Financial Management

Chapter 3 – Financing decisions,

capital structure and cost of capital
 Topics to be covered

• Sources of finance

• Capital structure

• Theories of capital structure

• Lease financing
 Sources of capital
• Ordinary shares (common stock)
• Hybrid securities
– Preference shares (preferred stock)
– Warrants
– Convertible bonds

• Loan capital
– Bank loans
– Corporate bonds
 Ordinary shares (common stock)
• Dividends are only paid if profits are made and only after
other claimants have been paid e.g. lenders and
preference shareholders

• A high rate of return is required/high risk for the investors

• Provide voting rights - the appointment of new directors

• Preemitive right

• No tax benefit, unlike borrowing

 Preference shares (preferred stock)
• Lower risk than ordinary shares – fixed dividend

• Payment before ordinary shareholders in a liquidation situation;

• No voting rights: Holders of preferred stock typically are not

entitled to vote at all.

• They are hybrid securities with some property of debt and some

property of equity;

• Cumulative Vs Non-Cumulative Preference Shares:

• In cumulative PS, all past suspended payments must be made in

full before common stockholders can receive anything at all.

 Loan capital
• Financial instruments that pay a certain rate of interest until the
maturity date of the loan and then return the principal;

• Bank loans or corporate bonds;

• Interest on debt is allowed against tax;

• Seniority of debt:

– Seniority indicates preference in position over other lenders.

– Some debt is subordinated.

– In the event of default, holders of subordinated debt must give

preference to other specified creditors who are paid first.
 Warrants
• A warrant is a certificate entitling the holder to buy a
specific amount of shares at a specific price (the exercise
price) for a given period.

• If the price of the share rises above the warrant's

exercise price, then the investor can buy the security at
the warrant's exercise price and resell it for a profit.

• Otherwise, the warrant will simply expire or remain

unused.
 Convertible bonds
• A convertible bond is a bond that gives the holder the right to

"convert" or exchange the par amount of the bond for ordinary

shares of the issuer at some fixed ratio during a particular period.

• As bonds, they provide a coupon payment and are legally debt

securities, which rank prior to equity securities in a default situation.

• Their value, like all bonds, depends on the level of prevailing

interest rates and the credit quality of the issuer.

• Their conversion feature also gives them features of equity securities.

 The Cost of Capital

Expected Return

Risk premium
Risk-free rate
Time value of money
_________________________________________________________
_____
Treasury Corporate Preference Hybrid
Risk
Ordinary
Bonds Bonds Shares Securities Shares
Flotation Costs – cost of issuing securities
to the general public
• Accounting

• Legal

• Printing (prospectus)

• Underwriting (investment banker)

• Filing Fees (SEC)

 Cost of Debt
The Cost of Debt
• Required rate of return for creditors
• e.g. Suppose that a company issues bonds with a before
tax cost of 10%.
• Since interest payments are tax deductible, the true cost
of the debt is the After Tax cost (ATkd = kd(1 – T), where T
is tax rate)
• If the company’s tax rate is 40%, the after tax cost of debt
AT kd = 10%(1-.4) = 6%
 The Cost of Preferred Cost
shares
Preferred Stock

– Cost to raise a dollar of preferred stock.

Dividend (Dp)
Required rate kp =
Market Price (PP) - F

 Dp = preferred stock dividend

 Pp = Market price per share

 F = flotation costs per share

 Flotation costs reduce the amount of money you

get when you sell preferred stock

 Cost of Preferred Stock
• Example: You can issue preferred stock with a market price
of $45, and flotation costs of $3 per share, for a net price of
$42 and if the preferred stock pays a $5 dividend,

• The cost of preferred stock:

$5.00 11.9%
$42.00
 Compute Cost of Common Equity

Equity Financing
• Two Types of Common Equity Financing

– Retained Earnings (internal common equity)

– Issuing new shares of common stock (external

common equity)
 Compute Cost of Common Equity
Equity Financing
• Cost of Common Equity (Retained Earnings)
– Management should retain earnings only if they earn as
much as stockholder’s next best investment opportunity of
the same risk.
– Cost of Common Equity = opportunity cost of common
stockholders’ funds.
– Two methods to determine
• Dividend Growth Model
• Capital Asset Pricing Model
 Compute Cost of Common Equity
Equity Financing
• Cost of Common Equity (Retained Earnings)
• Dividend Growth Model

D1
kS = P0
+ g

Ks = cost of internal common equity

D1 = the next dividend to be paid
Po = the current market price of the stock
g = the projected rate of growth of the company
 Compute Cost of Common Equity
Equity Financing
• Cost of Internal Common Equity

– Dividend Growth Model

kS = D1 + g
Example: P0
The market price (Po) of a share of common stock is $60.
The prior dividend paid (D0) was $3, and the expected
growth rate (g) is 10%.
 If you are given D0, you must calculate D1
 D1 = D0 (1 + g)
 D1 = 3.00 (1.10) = 3.30
 Compute Cost of Common Equity
Equity Financing
• Cost of Internal Common Equity
– Dividend Growth Model

D1
kS = + g
P0
Example:

The market price of a share of common stock is $60. The prior

dividend (D0) is $3, and the expected growth rate is 10%.
(D1 = 3.00 x 1.10 = 3.30)

3.30 + .10 =.155 = 15.5%

kS =
60
 Compute Cost of Common Equity
Equity Financing
• Cost of New Common Stock
– Must adjust the Dividend Growth Model equation for
flotation (F) costs of the new common shares.
D1
kn = P - F + g
0

Kn = cost of sale of new common stock

D1 is the next dividend to be paid
Po is the current market price of shares outstanding
F is the flotation cost
G is the rate of growth
 Equity Financing
Example:

If additional shares are issued, floatation costs will be 12%

of price per share. D0 = $3.00 and estimated growth is
10%, Price is $60 as before. Flotation cost = $60 x .12 =
$7.20.

(Po – F = $60.00 – 7.20 = $52.80)

(D1 = 3.00 x 1.10 = 3.30)

3.30
kn = 52.80 + .10 = .1625 = 16.25%
Weighted Average Cost of Capital
• ABC Corporation estimates the following costs for each
component in its capital structure:

Source of Capital Cost

Bonds (after tax) kdt = 6.0%

Preferred Stock kp = 11.9%
Common Stock
Retained Earnings ks = 15.5%
New Shares kn = 16.25%

ABC’s tax rate is 40%

 Weighted Average Cost of Capital
• If using retained earnings (Internal Equity) to finance the
equity portion:
WACC = (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

WACC = weighted average cost of capital

WT = the weight, or percentage of each element of capital

(% of debt, preferred and common stock to total assets)

ATkd = after tax cost of debt

Kp = Cost of preferred stock

Ks = Cost of equity (Internal – retained earnings)

 Weighted Average Cost of Capital
• If using retained earnings (internal equity) to finance the
common equity portion :

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

• Assume that ABC’s desired capital structure is 40%

debt, 10% preferred and 50% common equity.
 Weighted Average Cost of Capital
• If using retained earnings (Internal Equity) to finance the
equity portion:
WACC = (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

• Assume that ABC’s desired capital Structure is 40%

debt, 10% preferred and 50% common equity.
WACC =
Cost of Debt .40 x 6.0% = 2.40%
+ Cost of Preferred .10 x 11.9% = 1.19%
+ Cost of Int. Equity .50 x 15.5% = 7.75%
1.00 = 11.34%
 Weighted Average Cost of Capital
• If using new common stock (External Equity) to finance the
common stock portion:

WACC = (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

• Then we must use the cost of stock adjusted for the
Flotation costs
WACC =
Cost of Debt .40 x 6.0% = 2.40%
+ Cost of Pref .10 x 11.9% = 1.19%
+ Cost of Ext. Eq.. .50 x 16.25%= 8.13%
= 11.72%
 Marginal Cost of Capital
• ABC’s weighted average cost will change if one
component cost of capital changes.

• This may occur when a firm raises a particularly large

amount of capital such that investors think that the
firm is riskier.

• The WACC of the next dollar of capital raised is called

the marginal cost of capital (MCC).
 What is “Capital Structure”?
• Definition
The capital structure of a firm is the mix of different
securities issued by the firm to finance its operations.
Securities
– Bonds, bank loans
– Ordinary shares (common stock), Preference shares (preferred
stock)
– Hybrids, eg warrants, convertible bonds
 What is “Capital Structure”?

Balance Sheet
Current Current
Assets Liabilities

Debt
Fixed Preference Financial
Assets shares
Structure
Ordinary
shares
 What is “Capital Structure”?

Balance Sheet
Current Current
Assets Liabilities

Debt
Fixed Preference
Assets shares

Capital
Ordinary Structure
shares
 Why should we care about capital
structure?
• By altering capital structure firms have the
opportunity to change their cost of capital and –
therefore – the market value of the firm
 What is an optimal capital structure?
• An optimal capital structure is one that minimizes the firm’s cost
of capital and thus maximizes firm value

• Cost of Capital:

– Each source of financing has a different cost

– In analyzing capital structure we look at the Weighted

Average Cost of Capital

– Capital structure affects the WACC

 Capital Structure Theories
• MM theory

– Zero taxes

– Corporate taxes

– Corporate and personal taxes

• Trade-off theory

• Signaling theory

• Pecking order

• Windows of opportunity
Modigliani and Miller Theory
 Modigliani-Miller (MM) Theory:
Zero Taxes
Firm U Firm L
EBIT $3,000 $3,000
Interest 0 1,200
NI $3,000 $1,800

CF to shareholder $3,000 $1,800

CF to debtholder 0 $1,200
Total CF $3,000 $3,000

Notice that the total CF are identical for both firms.

 MM (1958) Assumptions

1. No brokerage costs
2. No taxes
3. No bankruptcy costs
4. Investors can borrow and lend at the same
rate as corporations
5. All investors have the same information
6. EBIT is not affected by the use of debt

35
 MM Results: Zero Taxes
• MM prove that if the total CF to investors of
Firm U and Firm L are equal, then arbitrage is
possible unless the total values of Firm U and
Firm L are equal:

VL = VU

• Therefore, capital structure is irrelevant.

➢ No taxes, corresponding to the original M&M (1958) model.
In this case, how the pie—representing the value of a
firm’s cash flows from operations—is divided between debt and equity
does not affect the size of the pie, and thus capital
structure is irrelevant.
 MM Theory: Corporate Taxes
• Corporate tax laws allow interest to be deducted, which
reduces taxes paid by levered firms.

• Therefore, more CF goes to investors and less to taxes

when leverage is used.

• In other words, the debt “shields” some of the firm’s CF

from taxes.
 MM Result: Corporate Taxes
• MM show that the total CF to Firm L’s investors is equal to the
total CF to Firm U’s investor plus an additional amount due to
interest deductibility:

– CFL = CFU + rdDT.

• What is value of these cash flows?

– Value of CFU = VU

– MM show that the value of rdDT = TD

– Therefore, VL = VU + TD.
• If T=40%, then every dollar of debt adds 40 cents of extra value to firm.
 MM Result: Corporate Taxes
Example:

• Data
– EBIT = 25 million; Tax rate = 35%; Debt = $75 million;
Cost of debt = 9%; Unlevered cost of capital = 12%

• VU = 25(1-.35) / .12 = $135.42 million

• VL = 135.42 + 75(.35) = $161.67 million

• E = 161.67 – 75 = $86.67 million

MM relationship between value and debt
with corporate taxes
Value of Firm, V

VL
TD
VU

Debt
0
Under MM with corporate taxes, the firm’s value increases continuously
as more and more debt is used.
 MM relationship between capital costs and leverage
when corporate taxes are considered

Cost of
Capital (%)
rs

WACC
rd(1 - T)
Debt/Value
0 20 40 60 80 100 Ratio (%)
 Miller’s Theory: Corporate and
Personal Taxes
• Personal taxes lessen the advantage of corporate debt:

– Corporate taxes favor debt financing since

corporations can deduct interest expenses.

– Personal taxes favor equity financing, since no gain

is reported until stock is sold, and long-term gains
are taxed at a lower rate.
 Miller’s Model with Corporate
and Personal Taxes

VL = VU + 1− (1 - Tc)(1 - Ts) D
(1 - Td)

Tc = corporate tax rate.

Td = personal tax rate on debt income.
Ts = personal tax rate on stock income.
 Miller’s Model with Corporate
and Personal Taxes
Tc = 40%, Td = 30%, and Ts = 12%.
VL = VU + 1− (1 - 0.40)(1 - 0.12) D
(1 - 0.30)
= VU + (1 - 0.75)D
= VU + 0.25D.

Value rises with debt; each $1 increase in debt raises L’s

value by $0.25.
 Conclusions with Personal Taxes
• Use of debt financing remains advantageous, but benefits are
less than under only corporate taxes.

• Firms should still use 100% debt.

• Note: However, Miller argued that in equilibrium, the tax rates

of marginal investors would adjust until there was no advantage
to debt.
– Modigliani, F. and M.H. Miller (1958). “The Costs of Capital, Corporate Finance,
and the Theory of Investment.” American Economic Review 48 (June): 261-297.

• Some other studies find a contradictory result.

– Chowdhury, Chowdhury (2010) Impact of capital structure on firm’s value:
Evidence from Bangladesh, Business and Economic Horizons 3(3) 111-122
 Trade-off Theory
• MM theory ignores bankruptcy (financial distress) costs, which
increase as more leverage is used.

• At low leverage levels, tax benefits outweigh bankruptcy costs.

• At high levels, bankruptcy costs outweigh tax benefits.

• An optimal capital structure exists that balances these costs

and benefits.

– Graham, J. R., and C. R. Harvey, 2001, The theory and

practice of corporate finance: Evidence from the field,
Journal of Financial Economics, 60, 187-243.
 Tax Shield vs. Cost of Financial
Distress
Tax Shield
Value of Firm, V

VL
VU

0 Debt

Distress Costs
 Signaling Theory
• MM assumed that investors and managers have the same
information.

• But, managers often have better information. Thus, they would:

– Sell stock if stock is overvalued.

– Sell bonds if stock is undervalued.

• Investors understand this, so view new stock sales as a negative

signal.

• Implications for managers?

– Ross, Stephen A., 1977. “The determination of financial structure: The incentive
signaling approach”, Bell Journal of Economics 8, 23-40.
 Pecking Order Theory
• Firms use internally generated funds first (1):
– No flotation costs
– No negative signals

• If more funds are needed, firms then issue debt (2)

– Lower flotation costs than equity
– No negative signals

• If more funds are still needed, firms then issue equity (3)

Myers, Stewart C., and Nicolas S. Majluf, 1984, “Corporate financing and investment decisions when
firms have information that investors do not have”, Journal of Financial Economics 13,187-221.
50
 Pecking Order Theory

INTERNAL EXTERNAL
DEBT 2
EQUITY 1 3

51
 Windows of Opportunity
• Managers try to “time the market” when issuing securities.

• They issue equity when the market is “high” and after big
stock price run ups.

• They issue debt when the stock market is “low” and when
interest rates are “low.”

• They issue short-term debt when the term structure is

upward sloping and long-term debt when it is relatively flat.

– Baker, Malcolm and Jeffrey Wurgler, 2002, “Market timing and capital
structure”, Journal of Finance 57, 1-32.
Determinants of Capital Structure
Several factors affect the capital structure of the firm. The
most common ones are described below:

1. Sales stability. A firm whose sales are relatively stable can

safely take on more debt and incur higher fixed charges than
a company with unstable sales.

2. Asset structure. Firms whose assets are suitable as security for

loans tend to use debt rather heavily. General-purpose assets
that can be used by many businesses make good collateral,
whereas special-purpose assets do not.
3. Taxes. Interest is a deductible expense, and
deductions are most valuable to firms with high tax
rates. Therefore, the higher a firm’s tax rate, the
greater the advantage of debt.
4. Financial flexibility. Financial flexibility means
maintaining adequate reserve borrowing capacity. If
a firm has adequate reserve borrowing capacity, it
opt for debt financing than equity financing.
5. Managerial conservatism or aggressiveness.
1) Explain the M & M Theory?
2) What is the Signaling theory concept?
3) According to the pecking order theory, if additional
external financing is required, what type of securities
should a firm issue first? Last?
4) Explain why, according to the pecking order theory, firms
prefer internal financing to external financing.
5) What are the determinants of a firm’s capital structure?
 Leasing
• The Basics
– Leasing refers to acquiring use of an asset by agreeing to
make a series of periodic tax deductible payments.
– A lease is a contractual agreement between a lessee and
lessor.
– The agreement establishes that the lessee has the right to
use an asset and in return must make periodic payments to
the lessor.
– The lessor is either the asset’s manufacturer or an
independent leasing company.
Cont’d…
 Reasons to Consider Leasing (valid)

• May be lower interest rate

• Way to avoid risk of technological change

• Way to avoid transactions costs associated with buying

and selling

• Way to avoid restrictions (covenants) of debt financing

• Maintenance costs may be included

 Basic Types of Leases

• The two basic types of leases available to a

business are operating leases and financial
leases.

• Accountants also use the term capital

leases to refer to financial leases.
 Operating Leases
• Operating leases are usually not fully amortized:

➢This means that the payments required under the

terms of the lease are not enough to recover the full
cost of the asset for the lessor.

➢This occurs because the term, or life, of the operating

lease is usually less than the economic life of the
asset.

➢Thus, the lessor must expect to recover the costs of

the asset by renewing the lease or by selling the
asset for its residual value.
 Cont’d…
• Usually require the lessor to maintain and insure the
asset.

• Lessee enjoys a cancellation option. This option gives

the lessee the right to cancel the lease contract before
the expiration date.
 Capital/Financial Lease
• Financial leases are the exact opposite of operating
leases, as is seen from their important characteristics:

1) Financial leases are fully amortized.

2) Financial leases do not provide for maintenance or
service by the lessor.
3) The lessee usually has a right to renew the lease on
expiration.
4) Generally, financial leases cannot be canceled.

• Two special types of financial leases are the sale and

leaseback arrangement and the leveraged lease
arrangement.
 Cont’d…
• A lease must be capitalized if any one of the following is
met:
– The present value of the lease payments is at least 90-
percent of the fair market value of the asset at the start of
the lease.
– The lease transfers ownership of the property to the lessee
by the end of the term of the lease.
– The lease term is 75-percent or more of the estimated
economic life of the asset.
– The lessee can buy the asset at a bargain price at expiry.
 Sale and Lease-Back
• A particular type of financial lease.

• Occurs when a company sells an asset it already owns to

another firm and immediately leases it from them.

• Two sets of cash flows occur:

– The lessee receives cash today from the sale.

– The lessee agrees to make periodic lease payments,

thereby retaining the use of the asset.
 Leveraged Leases
• A three-sided arrangement between the lessee, the
lessor, and lenders:

– The lessor owns the asset and for a fee allows the
lessee to use the asset.

– The lessor borrows to partially finance the asset.

– The lenders typically use a nonrecourse loan. This

means that the lessor is not obligated to the lender
in case of a default by the lessee.
 The Cash Flows of Leasing
Consider a firm that wishes to acquire a delivery truck,
Lessee Co.:
– The truck is expected to reduce costs by $4,500 per year.

– The truck costs $25,000 and has a useful life of five years.

– If the firm buys the truck, they will depreciate it straight-line

to zero.

– They can lease it for five years from a Leasing Co. with an
annual lease payment of $6,250.
 The Cash Flows of Leasing - Lessee
• Cash Flows: Buy
Year 0 Years 1-5
Cost of truck –$25,000
After-tax savings (34%) 4,500×(1-.34) = $2,970
Depreciation Tax Shield _ 5,000×(.34) = $1,700
–$25,000 $4,670
• Cash Flows: Lease
Year 0 Years 1-5
Lease Payments –6,250×(1-.34) = –$4,125
After-tax savings 4,500×(1-.34) = $2,970
–$1,155
 The Cash Flows of Leasing - Lessee
• Cash Flows: Leasing Instead of Buying
Year 0 Years 1-5
$25,000 –$1,155 – $4,670 = –$5,825
• Cash Flows: Buying Instead of Leasing
Year 0 Years 1-5
–$25,000 $4,670 – (-$1,155) = $5,825
• However we wish to conceptualize this, we need to have
an interest rate at which to discount the future cash flows.

• That rate is the after-tax rate on the firm’s secured debt –

the after-tax cost of financing the purchase
 NPV Analysis of the Lease-vs.-Buy Decision
• There is a simple method for evaluating leases: discount all
cash flows at the after-tax interest rate on secured debt
issued by the lessee. Suppose that rate is 5-percent.
NPV - Leasing Instead of Buying
Year 0 Years 1-5
$25,000 –$1,155 – $4,670 = -$5,825
5
$5,825
NPV = $25,000 −  t
= −$219.20
t =1 (1.05)

NPV Buying Instead of Leasing

Year 0 Years 1-5
-$25,000 $4,670 – (-$1,155) = $5,825
5
$5,825
NPV = −$25,000 +  t
= $219.20
t =1 (1.05)
Debt Displacement and Lease Valuation
• Considering the issues of debt displacement allows
for a more intuitive understanding of the lease
versus buy decision.
• Leases displace debt - this is a hidden cost of leasing.
If a firm leases, it will not use as much regular debt
as it would otherwise.
– The interest tax shield will be lost.
 Does Leasing Ever Pay: The Base Case
• In the above example, the Lessee Co. chose to buy, because
the NPV of leasing was a negative $219.20

• It is the opposite of the NPV that the Lessor Co. would have:
• Cash Flows: Lessor Co
Year 0 Years 1-5
Cost of Truck –$25,000
Depreciation Tax Shield 5,000×(.34) = $1,700
Lease Payments 6,250×(1-.34) = $4,125
–$25,000 $5,825
5
$5,825
NPV = −$25,000 +  t
= $219.20
t =1 (1.05)
• The XYZ Co. makes a pipe-boring machine that can be purchased for
$10,000. ABC Co. has determined that it needs a new machine, and the
XYZ model will save ABC $6,000 per year in reduced electricity bills for
the next five years.

• ABC has a corporate tax rate of 34 % and assume that five-year straight-
line depreciation is used for the pipe-boring machine, and the machine
will be worthless after five years.

• Friendly Leasing Corporation has offered to lease the same pipe-boring

machine to ABC for $2,500 per year for five years.

• Assume the firm’s cost of debt is 5%.

• Should the firm buy or lease?

• Operating costs are not directly affected by leasing. ABC
will save $3,960 (after taxes) from use of the XYZ machine
regardless of whether the machine is owned or leased.

• If the machine is leased, ABC will save the $10,000 it

would have used to purchase the machine. This saving
shows up as an initial cash inflow of $10,000 in Year 0.

• If ABC leases the pipe-boring machine, it will no longer

own this machine and must give up the depreciation tax
benefits. These lost tax benefits show up as an outflow.

• If ABC chooses to lease the machine, it must pay $2,500

per year for five years. The lease payments are tax
deductible and, as a consequence, generate tax benefits
of $850 (0.34 x $2,500).
The cash flows from leasing relative to
the cash flows from the purchase:
End