Cost of Capital and Capital

Structure
 The Cost of Capital: Issues

§ Key issues:

§ What do we mean by “cost of capital”

§ How can we come up with an

estimate?
 The Cost of Capital: Issues
§ Preliminaries
1. The cost of capital is an opportunity
cost—it depends on where the money
goes, not where does it come from.
2. For now, assume the firm’s capital
structure (mix of debt and equity) is
fixed.
 The Cost of Equity

§From the firm’s perspective, the expected

return is the Cost of Equity Capital:

Ri = RF + βi ( R M - RF )
 The Cost of Equity

§ To estimate a firm’s cost of equity capital,

we need to know three things:
1. The risk-free rate RF
2. The market risk
R M - RF
premium,
3. The company
beta,
Cov ( Ri , RM ) σ i , M
βi = = 2
Var ( RM ) σM
 Using the SML to Estimate the
Risk-Adjusted Discount Rate for
Projects
Good
Project’s
Return

project SML
A

30% B Bad
project
5% C

Firm’s risk (beta)

2.5
Using a well known portfolio theory
principle:

D E
β A = βD + βE
D +E D+E

and, assuming for the moment that

debt is “risk free”
0 D E
βA = βD + βE
D+E D+E
It follows that:

æD+E ö Dö
bE = b A ç ÷ = b A (1 + ÷
è E ø Eø
-
i.e. the value of the equity beta changes
with changes in the D/E ratio because
the “financial risk” of the firm also does.
 The Cost of Debt
§ Cost of debt

1. The cost of debt, rB, is the interest

rate on new borrowing.

2. The cost of debt is observable through:

a. The yield on currently outstanding
debt.
b. The yield on newly-issued similarly-
rated bonds.
 The Cost of Debt

3. The historic cost of debt is not the

best choice to estimate the current
cost of capital - why?
 The Cost of Debt
Example: A firm sold a 20-year, 12% bond
ten years ago. It’s market price today is 86.
Assume there was not a change in the risk
category of the bond since the emission.

What is the discount rate that applies at

present to our debt?
 The Cost of Debt
Example: We sold a 20-year, 12% bond ten
years ago. It’s market price today is 86.

What is the discount rate that applies at

present to our debt?

20 20
CFi 1
86 = å =å (6)
(1 + r ) (1+ r )
i i
i =1 i =1
 The Cost of Debt
Example: We sold a 20-year, 12% bond ten
years ago. It’s market price today is 86.

What is the discount rate that applies at

present to our debt?

20 20
CFi 1
86 = å =å (6)
(1 + r ) (1+ r )
i i
i =1 i =1

The value that makes this equation true is

r=.07, or 14% annualized, NOT 12%.
 The Weighted Average
Cost of Capital
§ Capital structure weights
1.Let: S = the market value of the equity.
B = the market value of the debt.
Then V = S + B, so S/V + B/V = 100%

2.So the firm’s capital structure weights

are S/V and B/V.
 The Weighted Average
Cost of Capital

3. Interest payments on debt are tax-

deductible, so the aftertax cost of debt is the
pretax cost multiplied by (1 - corporate tax
rate).
 The Weighted Average
Cost of Capital

3.Interest payments on debt are tax-

deductible, so the aftertax cost of debt is the
pretax cost multiplied by (1 - corporate tax
rate).
4.Thus, the weighted average cost of capital
is given by:
WACC = (S/V) x rS + (B/V) x rB x (1 - Tc)
Example:
Eastman Chemical’s WACC
§ Eastman Chemical has 80 million shares
of common stock outstanding.
§ The book value per share is $19.10, and
the market price is $62.375.
§ T-bills yield 5%, and the market risk
premium is assumed to be 8.5%.
§ The stock beta is 1.1.
§ The tax rate is 35%.
Example:
Eastman Chemical’s WACC

§ The firm has three debt issues

outstanding:
Coupon Book Value Market Value Yield-to-Maturity
6.375% $499m $521m 5.70%
7.250% $495m $543m 6.50%
7.625% $200m $226m 6.60%
§ Cost of equity (SML approach):

rS = .05 + 1.1 x (.085) = .05 + .0935

= .1435 » 14.4%

§ Cost of debt:
Multiplying the proportion of total debt that
corresponds to each issue by its yield to maturity, the
weighted average cost of debt is equal to 6.2%
§ Capital structure weights:

Market value of equity = 80 million x $62.375

= $4.99 billion

Market value of debt = $521m + $543m + $226m

= $1.29 billion

V = $4.99 billion + $1.29 billion = $6.28 billion

§ Capital structure weights:

B/V = $1.29b/$6.28b = .2054 » 21%

S/V = $4.99b/$6.28b = .7946 » 79%

§ Cost of debt = 6.2%

§ Cost of equity = 14.4%

Weighted Average Cost of Capital
for Eastman Chemical

WACC = (.79 x .144) + (.21 x .062 x .65)

= .1222 » 12.2%
Cost of Capital
and Capital
Structure
 Financial Leverage
and Financial Risk
Terminology:
§Financial Leverage - The substitution of
fixed cost financing for common stock.
§Business Risk - The inherent variability of
a firm’s operating earnings.
§Financial Risk - The risk shareholders
bear for the firm’s use of financial
leverage.
 Effects of Financial
Leverage on ROE

ROE = rA + (rA - i) D / E
Where:
rA = return on assets before financing costs
i = after-tax cost of debt
D = amount of debt in the capital structure
E = amount of equity in the capital structure
 Consequences of Leverage

Hi-Tech Running Shoes needs $5 million

in assets to support sales.
Option A: Issue 500,000 shares @ $10/share
Option B: Issue 250,000 shares @ $10/share;
also issue $2.5 million in debt @ 10%
Expected EBIT = $1,000,000;
EBIT (Low Estimate) = $200,000;
EBIT (High Estimate) $2,000,000
 Consequences of Leverage - An Example

Effect of leverage on Hi-Tech’s Earnings Per Share

States of the World
Bad Mediocre Normal Good
No Leverage
500,000 shares @
$ 10/share
EBIT $200,000 $500,000 $1,000,000 $2,000,000
Less: Interest@ 10% 0 0 0 0
Equity Income $200,000 $500,000 $1,000,000 $2,000,000
Less: Tax @ 50% 100,000 250,000 500,000 1,000,000
Equity income after tax $100,000 $250,000 500,000 $1,000,000
EPS $.20 $.50 $1.00 $2.00
ROE (%) 2 5 10 20
 Consequences of Leverage - An
Example
Effect of leverage on Hi-Tech’s Earnings Per Share
States of the World
Bad Mediocre Normal Good
50 % debt: 250K @ $ 10/share; $2.5 million in debt @10%
EBIT $200,000 $500,000 $1,000,000 $2,000,000
Less: Interest@ 10% 250,000 250,000 250,000 250,000
Equity Income ($50,000) $250,000 $750,000 $1,750,000
Less: Tax @ 50% ($25,000) 125,000 375,000 875,000
Equity income after tax ($25,000) $125,000 $375,000 $875,000
EPS ($.10) $.50 $1.50 $3.50
ROE (%) -1 5 15 35
 EBIT - EPS Indifference Point

[( EBIT - I A )( 1 - tc ) - PA ] [( EBIT - I B )( 1 - tc ) - PB ]
* *
=
NA NB
Where:
EBIT* = EBIT-EPS indifference point
IA,IB = interest expense under plan A and B
PA,PB = preferred stock dividends under plan A and B
tc = corporate tax rate
NA,NB = number of shares outstanding under plan A and B
 Hi-Tech’s EBIT - EPS Indifference
Point

Stock Debt
[(EBIT - 0)(0.50)] [(EBIT - 250,000)(0.50)]
* *
=
500,000 250,000

EBIT = $500,000
*
 Financial Leverage and EPS
.90 Debt
.80
Indiference
Point
.70

.60
EPS

.50 No Debt
.40

.30
500,000 600,000 700,000
EBIT
 Effects of Financial Leverage
on Risk and Return
§When ROA exceeds the after-tax interest
cost of debt, financial leverage increase
both EPS and ROE.

§Financial leverage increase the variability of

EPS and ROE.

§Financial leverage increases the expected

level of EPS and ROE.
 Traditional Approach to Capital
Structure

According to the traditional approach to

capital structure, the prudent use of debt
can lower the firm’s overall cost of capital
and thereby increase its market value.
 Traditional Approach to Capital Structure
- A Graphical View

ke = Cost of
equity capital
Required return

k0 = Weighted
Average Cost
of Capital

kd = Cost of
debt capital

L*
Debt/Total Equity
 Financial Leverage and Financial
Distress
§Financial Distress - A situation where
a firm has difficulty meeting its contractual
obligations.

§Bankruptcy - An extreme form of financial

distress where a firm defaults on its
obligations and is placed under the protection
of the court until a plan to pay creditors is
devised.
 Financial Leverage and Financial
Distress - A Graphical View
PV of interest
tax shield
Market value of the firm

PV costs of
financial distress

Value of firm with

debt financing
Value of firm if
all-equity financed

L* = optimal Debt Ratio

debt ratio
 Probability of Financial Distress

For any given level of debt, the higher the

business risk, the greater will the likelihood of
financial distress be.
 Probability of Financial Distress
Determinants of business risk are:
§ The Firm’s Cost Structure
§ Demand Stability
§ Competition
§ Price Fluctuations
§ Firm Size and Diversification
§ Stage in the Industry Life Cycle
 Capital Structure and Corporate
Strategy
§Debt and depredatory behavior:
Leverage in a firm might influence the
behavior of its competitors.

§If a highly leveraged company becomes

vulnerable to “depredatory” attacks, its
competitors with a more conservative capital
structure may take the opportunity to get rid
of the company and overtake its market share.
 Capital Structure and
Corporate Strategy
§ At least three reasons explain why highly
leveraged companies tend to loose their
market share:
 Capital Structure and
Corporate Strategy
1. When pressed by its financial compromises,
a highly leveraged firm invests too little and
sometimes even sells part of its assets.
2. Uncertainty about its permanence
in the market makes it difficult to attract
customers.
3. Competitors perceive an overleveraged
company like a less dangerous competitor due
to its lesser freedom of action.
 Capital Structure and
Corporate Strategy

§According with Donaldson (1961), the

dynamic process that determines the
capital structure adjusts to the following
principles:
 Capital Structure and
Corporate Strategy

§ Companies prefer to pay for their

investments with retained earnings instead
of external sources.

§ Due to their internal financing preference,

they adjust dividends in order to reflect
their investment needs.
 Capital Structure and
Corporate Strategy
§ However, we know they are reticent to
modify their dividend policy, so retained
earning may as well be greater or lesser
than their investment needs.
 Capital Structure and
Corporate Strategy
§If the company has excess cash, it
will first attempt to pay off its debt
and afterwards to repurchase
stocks.

§If the company doesn’t have enough cash, it

will issue financial securities starting with the
less risky: debt, convertible bonds and
shares as a last resort.
 Dynamic considerations
on Capital Structure

§Existence of conflicts between

shareholders and debt-holders
ØHighly leveraged firms will seldom
issue stock.
ØMost bankruptcy costs will, thus,
gravitate on bond-holders’ shoulders.
 Empirical Evidence on
Capital Structure choice
§Firms in the same industry tend to
select similar capital structures.
§Debt ratios are systematically related
to associated variables like: costs of
bankruptcy and liquidity.
 Empirical Evidence on
Capital Structure choice

§Debt ratios are

negatively related
to historical
profitability, to
the intensity
of R&D expenses
and to the
importance of
publicity and
sales expenses.
 Empirical Evidence on
Capital Structure choice
§Companies in
industries that
produce durable
goods (machinery and
equipment) show
lower levels of
leverage than
companies that
produce non-durable
goods.
 Empirical Evidence on
Capital Structure choice
§Smaller firms utilize approximately
as much long term debt as larger
firms, but more short term debt than
the latter.
 Summary of Empirical Evidence
on Capital Structure Choice

*See Bronars and Deere (1991).