Lecture 29th April 2019 & 6th

May 2019
The Cost of Capital and Capital
Structure

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Overall Cost of Capital of the
Firm

What is the Cost of Capital?

The Cost of Capital is the required rate of

return on the various types of financing.
The overall cost of capital is a weighted
average of the individual required rates of
return (costs).
 Sources of Capital
• Debt- long term loans, bonds
• Equity- new equity raising, retained
earnings
• Mezzanine- Preferred Stock/debentures

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 Why important to know the cost
capital?
• Cost of capital (as the minimum rate of return required
from investment project) is used in the evaluation of
projects as the discounting rate (in NPV, discounted PB
and PI) and as the selection benchmark-rate (in IRR).
• Since the capital structure (mix of capital components)
affect the cost of capital (MC), then, knowing the cost of
capital facilitates the selection of the best mix of capital
components (the mix at which the cost of capital is at
minimum).

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Why important to know the cost capital?
• For control and evaluation of managers’
behaviors:
– Appraising the financial performance of top
management…(to measure whether the management
performs to maximize shareholders’ return)
• For investment purposes:
– Cost of capital facilitates the determination of the price
of securities which investors may be willing to offer
given the expected rate of return.
– Thus, the amount to be collected when issuing the
securities.
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 Determination of Cost of Capital

Steps to follow
• Estimate the cost of each capital
components (debt, preferred shares,
common equity).
• Find the share (weight) of each capital
components to total capital.
• Calculate the weighted average cost of
capital (WACC), which is the cost of capital
or MC.
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 Cost of Debt
•Cost of Debt is the required rate of return on
investment of the lenders of a company.
–The price paid is a function of the expected cash flows from
that investment
n I j  Pj
P0   1  k 
j 1 d

ki  k d 1  T 
Where:
I = Rate of interest paid on the bond
P = Present market value of the bond
ki = interest rate charged for the kind of debt the company would issue
T = tax rate (interest expense is tax deductible)
 Determination of the Cost of
Debt
Assume that Basket Wonders Ltd (BWL) has
Tshs 10,000 par value zero-coupon bonds
outstanding. BWL bonds are currently trading
at Tshs 3,855.40 with 10 years to maturity.
BWL tax bracket is 40%.
Required: Determine the cost of debt for
BWL

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 Cost of Capital
Equity: retained earnings
D1
ke  g
P0
ke = cost of equity capital
D1 = dividend, next period
P0 = current stock price
g = rate at which dividend is expected to grow

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 Cost of Capital
• Equity: new raisings
D1
ke  g
P0 (1  f )
ke = cost of equity capital
D1 = dividend, next period
P0 = current stock price
g = rate at which dividend is expected to grow
f = flotation costs (as % of P0)
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 Cost of Capital

Capital Asset Pricing Model (CAPM)

kj = Rf + β(km – Rf)

kj = required rate of return on stock j

Rf = risk-free rate
km = rate of return on the market portfolio
β = volatility of a stock’s returns relative to the return on a total
stock market portfolio
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 Cost of Capital
• Mezzanine- Preferred stock
• The cost of preferred stock is given as

• Note: is the actual amount that a firm receives per

share. Ppn = Pp - F (F is issuing cost)
• Assume a preferred issue is a perpetuity that sells for $75 a
share and pays an $8 annual dividends. If a firm incur a
selling issue cost of $3 per share, what is which a firm kp
that actually incurs.
kp = 11.11%
Note: The rate of return on shares which investors receive is
10.67%, but the cost of preferred shares which the firm actually
incur is 11.11%.
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 Cost of Capital
• Weighted average cost of capital (WACC):
the average of the cost of debt financing, the
cost of equity financing and cost of mezzanine
financing, weighted by their proportions in the
total capital structure at market values
– There is a point where the combination of
components (debt, equity & mezanine) is optimal
and WACC is at a minimum

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 “Cost of Capital?”
• When we say a firm has a “cost of capital” of, for
example, 12%, we are saying:
– The firm can only have a positive NPV on a project if
return exceeds 12%
– The firm must earn 12% just to compensate investors
for the use of their capital in a project
– The use of capital in a project must earn 12% or more,
not that it will necessarily cost 12% to borrow funds for
the project
• Thus cost of capital depends primarily on the USE
of funds, not the SOURCE of funds
 Weighted Average Cost of Capital
(overview)
• A firm’s overall cost of capital must reflect the
required return on the firm’s assets as a whole
• If a firm uses debt, equity financing as well as
mezzanine financing, the cost of capital must
include the cost of each, weighted to proportion of
each (debt and equity) in the firm’s capital
structure
• This is called the Weighted Average Cost of
Capital (WACC)
 Cost of Equity
The Cost of Equity may be derived from the dividend growth
model as follows:
P= D/R –g E

Where the price of a security equals its dividend (D) divided by

its return on equity (R ) less its rate of growth (g). We can
E

invert the variables to find R as follows:

E

R = D/P+g
E

But this model has drawbacks when considering that some

firms concentrate on growth and do not pay dividends at all, or
only irregularly. Growth rates may also be hard to estimate.
Also this model doesn’t adjust for market risk.
 Cost of Equity (2):
Therefore many financial managers prefer the security market
line/capital asset pricing model (SML or CAPM) for estimating the
cost of equity:
RE = Rf + βE x (RM – Rf)
Or, Return on Equity = Risk free rate + (risk factor x risk premium)
Advantages of SML: Evaluates risk, applicable to firms that don’t
pay dividends
Disadvantages of SML: Need to estimate both Beta and risk
premium (will usually base on past data, not future projections.)
 Cost of Debt
• The cost of debt is generally easier to calculate
– Equals the current interest cost to borrow new funds
– Current interest rates are determined from the going rate in
the financial markets
– The market adjusts fixed debt interest rates to the going rate
through setting debt prices at a discount (current rate > than
face rate) or premium (current rate < than face rate)
 Weighted Average Cost of Capital
(WACC)
• WACC weights the cost of equity and the cost of debt by
the percentage of each used in a firm’s capital structure
• WACC=(E/ V) x RE + (P/ V) x RP (D/ V) x RD x (1-TC)
– (E/V)= Common stock % of total value
– (P/V)= Preferred stock % of total value
– (D/V)=Debt % of total value
– (1-Tc)=After-tax % or reciprocal of corp. tax rate Tc. The
after-tax rate must be considered because interest on corporate
debt is deductible
 WACC Illustration
• ABC Company Ltd has 1.4 million shares common
valued at Tshs 200 per share = Tshs 280 million.
Debt has face value of Tshs 50 million and trades
at 93% of face (Tshs 46.5 million) in the market.
Total market value of both equity + debt thus =
Tshs 326.5 million. Equity % = .8576 and Debt %
= .1424
– Risk free rate is 4%, risk premium =7% and
ABC’s β = 0.74
– What is WACC?
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 Final notes on WACC
• WACC should be based on market rates and valuation,
not on book values of debt or equity.
– Book values may not reflect the current marketplace
• WACC will reflect what a firm needs to earn on a new
investment. But the new investment should also reflect
a risk level similar to the firm’s Beta used to calculate
the firm’s RE.
– In the case of ABC Co., the relatively low WACC of 8.81%
reflects ABC’s β = 0.74. A riskier investment should reflect a
higher interest rate.
 Capital Structure
Capital structure can be defined as the mix of
owned capital (equity, reserves & surplus) and
borrowed capital (debentures, loans from banks,
financial institutions)
Remember: Maximization of shareholders’ wealth
is prime objective of a financial manager.
The same may be achieved if an optimal capital
structure is designed for the company.
Planning a capital structure is a highly
psychological, complex and qualitative process.
 Planning the Capital Structure
Important Considerations
 Return: ability to generate maximum returns to the shareholders, i.e.
maximize EPS and market price per share.
 Cost: minimizes the cost of capital (WACC).
 Debt is cheaper than equity due to tax shield on interest & no benefit on
dividends.
 Risk: insolvency risk associated with high debt component.
 Control: avoid dilution of management control, hence debt preferred
to new equity shares.
 Flexible: altering capital structure without much costs & delays, to
raise funds whenever required.
 Capacity: ability to generate profits to pay interest and principal.
Value of a Firm – directly co-related with
the maximization of shareholders’ wealth.
 Value of a firm depends upon earnings of a firm
and its cost of capital (i.e. WACC).
 Earnings are a function of investment decisions,
operating efficiencies, & WACC is a function of
its capital structure.
 Valueof firm is derived by capitalizing the
earnings by its cost of capital (WACC). Value of Firm
= Earnings / WACC
 Thus, value of a firm varies due to changes in the
 Importance of Capital Structure
• 1. Debt and Equity have different costs
(Interest rates and rate of return
• Other costs are: Flotation costs & tax
treatments
• 2.Financial Risk: Interest payments are
expenses that increase the volatility of net
income and EPS
• 3 Borrowing increase cost of equity capital
in the stock market
• May lead to Financial Distress
Capital Structure Theories
Relationship between capital structure, cost of capital and value of a
firm.
ASSUMPTIONS –
 Firms use only two sources of funds – equity & debt.
 No change in investment decisions of the firm, i.e. no change in total
assets.
 100 % dividend payout ratio, i.e. no retained earnings.
 Business risk of firm is not affected by the financing mix.
 No corporate or personal taxation.
 Investors expect future profitability of the firm.
 Capital Structure Theories –
A) Net Income Approach (NI)
 NetIncome approach proposes that there is a
definite relationship between capital structure and
value of the firm.
 The capital structure of a firm influences its cost of
capital (WACC), and thus directly affects the value
of the firm.
 NI approach assumptions –
o NI approach assumes that a continuous increase in
debt does not affect the risk perception of investors.
 Capital Structure Theories –
A) Net Income Approach (NI)
 Asper NI approach, higher use of debt capital will
result in reduction of WACC.
 As a consequence, value of firm will be increased.
Value of firm = Earnings
WACC
 Earnings(EBIT) being constant and WACC is
reduced, the value of a firm will always increase.
 Thus,
as per NI approach, a firm will have
maximum value at a point where WACC is
 Capital Structure Theories –
A) Net Income Approach (NI)
As the proportion of
Cost
debt (Kd) in capital
structure increases,
ke, ko ke
the WACC (Ko)
kd
ko
kd reduces.

Debt
 Net Income View
Cost of Debt Cost of Proportion Proportion WACC Value of the
Equity of Debt of Equity Firm

0.05 0.10 0 1 0.100 10.0

0.05 0.10 0.25 0.75 0.088 11.4

0.05 0.10 0.50 0.50 0.075 13.3

0.05 0.10 0.75 0.25 0.063 16.0

0.05 0.10 1 0 0.050 20.0

 Capital Structure Theories –
A) Net Income Approach (NI) (Cont…)
Calculate the value of Firm and WACC for the following capital
structures
EBIT of a firm Tshs 200,000,000 Ke = 10% Kd = 6%
Debt Capital Tshs Debt = Tshs Debt = Tshs
500,000,000 700,000,000 200,000,000

Particulars Case 1 Case 2 Case 3

EBIT 200,000,000 200,000,000 200,000,000
(–) Interest 30,000,000 42,000,000 12,000,000
EBT 170,000,000 158,000,000 188,000,000

Ke 10% 10% 10%

Value of Equity 1,700,000,000 1,580,000,000 1,880,000,000
(EBT/Ke)

Value of Debt 500,000,000 700,000,000 200,000,000

Total Value of Firm 2,200,000,000 2,280,000,000 2,080,000,000

WACC 9.09% 8.77% 9.62%

(EBIT/Value) * 100
 Capital Structure Theories –
B) Net Operating Income (NOI)
 Net
Operating Income (NOI) approach is the exact
opposite of the Net Income (NI) approach.
 Asper NOI approach, value of a firm is not
dependent upon its capital structure.
 Assumptions:
o WACC is always constant, and it depends on the
business risk.
o Value of the firm is calculated using the overall cost of
capital i.e. the WACC only.
 Capital Structure Theories –
B) Net Operating Income (NOI)
 NOI propositions (i.e. school of thought):
The use of higher debt component (borrowing) in the capital
structure increases the risk of shareholders.
Increase in shareholders’ risk causes the equity capitalization
rate to increase, i.e. higher cost of equity (Ke)
A higher cost of equity (Ke) nullifies the advantages gained
due to cheaper cost of debt (Kd )
In other words, the finance mix is irrelevant and does not
affect the value of the firm.
 Capital Structure Theories –
B) Net Operating Income (NOI)
 Cost of capital (Ko)
Cost is constant.
ke
 As the proportion of
ko
debt increases, (Ke)
kd increases.
 No effect on total
Debt
cost of capital
(WACC)
 Capital Structure Theories –
B) Net Operating Income (NOI)
Calculate the value of Firm and WACC for the following capital
structures
EBIT of a firm Tshs 200,000,000 Ke = 10% Kd = 6%
Debt = Tshs 300,000,000; Tshs 400,000,000; Tshs 500,000,000
(under 3 options)

Particulars Option I Option II Option III

EBIT 200,000,000 200,000,000 200,000,000

WACC (K0) 10% 10% 10%

Value of the Firm 2,000,000,000 2,000,000,000 2,000,000,000

Value of Debt @ 300,000,000 400,000,000 500,000,000

6%

Value of Equity 1,700,000,000 1,600,000,000 1,500,000,000

(bal. fig)

Interest @ 6% 18,000,000 24,000,000 30,000,000

EBT (EBIT - 182,000,000 176,000,000 170,000,000

Interest)

Hence, Cost of 10.71% 11.00% 11.33%

Equity (Ke)
 Capital Structure Theories –
C) Modigliani – Miller Model (MM)
 MM approach supports the NOI approach, i.e. the
capital structure (debt-equity mix) has no effect on
value of a firm.
 Further, the MM model adds a behavioural
justification in favour of the NOI approach
(personal leverage)
 Assumptions:
o Capital markets are perfect and investors are free to
buy, sell, & switch between securities. Securities are
infinitely divisible.
 Capital Structure Theories –
C) Modigliani – Miller Model (MM)
MM Model proposition:
o Value of a firm is independent of the capital structure.
o Value of firm is equal to the capitalized value of
operating income (i.e. EBIT) by the appropriate rate (i.e.
WACC).
o Value of Firm = Mkt. Value of Equity + Mkt. Value of
Debt
= Expected EBIT
Expected WACC
 Capital Structure Theories –
C) Modigliani – Miller Model (MM)
MM Model proposition –
o As per MM, identical firms (except capital structure) will
have the same level of earnings.
o As per MM approach, if market values of identical firms
are different, ‘arbitrage process’ will take place.
o In this process, investors will switch their securities
between identical firms (from levered firms to un-
levered firms) and receive the same returns from both
firms.
 Capital Structure Theories –
C) Modigliani – Miller Model (MM)
Levered Firm
• Value of levered firm = Tshs 1,100,000,000
• Equity Tshs 600,000,000 + Debt Tshs 500,000,000
• Kd = 6 % , EBIT = Tshs. 100,000,000
• Investor holds 10 % share capital

Un-Levered Firm
• Value of un-levered firm = Tshs 1,000,000,000 (all
equity)
• EBIT = Tshs 100,000,000 and investor holds 10 % share
 Read
• Prepare for a Test

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