess cash to buy back stock at shs.

000 150. The company¶s beta is 1. 48. During the year. 19. the total market value of BBA Company was shs.490. !!! ! !!! !! Shs 200.000 50. The weighted average cost of capital II. On January 1st. Your fist assignment is to study the capital structure of the company in order to advise the company¶s management about the cost of capital that the company should use.21. and have a current market value of shs. 30 million in new projects.000 5 . the shares are currently selling a shs. O/ shares at 1/= @ Retained profit Creditors 12% Debentures Total Further information: The debentures are repayable in 1995.02. the company plans to raise and invest shs. Required: to explain briefly what you understand by: a) Capital structure. 2. b) Why do public utility companies usually have capital structures that are different form those of retail firms? c) How might increasingly volatile inflation rates and interest rates affect optimal capital structure for corporation? Question no. optimal capital structure.3 b) Discuss the usefulness and the limitation of the capital asserts pricing model (CAPM) for capital investment decisions Question no 2 Assume that you have graduated as a CPA holder and have just reports to work for a company as financial officer. !!! ! # .5% with the return on the market being 15%.5 and its is expected that company will grow at a rate of 5%. shown 53 of 55 1st Draft to be improved " " Total 5 .000 shs 200.000 50. targeted capital structure.000 50. 19 a) Using: I. The firm¶s present value capital structure. The dividend for the current year was shs.5 8% 12% Company A Fixed assets Current assets 2 .65. The capital asset pricing model Calculate the cost of capital for the following company 0. 60 million. Your boss has developed the following questions which you must answer to explain a number of issues.y Beta coefficient for X Ltd shares y Expected rate of return on risk free securities y Expected return on the market portfolio Question no. The risk free rate is currently 8.

22 A firm needs shs.185 Tax rate 33% of earnings a) What are earnings if the owners put up the shs.200 Expenses shs. Common stock currently selling at shs. what are the profits received by the owner? c) What is the return on the owners' investment in each case? Why do the returns differ? d) If expenses rise to shs. 30/= a share can be sold to net the company shs.40 of the initial at 10%.000 30.000. 1.2 Given the following schedules: Debt/Assets 0% 10 20 30 40 50 60 54 of 55 $ Cost of Debt 7% 7 7 8 8 10 10 Cost of Equity 14% 14 14 14 16 18 20 1st Draft to be improved .100? b) If the firm borrows shs.2/30 =4%) retained profit for the year are estimated to be shs. Assume that there is n ot short term debt. 1.000 60. what will be the returns in each case? e) In which case did the returns decline more? f) What generalization can you draw form the above? Question no.000. Shs 30.000.000 Debt Common stock equity Total New bonds will have an 8% coupon rate and they will be sold at par.194.below is considered to be optimal. how much of the new investment must be financed by common equity? b) How much of the needed new investment funds must be generated internally? Externally? c) Calculate the firm¶s weighted average cost of capital Question no. Stockholders¶ required rate of return is estimated to be 12% consisting of a dividend yield of 4% and an expected constant growth rate of 8% (the next dividend is shs. 3 million ( the marginal corporate tax rate is 40%) Required: a) To maintain the present capital structure.2 so shs. 27/= a share.100 to start and expects: Sales shs.

000 units of output at shs.2.1. The variable costs of production are shs.) a) What is the operating income (EBIT) for both firms? b) What are the earnings after interest? c) If sales increase by 10 percent to 11. 000.5. 24 A firm has three investment opportunities.000 in debt (with a 10 percent rate of interest) and shs.a) What is firm's cost of capital at the various combinations of debt and equity? b) What is the firm's optimal capital structure? Construct a balance sheet showing that combination of debt and equity financing.000 in equity. d) Why are the percentage changes different? 55 of 55 1st Draft to be improved .5. by what percentage will each firm¶s earnings after interest income? To answer the question. Question no. which investment(s) should the firm make? b) What is the internal rate of return of investment A? The internal rate of return of investment B is 10.000 units.25 Firm A had shs. but these assets are financed by shs. The cash inflow of each investment is as follows: Cash Inflow Year 1 2 3 4 A B C 300 300 300 300 500 400 200 100 100 200 400 500 a) If the net present value method is used.000 in assets entirely financed with equity. Which investment(s) should the firm make? c) What is the payback period for each investment? Question no. Firm B also has shs. 000.15% for investment C.10. and the firm's cost of capital is 10 percent. 10.000.1. assume no income tax. Each costs shs.12.50 per unit.22% and 6. and fixed production costs are shs. (To ease the calculation. determine the earnings after taxed and compute the percentage increase in these earnings from the answers you derived in part b. Both firms sell 10.