WEEK 6

CAPITAL COST AND CAPITAL

STRUCTURE
 THIS WEEK
1. Recap – the cost of capital
2. The cost of debt
3. The cost of equity
4. The Weighted Average Cost of Capital (WACC)
5. The capital structure question
The traditional view
Modigliani Miller I
Modigliani Miller II
Interaction between business and financing risks
Pecking order theory
1 RECAP – THE COST OF CAPITAL
 THE COST OF CAPITAL

 The cost of capital is the rate of return that the company must pay to
those who provide funds. It reflects the risk that they are taking.
 It can be used as a discount rate in investment appraisal and as a
benchmark for company performance.
 The cost of capital depends on the capital structure of the company
(equity and debt)
 The cost of debt is likely to be lower than the cost of equity.
Debt is less risky.
Debt interest is corporation tax deductible.
2 THE COST OF DEBT
IRREDEEMABLE BONDS – WITH
TAXATION

Irredeemable bonds involve a constant annual payment

in perpetuity
𝐶
𝐾 𝑑=
𝑃0

Kd = cost of debt
C = annual coupon payment (cash)
P0 = current ex-interest market price
note that interest is tax-deductible, so…
𝐶
After   tax   𝐾 𝑑 = ×(1 −𝑇 )
𝑃0
 EXAMPLE

What is the after-tax Kd (cost of debt) for a 10%

irredeemable bond trading at £80, for a company
paying 25% corporation tax?
• Coupon = Par x coupon rate = £100 x 10% = £10
• Before tax Kd = £10/£80 = 12.5%
• After tax, multiply by (1 - T):
After tax Kd = 12.5% x (1 – 25%) = 9.375%
This is how much the firm would have to pay for such
finance today and represents the return required for the
risk taken.
 SOLUTION

 Kd (no tax) = £(10/80) x 100 = 12.5%

 Kd (with tax) = ((10 x (1-0.25))/80 x 100 = 9.4%

 REDEEMABLE BONDS
Redeemable bonds involves several interest payments plus a
redemption value

C(1 - T) C(1 - T) C(1 - T) .. C(1 – T) + RV

P0 = + + + +
(1 + Kd) (1 + Kd) (1 + Kd)
2 3
(1 + Kd)n

C = interest payment
RV = redemption value or principal
Kd = cost of debt capital
n = number of years to maturity
T = corporation tax rate
 EXAMPLE

Estimate the after-tax cost of a 12% bond, redeemable at

par in 5 years. The firm’s tax rate is 20%. Investors in the
bond require an annual return of 10%.
3 COST OF EQUITY
 THE COST OF EQUITY

 Equities: ordinary shares and preference shares

 No tax relief for dividends.
 Calculating the cost of ordinary share capital:
The dividend growth model
The Capital Asset Pricing Model (CAPM)
THE COST OF ORDINARY SHARES
DIVIDEND GROWTH MODEL

The cost of equity can be

found from the dividend growth Weaknesses of the model:
model: • g is only approximation.
𝐷0 ( 1+𝑔 ) • It cannot be used where
𝐾 𝑒= +𝑔 no dividend is paid.
𝑃0
• It takes capital gains into
Ke = cost of equity account by assuming that
P0 = the current ex dividend dividends will continue to
grow forever.
share price
D0 = the most recent dividend
g = the expected growth rate
of dividends.
 EXAMPLE, DIVIDEND GROWTH MODEL

Market price of a share is 542p

The most recent dividend was 76p
Dividends are expected to grow at a rate of 3% annually
Calculate the cost of equity capital
 THE CAPITAL ASSET PRICING MODEL

The return on a share, demanded by investors, depends

on three things:
 The return on a risk-free asset (government bonds);
 The return on a diversified portfolio of equities – the
market;
 The volatility of this share compared with the market – its
beta.
Rj = Rf + βj (Rm – Rf)
 CAPITAL ASSET PRICING MODEL

 Beta is a measure of the volatility of a stock’s price as

compared to the overall price volatility of the market.
 A stock with a beta equal to 1.00 indicates that a one
percent change in the market index will result in a one
percent change in the price of the stock – the individual
stock is as risky as the market as a whole.
 EXAMPLE

What is the return demanded by investors for a share

whose β is 0.8, when government bonds are returning 4%
and the return on the market is 9%?
Rj = Rf + βj (Rm – Rf)
Rj = 0.04 + 0.8 x (0.09 – 0.04)
= 0.04 + 0.04
= 0.08 = 8%
ANSWER

4 + (0.8(9-4)) = 8%
 THE COST OF PREFERENCE SHARES

For preference shares the future cash flows are the dividend
payments in perpetuity.

d is the dividend received

P0 is the ex dividend preference share price
Similar to calculating the cost of irredeemable debt
4 THE WEIGHTED AVERAGE
COST OF CAPITAL (WACC)
 THE WEIGHTED AVERAGE COST OF
CAPITAL (WACC)

WACC is the average cost of the company’s finance (equity, bonds,

bank loans) weighted according to the proportion each element bears
to the total pool of capital.
It can be calculated using a formula
𝐸 𝐷
𝑊𝐴𝐶𝐶= 𝐾 𝑒 × + 𝐾 𝑑 (1 −𝑇 )×
(𝐷+ 𝐸) (𝐷+ 𝐸)
E = market value of equity
D = market value of debt
E/(E+D) is the proportion of equity
D/(E+D) is the proportion of debt.
T is corporation tax rate.
 WACC EXAMPLE

The capital structure of a company is given:

 Equity: 2 million £1 Ordinary shares
 Market price of Ords is £3 and cost of equity is 15%
 Debt: £1 million 5% loan stock
 Market price of Loan Stock is £103 and the after-tax
cost of this debt is 4%
Calculate WACC
WACC EXAMPLE

Market value Weighting Cost Weighted

Equity 6,000,000 85.3% 15% 12.8%

Debt 1,030,000 14.7% 4% 0.6%

7,030,000

WACC = 13.4%
 PROBLEMS WITH CALCULATING WACC

 Calculating the cost of sources of finance

 Private companies, convertible bonds.

 Which sources of finance should be included?

 The rule: if finance is used to fund the long-term investments, then
include. However, short-term source of finance, such as bank
overdraft used on an on-going basis, can be included.

 Problems associated with weighting the sources

 Book value vs. market value; foreign currency conversion

 WACC is not constant

 Market values changes.
QUESTIONS
 QUESTION 1

Calculate the before and after-tax cost of 10%

irredeemable bonds which have an ex-interest market price
of £72. The corporation tax rate is 30%.
 QUESTION 2

The current ex dividend share price is 245p and the most

recent dividend was 15p. The expected growth rate of
dividends is 6% per year. Use the dividend growth model
to estimate the cost of equity.
 QUESTION 3

A 10% bond has a maturity date in four years’ time, when it

will be redeemed at par. The corporation tax rate is 25%.
Investors in this bond require an annual return of 12 per
cent.
Calculate the predicted market value of the bond.
 QUESTION 4

Cost of equity: Ke = 16.9%

Cost of redeemable debt: Kd = 8.7%
Cost of bank loans: Kbl = 8.8%
The company’s financial position statement shows ordinary
shares (£0.50 par value) of £3.2m; redeemable bonds of
£4.5m and a bank loan of £3.6m.Shares are trading for
£2.17 and the bonds are trading for £96. The corporation
tax rate is 30%.
Calculate the WACC.
 QUESTION 5A

Granger plc is currently financed by a combination of equity

and debt capital.
The equity shares have a current market value of £3.20 per
share and the current level of dividend is £0.20 per share
and this has been growing at the compound rate of 8% per
year. There are 43.75m shares in issue.
a) Calculate the cost of equity capital.
 QUESTION 5B-C

The loan capital (bonds) is repayable at par value in three

years’ time. Interest is payable on the loan at 10%.
Investors in this bond require an annual return of 9%.
There are £20m worth of bonds in book value on the
Balance Sheet. These bonds have a current market value
of £105 per £100 nominal.
The rate of Corporation tax applicable is 20%.
b) Calculate the after-tax cost of debt capital
c) Calculate the Weighted Average Cost of Capital to be
used for future investment decisions.
 QUESTION 5D

Discuss whether Grainger could reduce the Weighted

Average Cost of Capital by changing its capital structure.
 QUESTION 6
On a market value basis, Dani plc if financed 70% by
equity and 30% by debt. The company’s after-tax cost of
debt is 4% and its equity beta is 1.5. The risk-free rate of
return is 0.5% and the equity risk premium is 5%.
What is the after-tax weighted average cost of capital of
Dani plc?
A. 6.8%.
B. 5.05%.
C. 7.4%.
D. 6.0%.
5 THE CAPITAL STRUCTURE
QUESTION

The following section does not require any calculations

and is covered well in the textbook, so, for homework,
please study all of the following slides and read Chapter
9 of the textbook.
 CAPITAL STRUCTURE AND GEARING

 The capital structure of a company is the mixture of equity and

debt finance used by the company to finance its assets.
 Gearing is the amount of debt finance a company uses relative
to its equity finance.
 A high level of debt increases financial risk.
Increased volatility of equity returns (Why?)
Increase possibility of bankruptcy (Why? Who loses?)
Reduced credibility on the stock exchange (when does this
matter?)
 RECAP – MEASURES OF GEARING

Gearing ratios – confusingly both can be called ‘gearing’:

Debt/Equity ratio (Long-term debt/Shareholders’ funds)
Capital gearing ratio (Long-term debt/Long-term capital
employed)
 SO WHY TAKE ON DEBT?

 Keeps control by existing shareholders

 Cost of debt is less than cost of equity (Why?)
 Tax shield for debt
 The market value of a company is equal to the present
value of its future cash flows discounted by its WACC.
More debt lowers the WACC, increasing the market value
of the shares of the company - perhaps
 Need to pay interest keeps managers honest – perhaps
OPTIMAL CAPITAL STRUCTURE

Key question:
 Is there a mix of debt and equity that will minimise the
average cost of capital?
 Minimum cost of capital will maximise market value of
company and hence maximise shareholder wealth.
Approaches to capital structure:
The traditional approach
Miller and Modigliani (I&II)
Pecking order theory
 THE TRADITIONAL APPROACH

The Cost of Capital The Value of the Firm

Ke
Ko Vf

WACC

Kd

Optimal capital structure Gearing Optimal capital structure Gearing

 MILLER AND MODIGLIANI I

 Value of the firm is determined by future cash flows from its ‘real’
investments in factories, marketing, R&D, etc, discounted appropriately for
business risk
 Where the money came from – its gearing – should not affect the overall
value
 Assumptions include
 Perfect capital markets
 No transaction costs
 No taxes
 No bankruptcy costs
 Equal access to borrowing and lending at the same rates for individuals and
companies
 Individuals can tailor their position to suit own preferences for gearing
 Lend to hedge against the company’s gearing
 Borrow to create their own gearing
MILLER AND MODIGLIANI I:
THE NET INCOME APPROACH (NO TAX)
 MILLER AND MODIGLIANI II – RELAXED
ASSUMPTIONS

 If tax is taken into account, debt becomes relatively

cheaper, and there is more benefit from including this
source of finance
 Consequence would be that firms should gear up as
much as possible
MILLER AND MODIGLIANI II: WITH TAX
 MILLER AND MODIGLIANI II –
BANKRUPTCY AND TAX

 If bankruptcy costs are also taken into account, both

equity and debt investors will show increased rate of
growth of cost of capital at high levels of gearing
 Consequence is that at lower levels of gearing there is a
reduction in WACC from increasing debt because of tax
benefit
 This reaches an optimal point after which nervousness
about bankruptcy risk starts to increase WACC, i.e.
 MILLER AND MODIGLIANI II –
LOOKS LIKE THE TRADITIONAL VIEW!

The Cost of Capital

Ke
Ko

WACC

Kd

Optimal capital structure Gearing

INTERACTION OF BUSINESS AND
FINANCING RISK

High business risk – Cash flow too unreliable

start-up Match to commit to interest
payments
Missing an opportunity
Low business risk – for cheaper source of Match
stable, established capital
Low gearing = low High gearing = high
financing risk financing risk
 PECKING ORDER THEORY

 Instead of targeting an optimal gearing level, directors

are tactical – deciding about the next tranche of funding
needed.
 In doing so they have an order of preference for sources
of funds:
1. Retained earnings; if more needed, then…
2. Debt; and if it would create too much risk, then…
3. New equity
Why?
 QUESTION 7

What are the main differences in assumptions and

outcome for the two theories of capital structure known as
MM1 and MM2?
FOLLOW UP AND PREPARATION
WORK
 WEEK 7 FOLLOW UP

 Complete questions from this presentation

 Read Watson and Head chapter 9
 Answer the following questions from the end of chapter 9:
Self-test questions
1 – cost of equity
2 – cost of irredeemable bonds
3 – WACC
4 – choice of discount rate
9 – Modigliani Miller
10 – traditional view
Questions for review
1 – WACC calculation
5 – WACC problems
Suggested answers on
page 460 and 462 of the
4th ed e-book, but
question 5 in the 7th
edition was question 6 in
the e-book.
 WEEK 8 PREPARATION

 Read Watson and Head chapter 6

 Answer self-test question 4 from the end of chapter 6