Lecture 4:

Financing Decision &

Cost of Capital

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Learning Outcomes
 To understand:
 The theories behind capital structure
 If an optimal capital structure can be achieved
 The rationale behind financing decisions and Pecking Order
Theory.

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To start off, let’s recap:
 What is capital structure?
 Recall from Week 3 = firms need capital to operate / finance projects
 Capital comes in 2 forms: debt & equity
 Capital structure = combination of debt and/or equity firm uses to finance its
operations / projects
 What is a “financing decision”?
 Firm is trying to determine the most cost-effective method to pay for a project
 Step 1: equity or debt or both?
 Step 2: what instruments?
 Step 3: how will this impact the firm?
 What is WACC?
 The firm’s average benchmark cost of raising capital to finance a project (debt
and/or equity) in relation to their respective proportions, taking into consideration
market factors and taxes
 Also used as the discount rate when evaluating cashflows from prospective projects3
The Circular Argument of Capital Structure
In order to value a project,
you require an appropriate
discount rate

The value of the new project

will add to overall equity You need a new COC, suitably
value of the business. You adjusted to the new gearing
therefore need to know the level, to value the project
value of the project.

In order to calculate the new

COC, you need to know the
new MV of debt and equity
after the project’s acceptance 4
Life would be easier if it was 100% equity and everything was paid for in cash

True? False?

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A Simple Example – 100% Equity
Data
Number of shares 1,000
Price per share $10
Market value of shares $ 10,000

Outcomes
A B C D
Operating income $500 1,000 1,500 2,000
Earnings per share $.50 1.00 1.50 2.00 Expected outcome

Return on shares (%) 5% 10 15 20

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A Simple Illustration – 50/50
Data
Number of shares 500
Price per share $10
Market value of shares $ 5,000 • Borrowing causes EPS to
increase
Market value of debt $ 5,000
• Why?
• MV of capital is the same
Outcomes • # of shares is lower
• As long as Operating Income >
A B C D interest, net effect on EPS =
Operating income $500 1,000 1,500 2,000 positive
Less: Interest
Interest $500 500 500 500
Equity earnings $0 500 1,000 1,500
Earnings per share $0 1 2 3
Return on shares (%) 0% 10 20 30
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Is there an optimal capital structure?
 The previous example implies that debt = good
 Since we are referring to a “cost”, the optimal capital structure
would be one that minimizes WACC (or maximizes shareholder
wealth / EPS)
 Conventional theory solution = add debt to lower average cost
 M&M(1963) = add debt to take full advantage of tax deductions
on interest
 Mathematically, this would translate into a 99.99% debt capital structure
 Benefit of lower WACC > higher Ke from increasing risk
 Is this recommended?

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Is there an optimal capital structure?
 Theoretically not wrong to say that greater proportion of
debt capital is good for the firm
 However, issues to consider
 Bankruptcy costs
 Agency costs
 Tax exhaustion
 Cheaper debt vs Higher Ke

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Bankruptcy Costs
 Due to high level of debt:
 Higherrisk of bankruptcy – can company continue to repay
greater amount of interest payments?
 Shareholder / debtholders demand higher return for higher
risk
Ke, Kd, WACC will rise to compensate for greater risk
Shareholders face greater exposure. Why?
 With higher level of risk, share prices may fall

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Agency Costs
 Due to higher level of debt:
 Debtholders will impose more restrictions (covenants) in debt
agreements
 This is to protect their own interests (i.e. firm’s ability to repay)
 Example: limits on future debt-raising, maintenance of asset values,
restrict asset sales, restrict company activities
 Management may favor shareholders over debtholders
 Example: investing in risky projects for capital appreciation, large
dividend payout, anything that may limit firm’s ability to repay
 Remember: debtholders rate of return has limited upside = interest =
fixed 11
Tax Exhaustion
 M&M(1963): firms take advantage of tax shields to lower
WACC
 Interest is tax deductible;
 Generalview: more debt may mean more interest, in which
company may benefit from tax shields
 However,
 Tax shields have an annual limit
 As debt increases, savings from tax shield rises
 Taxexhaustion is reached when interest expense > tax
savings 12
Cheaper Debt vs Higher Ke
 Kd cannot be reduced to zero
 Therefore, WACC cannot be reduced to zero
 But  debt =  risk =  Ke
 Inorder to compensate  Ke, firm takes on riskier
projects =  risk
 Eventually becomes a vicious cycle
 Firm value and shareholder wealth is eroded

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Financial Distress
 Often, we are unable to observe details to measure a
firm’s bankruptcy risk, agency costs, tax exhaustion and
debt vs equity tradeoffs
 Solution: Observe costs / signs of financial distress
 Costsarising from bankruptcy or distorted business decisions
before bankruptcy that may cause decline in firm value
 Direct:redundancy payments; legal fees, admin costs;
shareholders’ efforts to receive liquidation dividend
 Indirect:order cancellations; less trade credit; lower
productivity; less access to financing; other human costs
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Trade-Off Theory
 Optimal capital structure at which value of firm is maximized and cost of
capital is minimized;
 Trade-off between tax benefits and cost of financial distress;
 Indicators:
 PV (tax shield) will initially increase as firm borrows more;
 PV (cost of financial distress) is small and value of firm will increase
with borrowings;
 High level of debt, PV (cost of financial distress) will dominates; and
 Theoretical optimum capital structure is achieved when the PV (tax
shields) is offset by increasing in PV (costs of financial distress).

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Trade-Off Theory (cont’)
Recall from Week 3

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Market Value = Value of all equity financed + PV of Tax Shields – PV costs of financial distress
Costs of Asymmetric Information
 Asymmetric information is the situation in which different
parties have different information.
 Ina corporation, managers will have a better information set
than investors.
 Thedegree of asymmetric information varies among
companies and industries.
 Thepecking order theory argues that the capital structure
decision is affected by management’s choice of a source of
capital that gives higher priority to sources that reveal the least
amount of information. 18
Pecking Order Theory

 Companies should choose internal financing over external financing

 Justification for POT:
 Company wants to minimize costs of issuance;
 Company wants to minimize the time and expenses involved in
persuading outside investors; and
 Company does not want to reveal too much, too soon 19
Considerations of Pecking-Order Theory
 Does it fit with firm’s financial goals?
 Using RE to finance a project means less reserves
 How will this affect the firm going forward?
 How will it affect firm profitability?
 RE comes from previous year profits
 If firm is not profitable, limited amount of RE available
 Does it fit with the nature of the industry?
 If the industry is a risky one, it may not be suitable
 E.g. cashflow risks, risk of failure, high upfront cost
 How will it affect firm’s debt-equity mix?
 Debt-equity mix maximizes shareholder wealth
 Using RE means lower RE per share 20
The Optimal Capital Structure
Taxes Costs of financial Optimal capital structure?
distress

No No No
Cost of capital is constant
Yes No Yes, 99% debt
Cost of capital declines as more debt is used

Yes Yes Yes, benefits of interest deductibility are

offset by the expected costs of financial
distress
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