Cost of Capital and Capital Structure

Lecture 08

1 Lecture 08 Cost of Capital and Capital Structure

 Contents
̶ Cost of Capital
▪ Required Return vs. Cost of Capital.
▪ Cost of Debt and Prefered Stock.
▪ Cost of Equity.
▪ WACC.
̶ Effect of Financial Leverage.
̶ Capital Structure and Cost of Equity Capital.
▪ M&M Propositions.
̶ Optimal Capital Structure.

2 Lecture 08 Cost of Capital and Capital Structure

 Cost of Capital vs. Required Return
̶ They both mean fundamentally the same thing, we use them
interchangeably.
̶ It depends on the risk of investment and on the use of the funds
(not the source).
̶ Financial policy and cost of capital:
▪ The mixture of debt and equity (capital structure) is a managerial variable.
▪ At first, we asumme that it as given (target capital structure).
▪ A company‘s overal cost of capital reflects the required return on the
assets of the firm as a whole.

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 Cost of Debt (1)
̶ It represents a return which is required by lenders on the debt of a
company (bond issue or taking a bank loan).
̶ Before-tax cost of debt vs. after-tax cost of debt.
̶ In case of bonds, the cost of debt is represented by the yield-to-
maturity (YTM).
𝑛 𝐶𝑡 𝐹𝑉
𝑃0 = σ𝑡=1 +
1+𝑌𝑇𝑀 𝑡 1+𝑌𝑇𝑀 𝑛
where P0 is a bond price, Ct is a regular coupon payment, YTM is yield-to-
maturity, FV is a face value of the bond and n is a number of periods that
remain to maturity.
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 Cost of Debt (2)
Example 1:
A company issued a 10year bond with 10% coupon 6 years ago. Bond is
currently selling for 96% of its face value, or 960 EUR. What is cost of debt
of a company if it has no other debts?

Example 2:
A company issues new bond for 20 years, face value is 100 000 EUR, it pays
10% semi-annual coupon. Uppon issuance, the bond was sold for 102 000
EUR. Calculate the cost of debt, if you know that tax rate is 21 %.

5 Lecture 08 Cost of Capital and Capital Structure

 Cost or Preffered Stock
̶ We know that a prererred stock has a fixed dividend paid every
period forever → perpetuity.
𝐷
𝑅𝑝 =
𝑃0
where D is a fixed dividend and P0 is the current price per share of preffered
stock.

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 Cost of Equity
̶ There is NO WAY of directly observing the return which is
required by the firm‘s equity investors.
̶ It has to be estimated.
▪ Dividend discount (growth) model.
▪ CAPM.
▪ Extended CAPM.
▪ Bond yield plus risk premium approach.
▪ Buil-up approach.

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 Cost of Equity – Dividend Discount (Growth)
Model (1)
̶ It is assumed that the dividend will grow at a constant rate.
̶ Growth rates are estimated on the basis of:
▪ Historical growth rates (average for several years is also possible) or
▪ Forecast of future rates (we average multiple estimates).
▪ Sustainable growth rate can also be used.
𝐷1 𝐷1
𝑃0 = → 𝑅𝐸 = +𝑔
𝑅𝐸 −𝑔 𝑃0

where P0 is the share price, D1 is the projected dividend for the next period,
RE is required return on the stock and g is growth rate.

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 Cost of Equity – Dividend Discount (Growth)
Model (2)
̶ Advantages:
▪ Simplicity – easy to understand and to use (! if dividends are paid).
̶ Disadvantages:
▪ A firm has to pay the divided.
▪ And the dividend growths at a constant g.
▪ Steady growth.
▪ Cost of equity is very sensitive to estimated g.
▪ Risk is not explicitly considered.

9 Lecture 08 Cost of Capital and Capital Structure

 Cost of Equity – CAPM (1)
̶ The Capital Asset Pricing Model was developed in 1964 as
̶ a model that allows estimation of a cost of equity.
̶ It accounts for systemic risk (variability in stock returns due to
changes in economic circumstances).
𝐸(𝑅𝑖 ) = 𝑅𝑓 + 𝛽𝑖 𝐸 𝑅𝑚 − 𝑅𝑓
𝐸(𝑅𝑖 ) = 𝑅𝑓 + (𝛽𝑖 𝑥 𝑚𝑎𝑟𝑘𝑒𝑡 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚)
where E(Ri) is expected return or the cost of equity, Rf is risk-free rate, βi is a
sensitivity of stock return (stock i) to changes in the market return and E(Rm) is
expected market return.
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 Cost of Equity – CAPM (2)
̶ Beta coefficient:
▪ It tells us how much of systematic risk an asset has relative to an average
asset.
▪ An average asset has β = 1.
▪ The larger beta, the larger systematic risk.
▪ The higher systematic risk, the greater expected return.

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 Cost of Equity – CAPM (3)
̶ Unlevered beta (asset beta):
▪ It allows us to capture the risk of firm‘s assets.
▪ The effect of financial leverage is eliminated.
▪ It represents the volatility of returns for the firm (only its assets, therefore
„asset beta“) if we do not consider its financial leverage.

𝐸𝑞𝑢𝑖𝑡𝑦 𝑏𝑒𝑡𝑎
𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑏𝑒𝑡𝑎 =
𝑑𝑒𝑏𝑡
1 + 1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒 𝑥
𝑒𝑞𝑢𝑖𝑡𝑦

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 Cost of Equity – CAPM (4)
̶ Levered beta (equity beta):
▪ It compares the volatility of a firm‘s stock retuns to broader market return
and it includes the impact of company‘s leverage.
▪ Betas that are provided on financial platforms, are levered. Analysts are
often interested in risk of firm‘s assets without impact of its funding.

𝐷𝑒𝑏𝑡
𝐿𝑒𝑣𝑒𝑟𝑒𝑑 𝑏𝑒𝑡𝑎 = 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑏𝑒𝑡𝑎 𝑥 1 + 1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒 𝑥( )
𝐸𝑞𝑢𝑖𝑡𝑦

Example: Calculate asset beta for Tesla, Volkswagen, Ford Motor, General
Motor and NIO and comment the results.
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 Cost of Equity – CAPM (5)

WESTERFIELD, Randolph a Jeffrey F. JAFFE. 2005. Corporate finance. Edited by Stephen A. Ross. 7th ed.
Boston: McGraw-Hill, p. 440.

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 Cost of Equity – CAPM (6)
̶ Advantages:
▪ Risk is adjusted.
▪ Steady growth rate is not necessary.
̶ Disadvantages:
▪ Market premium and beta coefficient has to be estimated (in case of poor
estimations, our outcome is poor as well).
▪ Predictions based on past (economic conditions change very quickly).

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 Cost of Equity – Expanded CAPM
̶ It represents an adaptation of the CAPM which accounts for
further risks.

𝐸(𝑅𝑖 ) = 𝑅𝑓 + 𝛽𝑖 𝐸 𝑅𝑚 − 𝑅𝑓 + 𝑆𝑚𝑎𝑙𝑙 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 +

+ 𝐼𝑛𝑑𝑢𝑠𝑡𝑟𝑦 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 + 𝐶𝑜𝑚𝑝𝑎𝑛𝑦 𝑠𝑝𝑒𝑐𝑖𝑓𝑖𝑐 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚
̶ Estimation of company-specific risk is a very subjective element of
the valuation process. A few methodologies were presented by
professionals and they are still checked in the valuation
community.

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 Cost of Equity – Bond Yield Plus Risk
Premium Approach
̶ The cost of equity can also be estimated in the following way.
𝑟𝑒 = 𝑟𝑑 + 𝑟𝑝
where rd is before tax cost of debt and rp represents a risk premium.

̶ Risk premium is a compensantion that is required by

shareholders for the additional risk of equity compared with debt.
▪ Historical spreads between bond yields and stock yields are often used
for estimation.

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 Cost of Equity – Build-up Model
̶ The essence of this approach is to build-up the required rate of
return as a set of premia that are added to risk-free rate.
𝐸(𝑅𝑖) = 𝑅𝑓 + Set of ri𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚s
̶ There are many variations of model based on included factors.

𝐸(𝑅𝑖) = 𝑅𝑓 + 𝐸𝑞𝑢𝑖𝑡𝑦 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 + 𝑆𝑚𝑎𝑙𝑙 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 +

𝐼𝑛𝑑𝑢𝑠𝑡𝑟𝑦 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 + 𝐶𝑜𝑚𝑝𝑎𝑛𝑦 𝑠𝑝𝑒𝑐𝑖𝑓𝑖𝑐 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚

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 Very Useful Data Can Be Found Here:
https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datacurr
ent.html

19 Lecture 08 Cost of Capital and Capital Structure

 Required Rate of Return When Company Is
Private – Estimation Issues (1)
̶ Size premiums.
▪ Are frequently used appraisers when calculating required return.
Estimates are often based on public company data for the smallest market
cap segments, however their premiums can be irrelavant to the valued
company.
̶ Availability of debt and cost of debt.
▪ Compared to public companies, private companies have less access to
debt financing, a private company then relies more on equity financing
(WACC ↑).
▪ Smaller size of a company can lead to higher cost of debt and greater
operating risk.
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 Required Rate of Return When Company Is
Private – Estimation Issues (2)
̶ Discount rate in an acquisition context.
▪ Finance theory theory indicates that the cost of capital should be derived
from the capital structrure and riskiness of cash flows of the target
company. The buyer‘s cost of capital is irrelavant.
̶ Projection risk.
▪ Rate of return should be increased due to managers who have less
experience in forecasting financial performance and due to lower
availability information from private companies (greater uncertainty in
projections).

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 Required Rate of Return When Company Is
Private – Estimation Issues (3)
̶ Stage of lifecycle.
▪ It is not easy to identify in which stage a company is and it is difficult to
estimate the required return in an early stage of development.

22 Lecture 08 Cost of Capital and Capital Structure

 WACC (1)
̶ The goal of capital structure decision is to determine the financial
leverage or capital structure which MAXIMIZES the value of the
firm by MINIMAZING weighted average cost of capital.
𝐷 𝐸
𝑤𝑎𝑐𝑐 = 𝑟𝑑 1 − 𝑡 + 𝑟𝑒
𝑉 𝑉
where D/V and E/V are the proportions of debt and equity in the capital
structure (they represents weights), rd is a before-tax marginal cost of debt
capital, re is a marginal cost of equity capital, t is firm‘s marginal tax rate, D is
the (market) value of outstanding debt, E is the (market) value of oustanding
equity, V is a value of the firm (D+E)
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 WACC (2)
̶ The equity and debt costs and the tax rate are marginal variables.
̶ Thus, the total cost of capital is also marginal variable.
▪ If a company wants to raise additional capital, then we are interested in
what it costs today, past is not relevant.
̶ The use of WACC:
▪ An overal return which has to be earned on the firm‘s assets to maintain
the value.
▪ The required rate of return on firm‘s investment if the risk is same as risk
of existing operations.
▪ Evaluation of a company‘s performance (EVA).
▪ Valuation of a company.

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 Project Cost of Capital – Different Risk (1)
̶ Investment with risk substantially different than overal risk of
a firm:
▪ The use of WACC in this affects the decisions negatively – poor decisions
can be made.
▪ A company can incorrectly accept risky projects and incorrectly reject less
risky projects.
▪ Such decisions will lead to the situation that a company will become
increasingly risky.

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 Project Cost of Capital – Different Risk (2)

WESTERFIELD, Randolph a Jeffrey F. JAFFE. 2005. Corporate finance. Edited by Stephen A.

Ross. 7th ed. Boston: McGraw-Hill, p. 510.

26 Lecture 08 Cost of Capital and Capital Structure

 Cost of Capital in Case of More Business
Lines
̶ In case a company has more divisions (business lines) with
different risk, the overall WACC is not a relevant cost of capital for
all divisions.
̶ Divisional cost of capital should be developed in such a case.

27 Lecture 08 Cost of Capital and Capital Structure

 How to Deal with Project and Divisional
Cost of Capital? (1)
̶ Examination of other investment possibilities outside of the
company should be made (with same risk level).
̶ Pure play approach:
▪ „Pure play“ – a firm which focuses on a sigle line of business.
▪ When estimating an appropriate discount rate, firms which do a business
in same line of business should be taken into account.
̶ Subjective approach:
▪ Subjective adjustments of the firm‘s overall WACC.

28 Lecture 08 Cost of Capital and Capital Structure

 How to Deal with Project and Divisional
Cost of Capital? (2)
Subjective approach:

WESTERFIELD, Randolph a Jeffrey F. JAFFE. 2005. Corporate finance. Edited by Stephen A. Ross. 7th ed. Boston: McGraw-Hill, p. 512.

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 Flotation Costs and WACC
̶ Flotation Costs:
▪ They occur in case a new project is accepted and a firm will issue new
shares or bonds. Costs related to this issuance are flotation costs.
▪ They should be incorporated into project analysis.

𝐸 𝐷
𝑓𝑐 = 𝑥 𝑓𝐸 + 𝑥 𝑓𝐷
𝑉 𝑉

where fc represents a weighted average flotation cost, fe is equity flotation

cost and fd is debt flotations cost, E/V and D/V represent weights in capital
structure.

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 Effect of Financial Leverage
̶ So far we know that capital structure that produces the highest
company value / lowest WACC is the most beneficial to owners.
̶ The use of debt financing can alter substantially the payoffs to
owners.

31 Lecture 08 Cost of Capital and Capital Structure

 Financial Leverage, EPS and ROE (1)
Example: The CFO of a company would like to change the capital structrure of
a company. Current and proposed capital structures are following:

WESTERFIELD, Randolph a Jeffrey F. JAFFE. 2005. Corporate finance. Edited by Stephen

A. Ross. 7th ed. Boston: McGraw-Hill, p. 570.

32 Lecture 08 Cost of Capital and Capital Structure

 Financial Leverage, EPS and ROE (2)

WESTERFIELD, Randolph a Jeffrey F. JAFFE. 2005. Corporate finance. Edited by

Stephen A. Ross. 7th ed. Boston: McGraw-Hill, p. 571.

33 Lecture 08 Cost of Capital and Capital Structure

 Financial Leverage, EPS and ROE (3)

WESTERFIELD, Randolph a Jeffrey F. JAFFE. 2005. Corporate finance.

Edited by Stephen A. Ross. 7th ed. Boston: McGraw-Hill, p. 572.

34 Lecture 08 Cost of Capital and Capital Structure

 Capital Structure and Cost of Equity:
M&M Proposition I. (with No Tax)
̶ The value of the company does not rely on its capital structure.

WESTERFIELD, Randolph a Jeffrey F. JAFFE. 2005. Corporate finance. Edited by Stephen A.

Ross. 7th ed. Boston: McGraw-Hill, p. 575.

35 Lecture 08 Cost of Capital and Capital Structure

 Capital Structure and Cost of Equity:
M&M Proposition II. (with No Tax)
̶ It says that a company‘s cost of equity is represented by a positive
linear function of its capital structure.
̶ We express re from WACC equation.
𝐷
𝑟𝑒 = 𝑤𝑎𝑐𝑐 + 𝑤𝑎𝑐𝑐 − 𝑟𝑑 𝑥
𝐸

re depends on required return on assets of a firm (wacc), cost of

debt and debt equity ratio.

36 Lecture 08 Cost of Capital and Capital Structure

 M&M Propositions I and II. (with No Tax)
̶ WACC remains same.
̶ The change in the capital
structure weights is
compensated by the
change in the cost of
equity.

WESTERFIELD, Randolph a Jeffrey F. JAFFE. 2005. Corporate finance. Edited by Stephen A.

Ross. 7th ed. Boston: McGraw-Hill, p. 576.

37 Lecture 08 Cost of Capital and Capital Structure

 M&M Propositions I and II. with Taxes
̶ When using debt financing, we
have to take into account:
▪ Paid interest is tax deductible.
▪ If a firm does not meet its obligations,
it can fill for a bankruptcy (financial
distress costs = direct and indirect
bankruptcy costs)
̶ The effect of taxes:
▪ Debt financing is very beneficial
(extreme, only debt)
▪ WACC decreases with more debt
financing.

WESTERFIELD, Randolph a Jeffrey F. JAFFE. 2005. Corporate finance.

Edited by Stephen A. Ross. 7th ed. Boston: McGraw-Hill, p. 583.

38 Lecture 08 Cost of Capital and Capital Structure

 Optimal Capital Structure (1)
̶ There is no theory that would capture all drivers of company‘s debt
vs. equity choices.
̶ There are several theories (e.g. static theory) that can be helpful
when determining the optimal capital structure for a company.
̶ Remember that value is created on the left side of the balance
sheet (from assets, operations and growth opportunities).

39 Lecture 08 Cost of Capital and Capital Structure

 Optimal Capital Structure (2)

WESTERFIELD, Randolph a Jeffrey F. JAFFE. 2005. Corporate finance. Edited by Stephen A. Ross. 7th ed.
Boston: McGraw-Hill, p. 588.

40 Lecture 08 Cost of Capital and Capital Structure

 Literature
BREALEY, R. A., S. C. MYERS and F. ALLEN. 2023. Principles of corporate
finance. 14th ed. New York: McGraw-Hill Education, chapter 17.

WESTERFIELD, Randolph a Jeffrey F. JAFFE. 2005. Corporate finance.

Edited by Stephen A. Ross. 7th ed. Boston: McGraw-Hill, chapter 15 and
chapter 17.

2022 CFA Program Curriculum Level II Box Set. Wiley, 1st ed. Book: Equity
and Fixed Income, part: Equity Valuation, chapter: Private Company Valuation.

41 Lecture 08 Cost of Capital and Capital Structure

Thank you for your attention.
Questions? Remarks? Impulses to discussion?

42 Lecture 08 Cost of Capital and Capital Structure