COST OF CAPITAL AND

CAPITAL STRUCTURE
THEORIES
SOUMENDRA ROY
FACULTY MEMBER
INC ASANSOL
 COST OF CAPITAL
 The cost of capital is the rate of return the company
any has to pay to various suppliers of funds in the
company.
 There are two main sources of capital for a company.
Shareholders and lenders usually debentureholders
and financial institutions. The cost of equity and costs
of debt are the rates of return that need to be offered
to these two groups of suppliers of capital in order to
attract funds from them.
 It is used for evaluating investment projects, for
determining the capital structure, for assessing leasing
proposals, for setting the rates that regulated
organisations.
 ELEMENTS OF COST OF CAPITAL

 COST OF EQUITY ( KE )
 COST OF RETAINED EARNINGS ( KR)
 COST OF PREFERRED CAPITAL ( KP)
 COST OF DEBT ( KD)
 COST OF EQUITY
The cost of equity may be defined as the minimum rate
of return that a company must earn on the equity
financed portion of an investment project so that
market price of the shares remain unchanged.
DIVIDEND YIELD METHOD:
As per this method, the cost of capital is defined as the
“ the discount rate that equates the present value of all
expected future dividends per share with the net
proceeds of the sale of a share.”
D1 where KE = cost of equity
KE = ---------- D1 = annual dividend per share
PE PE = ex-dividend market price
per share
DIVIDEND GROWTH METHOD
In this method, an allowance for future growth in
dividend is added to the current dividend yield. It
is recognised that the current market price of a
share reflects expected future dividends. The
dividend growth model is also called as Gordon
dividend growth model.
D1
KE = ---------- + g
PE
 PRICE EARNING METHOD

This method take into consideration the

earnings per share ( EPS ) and the market
price per share.
E where E = current market price

KE = ---------- per share

M M = market price per
share
 COST OF RETAINED EARNINGS
The cost of retained earnings is determined based on
the opportunity rate of earnings of equity shareholders
which is being forgone continuously . If the retained
earnings are distributed to the equity shareholders
attract personal taxation of the individual shareholders
and therefore, the cost of retained earnings is
calculated as follows:
KR = KE ( 1- T ) where KR = cost of retained
earnings
KE = cost of equity capital
T = tax rate of individuals
 COST OF PREFERENCE SHARES
The cost of preference share capital is the rate of
return that must be earned on preference capital rate
of preference investments to keep unchanged the
earnings available to equity shareholders.
COST OF IRREDEEMABLE PREFERENCE SHARES:
The cost of irredeemable preference share capital is
the rate of preference dividend, also called the coupon
rate dividend by net issue proceeds.
Dp where KP = cost of irredeemable preference
KP = -------- Dp = preference dividend
NP NP = net proceeds received from
issue of preference shares after
meeting the issue expenses.
 COST OF REDEEMABLE
PREFERENCE SHARES
The cost of redeemable preference shares is calculated as
follows:
Rv – Sv where KP = cost of redeemable
[ D + ( --------- ) ] preference shares
N D = constant annual
KP = --------------------- dividend payment
Rv + Sv N = years of life to redemption
[ ------------- ] of preference shares
2 Rv =
redeemable value of preference shares at
the
time of maturity
Sv = sale out value of preference
shares less discount and
 COST OF DEBT
The cost of debenture is defined as the discount rate
which equates the net proceeds from the issue of
debentures to the expected cash outflows in the form
of interest and principal repayments.
COST OF PERPETUAL DEBT:
The cost of perpetual debt is calculated by applying
the following formula:
I ( 1 – T ) where KD= cost of debt
KD = ------------- I = annual interest payment
D T= company’s effective
corporate tax rate
D= net proceeds of issue of
debt
 COST OF REDEEMABLE DEBT
The cost of redeemable debt is calculated by applying the
following formula :
Rv – Sv where KD = cost of debt
[ I + ( ----------- )](1 – T) I = annual interest
N payment
KD = ------------------------------ N= term of maturity

Rv + Sv period
-------------- R v = redeemable
2 value of debt
at the time of debt
Sv = sale value less
discount and
flotation expenses
 WEIGHTED AVERAGE COST OF
CAPITAL
Given the cost of specific sources of financing and the scheme of
weighing, the weighted average cost of capital can be readily
calculated by multiplying the specific cost of each source of
financing by its proportion in the capital structure and the
weighted values. In symbols, the weighted average cost of
capital may be expressed as follows:
WACC = we re + wp rp + wd rd ( 1- tc )
where WACC = weighted average cost of
capital
we = proportion of equity; wp = proportion of preference
re = cost of equity ; rp = cost of preference
wd = proportion of debt ; rd = cost of debt
tc = corporate tax rate
 WEIGHTED MARGINAL COST OF
CAPITAL SCHEDULE
A schedule or graph showing the relationship
between additional financing and the weighted
average cost of capital is called the weighted
marginal cost of capital schedule.
DETERMINING THE WEIGHTED MARGINAL
COST OF CAPITAL SCHEDULE:
1) Estimate the cost of each source of financing
for various levels of its use through an
analysis of current market conditions and an
assessment of the expectations of investors
and lenders.
2) Identify the levels of total new financing at
which the cost of the new components would
change, given the capital structure policy of the
firm. These levels, called breaking points, can
be established using the following relationship:
TFj
BPj = -------
wj
3) Calculate the WACC for various ranges of total
financing between the breaking points.
4) Prepare the weighted marginal cost of capital
schedule which reflects the WACC for each
level of total new financing.
 CAPITAL STRUCTURE THEORIES
Capital structure ordinarily implies the proportion of
debt and equity in the total equity in the total capital of
a company. The term ‘structure’ has been associated
with the term ‘capital’.
Capital = Total Assets – Current Liabilities. Further,
capital of a company may be categorised into ‘equity’
and ‘debt’.
 Equity consists of the following:
Equity share capital + Preference share capital
+ Share premium + Free reserves + Surplus profits +
Discretionary provisions for contingency +
Development rebate reserve
 Debt consists of the following:
All borrowings from Government etc. + Term
loans from banks, financial institutions +
Debentures + All deferred payment liabilities
OPTIMAL CAPITAL STRUCTURE:
The optimal capital structure strikes a balance
between these risks and returns and thus
examines the price of the stock.
 ASSUMPTIONS IN CAPITAL
STRUCTURE THEORIES
 The company distributes all its earnings as dividends
to its shareholders and no consideration of dividend
and retention policies.
 The taxation and its effect on cost of capital is ignored.
 Business risk is treated constant at different capital
structures of a company.
 There are no transaction costs and a company can
alter its capital structure without any transaction costs.
 The continuous and perpetual earning of profits to the
expectations of the stockholders.
 FACTORS AFFECTING THE CAPITAL
STRUCTURE
 TAX ADVANTAGE OF DEBT
 INVESTORS ATTITUDE TO RISK AND RETURN
 FINANCING DECISIONS AND FIRM’S RISK
EXPOSURE
 CONTROL OF FIRM
 FLEXIBILITY
 TIMING
 LEGAL PROVISIONS
 PROFITABILITY OF THE COMPANY
 GROWING COMPANIES
NET INCOME APPROACH:
According to this approach, the cost of equity capital
and the cost of debt capital remain unchanged when
the degree of leverage varies.
NET OPERATING INCOME APPROACH:
According to the net operating income approach, the
value of the firm is independent on its capital structure.
It assumes that the weighted average cost of capital is
unchanged irrespective of the level of gearing. The
underlying assumption behind this approach is that the
increase in the employment of debt capital increases
the expected rate of return by the stockholders and
the benefit of using relatively cheaper debt fund is
offset by the loss arising out of the increase in cost of
equity.
 MODIGLIANI AND MILLER APPROACH
According to MM, under competitive conditions
and perfect markets, the choice between equity
financing and borrowing does not affect a firm’s
market value because the individual investor
can alter investment to any mix of debt and
equity.
ASSUMPTIONS OF MM THEORY :
 Perfect capital markets exist where individuals
and companies can borrow unlimited amounts
at the same rate of interest.
 There are no taxes or transaction costs.
 The firm’s investment schedule and cash flows
are assumed constant and perpetual.
 Firm’s exist with the same business or
systematic risk at different levels of gearing.
 The stock markets are perfectly competitive.
 Investors are rational and expect other
investors to behave rationally.
PROPOSITION I :
The market value of any firm is independent of
its capital structure, changing the gearing ratio
cannot have any effect on the company’s
annual cash flow. It is determined by the assets
in which the company has invested and not
how those assets are financed.
PROPOSITION II :
The rate of return by shareholders increases
linearly as the debt / equity ratio is increased
i.e., the cost of equity rises exactly in line with
any increase in gearing to precisely offset any
benefits conferred by the use of apparently
cheap debt.
PROPOSITION III :
MM Theory’s third proposition asserts that the cut-off
rate for new investment will in all cases be average
cost of capital and will be unaffected by the type of
security used to finance the investment.
MM THEORY: ARBITRAGE
The cost of equity will rise by an amount just sufficient
to offset any possible saving or loss. The supply of
debt is determined by the lenders. The optimal level is
simply the maximum amount of debt which lenders are
prepared to subscribe in any given circumstances e.g.,
level of inflation, rate of economic growth, level of
profit etc.. The investors will exercise their own
leverage by mixing their own portfolio with debt and
equity. They call this the arbitrage process.
 CASE STUDY: GATEWAY INC.
HOW DO YOU CALCULATE A
COMPANY’S COST OF CAPITAL
To demonstrate how to calculate a company’s cost of
capital, we will use the Gateway case study.
1) COST OF CAPITAL COMPONENTS:
Gateway draws upon two major sources of capital
from the capital markets: debt and equity.
A) COST OF GATEWAY’S DEBT CAPITAL:
As of the end of 1999, Gateway only had a debt of $
8.488 million. Because this amount is so small, it will
not significantly affect our Weighted Average Cost of
capital calculation.
This document tells us that Gateway has two
components to its total debt of $ 8.488 million
1) REGULAR DEBT : Gateway has $ 8.415 million of “
notes payable with interest rates ranging from 3.9% to
5.5%.” We can calculate
that Gateway’s Notes payable of $ 8.415 million
comprises 99.14% of the company’s total debt of $
8.488 million.
2) CAPITAL LEASES : Gateway also has $ 73,000 in
“capital leases”. A capital lease is a debt- like
agreement in which a firm agrees to pay fixed amount
to someone who leases them land or equipment.
Gateway’s SEC filing tell us that this debt- equivalent
capital lease has a “fixed rate of 6.5%”. We can
calculate that Gateway’s $ 73,000 of capital leases
comprises 0.86% of the company’s total debt of $
8.488 million.
Because there are two kinds of debt with
different interest rates, we have to weight the
different interest rates associated with each
kind of debt by the relevant proportion of debt
that each comprises. In this case, the pre- tax
cost of debt would be equivalent to (4.7% x
99.14%) + (6.5% x .086%) or 4.72%.
We have to adjust for the tax- deductibility of
interest expenses, which lowers the cost of
debt according to the following formula:
After-Tax Cost of Capital = The Yield-to-maturity
on long-term debt x (1- the marginal tax rate).
Given Gateway’s marginal tax rate of 35%, the
company’s after-tax cost of debt equates to
4.72% x (100%-35%) or 3.1%.
Notably, Gateway has both near-zero debt
levels and a near-zero after-tax cost of debt
which means it will virtually no effect on the
company’s weighted average cost of capital.
Here in this case, actual cost of debt is used as
a proxy for its marginal cost of long-term debt. A
company’s marginal cost of long-term debt may
be estimated by summing the risk-free rate and
the “credit spread” that lenders would charge a
company with a specific credit rating.
B) COST OF GATEWAY’S EQUITY CAPITAL:
Cost of Equity Capital = Risk-Free Rate +
( Beta times Market Risk Premium )
 Risk-free rate of 5.85%.
 Beta coefficient of 1.3.
 Equity risk premium of 3.2%.
Using these estimates, Gateway’s cost of equity
capital = 5.85 % + ( 1.3 x 3.2% ) or,10%.
3) WEIGHING THE COMPONENTS:
Finally, we weight the cost of each kind of capital by
the proportion that each kind of capital contributes to
the entire enterprise. This gives us the Weighted
Average Cost of Capital
(WACC), the average cost of each dollar of cash
employed in the business.
Thus, debt contributes virtually 0% of Gateway’s
capital while equity contributes virtually 100%.
Gateway’s weighted average cost of capital is thus
4.72% x 0% + 10% x 100% or 10%.