Capital Structure & Cost of

Capital
Issues:

 What is capital structure?

 What are the relative costs of debt and equity?
 Why is capital structure/cost of capital important?
 What are the sources of capital available to a company?
 What is business risk and financial risk?
 What are the main theories of capital structure?
 Is there an optimal capital structure?
 Case study on optimal capital structure
 What is “Capital Structure”?

 Definition
The capital structure of a firm is the mix of different
securities issued by the firm to finance its operations.
Securities
 Bonds
 Ordinary shares (common stock), Preference shares
(preferred stock)
 Hybrids, e.g. warrants, convertible bonds

Bank loans
 What is “Capital Structure”?

Balance Sheet
Current Current
Assets Liabilities

Debt Financial
Fixed Preference Structure
Assets shares

Ordinary
shares
 What is “Capital Structure”?

Balance Sheet
Current Current
Assets Liabilities

Debt
Fixed Preference
Assets shares Capital
Structure
Ordinary
shares
 Sources of capital

 Ordinary shares (common stock)

 Preference shares (preferred stock)
 Hybrid securities
– Warrants: Gives buyer the right to get a specified
number of shares at a pre-decided date and prices.
– Convertible bonds
 Loan capital
– Bank loans
– Corporate bonds
 Ordinary shares (common stock)
 Risk finance
 Dividends are only paid if profits are made and only
after other claimants have been paid e.g. lenders and
preference shareholders
 A high rate of return is required
 Provide voting rights – the power to hire and fire
directors
 No tax benefit, unlike borrowing
 Preference shares (preferred stock)
 Lower risk than ordinary shares – and a lower dividend
 Fixed dividend - payment before ordinary shareholders
and in a liquidation situation
 No voting rights - unless dividend payments are in
arrears
 Cumulative - dividends accrue in the event that the
issuer does not make timely dividend payments
 Participating - an extra dividend is possible
 Redeemable - company may buy back at a fixed future
date
 Loan capital
 Financial instruments that pay a certain rate of
interest until the maturity date of the loan and
then return the principal (capital sum borrowed)
 Bank loans or corporate bonds
 Interest on debt is allowed against tax
 Seniority of debt

 Seniority indicates preference in position over

other lenders.
 Some debt is subordinated.
In the event of default, holders of subordinated
debt must give preference to other specified
creditors who are paid first.
 Security
 Security is a form of attachment to the borrowing
firm’s assets. It provides that the assets can be
sold in event of default to satisfy the debt for
which the security is given.
 Indenture

 A written agreement between the corporate

debt issuer and the lender.
 Sets forth the terms of the loan:
– Maturity
– Interest rate
– Protective covenants
 e.g. financial reports, restriction on further loan issues,

restriction on disposal of assets and level of dividends

 Warrants

 A warrant is a certificate entitling the holder to buy a

specific amount of shares at a specific price (the
exercise price) for a given period.
 If the price of the share rises above the warrant's
exercise price, then the investor can buy the security at
the warrant's exercise price and resell it for a profit.
 Otherwise, the warrant will simply expire or remain
unused.
 Convertible bonds
 A convertible bond is a bond that gives the holder the
right to "convert" or exchange the par amount of the
bond for ordinary shares of the issuer at some fixed
ratio during a particular period.
 As bonds, they provide a coupon payment and are
legally debt securities, which rank prior to equity
securities in a default situation.
 Their value, like all bonds, depends on the level of
prevailing interest rates and the credit quality of the
issuer.
 Their conversion feature also gives them features of
equity securities.
 Convertible bonds
 A convertible bond is a bond that gives the holder the
right to "convert" or exchange the par amount of the
bond for ordinary shares of the issuer at some fixed
ratio during a particular period.
 As bonds, they provide a coupon payment and are
legally debt securities, which rank prior to equity
securities in a default situation.
 Their value, like all bonds, depends on the level of
prevailing interest rates and the credit quality of the
issuer.
 Their conversion feature also gives them features of
equity securities.
Measuring capital structure

 Debt/(Debt + Market Value of Equity)

 Debt/Total Book Value of Assets

 Interest coverage: EBITDA/Interest

Measuring capital structure

 Debt/(Debt + Market Value of Equity)

 Debt/Total Book Value of Assets

 Interest coverage: EBITDA/Interest

 Business risk and Financial risk

 Firms have business risk generated by what they

do (e.g. the breakdown or theft of key
equipment.)
 But firms adopt additional financial risk when
they finance with debt (e.g. interest rate rise on
your business loan)
 Business Risk
 The basic risk inherent in the operations of a
firm is called business risk
 Business risk can be viewed as the variability
of a firm’s Earnings Before Interest and Taxes
(EBIT)
 Financial Risk
 Debt causes financial risk because it imposes a
fixed cost in the form of interest payments.
 The use of debt financing is referred to as
financial leverage.
 Financial leverage increases risk by increasing
the variability of a firm’s return on equity or the
variability of its earnings per share.
Financial Risk vs. Business Risk

 There is a trade-off between financial risk and business

risk.
 A firm with high financial risk is using a fixed cost
source of financing. This increases the level of EBIT a
firm needs just to break even.
 A firm will generally try to avoid financial risk - a
high level of EBIT to break even - if its EBIT is very
uncertain (due to high business risk).
 How Can a Firm Raise
Capital?
 _____, ______, ______
 Each of these offers a rate of return to
investors.
 Each return is a cost to the firm.
 “Cost of capital” actually refers to the
weighted average cost of capital – a
weighted average cost of financing
sources.
 Weighted Average Cost of Capital
 To calculate the firm’s weighted
average cost of capital (or WACC),we
must first calculate the costs of the
individual financing sources:
 Cost of Debt
 Cost of Preferred Stock
 Cost of Common Stock
 Why should we care about
capital structure?
 By altering capital structure firms have the
opportunity to change their cost of capital and –
therefore – the market value of the firm
 What is an optimal capital structure?

 An optimal capital structure is one that

minimizes the firm’s cost of capital and thus
maximizes firm value
 Cost of Capital:
– Each source of financing has a different cost
– The WACC is the “Weighted Average Cost of
Capital”
– Capital structure affects the WACC
 Capital Structure Theory

 Basic question
– Is it possible for firms to create value by altering
their capital structure?
 Major theories
– Modigliani and Miller theory
– Trade-off Theory
– Signaling Theory
Modigliani and Miller (MM)

 Basic theory: Modigliani and

Miller (MM) in 1958 and 1963
 Old - so why do we still study
them?
– Before MM, no way to analyze debt
financing
– First to study capital structure and
WACC together
– Won the Nobel prize in 1990
 Modigliani and Miller theory

 M&M irrelevance theory explained that

capital structure does not affect the
value of firms under perfect market
conditions because it is the return to
assets rather than the costs of capital
that determine the value of the firms

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 Trade-off Theory

 There is a trade-off between the benefits of

using debt and the costs of using debt.

– The use of debt creates a tax shield benefit from the

interest on debt.

– The costs of using debt, besides the obvious interest

cost, are the additional financial distress costs and
agency costs arising from the use of debt financing.
Trade-Off Theory (Cont’d)
 Debt versus Equity

– A firm’s cost of debt is always less than its cost of

equity
 debt has seniority over equity
 debt has a fixed return
 the interest paid on debt is tax-deductible.

– It may appear a firm should use as much debt and as

little equity as possible due to the cost difference, but
this ignores the potential problems associated with
debt.
 Signaling Theory

 The signaling theory emanates from

information asymmetries between firm
management and shareholders.
 If managers believe that their firms are
undervalued, they will issue
debt first and then issue equity as a last
resort.

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 Signaling Theory
 Conversely, if management believes
that their firm is overvalued, they will
issue equity first.
 The signaling theory posits that if
managers have inside information, their
choice of capital structure will signal
information to the market.

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 How to Calculate Cost of
Debt
 Knowing your cost of debt can help you
understand what you’re paying for the
privilege of having fast access to cash.
 To calculate your total debt cost, add up all
loans, balances on credit cards, and other
financing tools your company has.

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 How to Calculate Cost of
Debt
 Then, calculate the interest rate expense for
each for the year and add those up.
 Next, divide your total interest by your total
debt to get your cost of debt

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 Cost of Debt Formula

 There are a few ways to calculate your cost

of debt, depending on whether you’re
looking at it pre-tax or post-tax.
 If you want to know your pre-tax cost of
debt, you use the above method and the
following formula cost of debt formula:
 Total interest / total debt = cost of debt

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 Cost of Debt Formula
 But often, you can realize tax savings if you
have deductible interest expenses on your
loans.
 That’s where calculating post-tax cost of
debt comes in handy. To do so, you’ll need
to know your effective tax rate.

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 Cost of Debt Formula
 Before we get to the formula, let’s look at
another definition: weighted average cost of
your debt.
 This refers to the total interest you are
paying across all loans.
 To calculate your weighted average interest
rate, multiply each loan times the interest
rate you pay on it.
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 Cost of Debt Formula
 Example
 SME loan: $100,000 * 5% =$5,000
 Business credit card: $5,000 * 22.5% = $1,125
 Merchant cash advance: $3,000 * 30% = $900
 Then add those results together.
 $5,000 + $1,125 + $90 = $7,025
 Next, add up all your debts:
 $100,000 + $5,000 + $3,000 = $108,000
 To calculate the weighted average interest rate, divide your interest number by
the total you owe.
 $7,025/$108,000 = .065
 6.5% is your weighted average interest rate.

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 Cost of Debt Formula
 Now, back to that formula for your cost of
debt that includes any tax cost at your
corporate tax rate.
 Effective interest rate * (1 – tax rate)

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 Cost of Debt Formula
 Cost of Debt Examples
 In summary, there are two ways to calculate
the cost of your loans, depending on
whether you look at it as a pre- or post-tax
cost.

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 Cost of Debt Formula
 Simple Cost of Debt
 If you only want to know how much you’re
paying in interest, use the simple formula.
 Total interest / total debt = cost of debt
 If you’re paying a total of $3,500 in interest
across all your loans this year, and your total
debt is $50,000, your simple cost of debt is 7%
 $3,500 / $50,000 = 7%
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 Cost of Debt Formula
 Complex Cost of Debt
 But let’s say you do care about how your
cost of debt changes after taxes.
 Effective interest rate * (1 – tax rate)
 Let’s go back to that 6.5% we calculated as
our weighted average interest rate for all
loans. That’s the number we’ll plug into the
effective interest rate slot.
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 Cost of Debt Formula
 Let’s say you have a 9% corporate tax rate.
Here’s how your cost of debt formula
would look.
 6.5% (or .065) * (1-.09) = .591 or 5.9%
 So after tax savings, your cost of debt is
5.9%.

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 Costs of Debt - Example
 Disney’s bond rating in May 2009 was A,
and based on this rating, the estimated
pretax cost of debt for Disney is 6%. Using
a marginal tax rate of 38%, the after-tax
cost of debt for Disney is 3.72%.
 After-Tax Cost of Debt = 6.00% (1 – 0.38)
= 3.72%
 Costs of Equity
 The formula used to calculate the cost of
equity is either the dividend discount model
or the CAPM.

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 Costs of Equity
 The dividend discount model
 To value a company’s stock, an individual
can use the dividend discount model
(DDM).
 The dividend discount model is based on
the idea that a stock is worth the sum of its
future payments to shareholders, discounted
back to the present day.
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 Costs of Equity
 The dividend discount model

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 Costs of Equity
 The dividend discount model

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 Costs of Equity
 The Capital Asset Pricing Model (CAPM)
 CAPM can be used on any stock, even if
the company does not pay dividends.
 The theory suggests that the cost of equity
is based on the stock’s volatility and level
of risk compared to the general market.

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 Costs of Equity
 The CAPM Formula is:
 Cost of Equity = Risk-Free Rate of Return
+ Beta × (Market Rate of Return - Risk-
Free Rate of Return)

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Costs of Equity

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 Costs of Equity
 In this equation, the risk-free rate is the rate
of return paid on risk-free investments such
as Treasuries (T/Bill).
 Beta is a measure of risk calculated as a
regression on the company’s stock price.
The higher the volatility, the higher the beta
and relative risk compared to the general
market.
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 Costs of Equity
 The market rate of return is the average
market rate.
 In general, a company with a high beta—
that is, a company with a high degree of
risk—will have a higher cost of equity.

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 Costs of Equity – Numerical
Example
 The beta for Disney’s stock in May 2009
was 0.9011. The T. bond rate at that time
was 3.5%. Using an estimated equity risk
premium of 6%, we estimated the cost of
equity for Disney to be 8.91%:
 Cost of Equity = 3.5% + 0.9011(6%) =
8.91%
 Costs of Equity
 Consider company A trades on the S&P 500
at a 10% rate of return. Meanwhile, it has a
beta of 1.1, expressing marginally more
volatility than the market. Presently, the T-
bill (risk-free rate) is 1%. Use the capital
asset pricing model (CAPM) to determine
its cost of equity financing.

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 Weighted Average Cost of
Capital (WACC)
 The weighted average cost of capital
(WACC) is a calculation of a firm's cost of
capital in which each category of capital is
proportionately weighted.
 All sources of capital, including common
stock, preferred stock, bonds, and any other
long-term debt, are included in a WACC
calculation.
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Measuring Cost of Capital

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 WACC Illustration
Gamtel Corp has 1.4 million shares common valued at $20 per
share =$28 million. Debt has face value of $5 million and trades
at 93% of face ($4.65 million) in the market. Total market value
of both equity + debt thus =$32.65 million. Equity % = .8576
and Debt % = .1424
Risk free rate is 4%, risk premium=7% and ABC’s β=.74
Return on equity per SML : RE = 4% + (7% x .74)=9.18%
Tax rate is 40%
Current yield on market debt is 11%
 WACC Illustration

WACC = (E/V) x RE + (D/V) x RD x (1-Tc)

= .8576 x .0918 + (.1424 x .11 x .60)
= .088126 or 8.81%
 COST OF CAPITAL
 EXAMPLE: Project A has IRR of 13% and is
financed with 8% debt; Project B has IRR of 15% &
financed with 16% equity. WACC is 12%. Which
should you do?

 Both! ==> Why?

 Both have IRR > Cost of Capital

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 Costs of Debt & Equity
 A recent article in an Asian business
magazine argued that equity was cheaper
than debt, because dividend yields are much
lower than interest rates on debt.
 Do you agree with this statement?
 Yes
 No
 Costs of Debt & Equity
 Can equity ever be cheaper than debt?
  Yes
  No
 Optimal Capital Structure
Definition: Meaning, Factors,
and Limitations

 What Is Optimal Capital Structure?

 The optimal capital structure of a firm is the
best mix of debt and equity financing that
maximizes a company’s market value while
minimizing its cost of capital.

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 What Is Optimal Capital
Structure?
 In theory, debt financing offers the lowest
cost of capital due to its tax deductibility.
However, too much debt increases the
financial risk to shareholders and the return
on equity that they require.
 Thus, companies have to find the optimal
point at which the marginal benefit of debt
equals the marginal cost.
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 Understanding Optimal
Capital Structure
 The optimal capital structure is estimated
by calculating the mix of debt and equity
that minimizes the weighted average cost of
capital (WACC) of a company while
maximizing its market value.
 The lower the cost of capital, the greater the
present value of the firm’s future cash
flows, discounted by the WACC.
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 Understanding Optimal
Capital Structure
 Thus, the chief goal of any corporate
finance department should be to find the
optimal capital structure that will result in
the lowest WACC and the maximum value
of the company (shareholder wealth).

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 Understanding Optimal
Capital Structure
 The cost of debt is less expensive than
equity because it is less risky.
 The required return needed to compensate
debt investors is less than the required
return needed to compensate equity
investors, because interest payments have
priority over dividends, and debt holders
receive priority in the event of a liquidation.
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 Understanding Optimal
Capital Structure
 Debt is also cheaper than equity because
companies get tax relief on interest, while
dividend payments are paid out of after-tax
income.

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 Understanding Optimal
Capital Structure
 However, there is a limit to the amount of
debt a company should have because an
excessive amount of debt increases interest
payments, the volatility of earnings, and the
risk of bankruptcy.

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 Understanding Optimal
Capital Structure
 This increase in the financial risk to
shareholders means that they will require a
greater return to compensate them, which
increases the WACC—and lowers the
market value of a business.

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 Understanding Optimal
Capital Structure
 Companies with consistent cash flows can
tolerate a much larger debt load and will
have a much higher percentage of debt in
their optimal capital structure.
 Conversely, a company with volatile cash
flows will have little debt and a large
amount of equity.

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 Determining the Optimal
Capital Structure
 As it can be difficult to pinpoint the optimal
capital structure, managers usually attempt
to operate within a range of values.
 They also have to take into account the
signals their financing decisions send to the
market.

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 Determining the Optimal
Capital Structure
 A company with good prospects will try to
raise capital using debt rather than equity,
to avoid dilution and sending any negative
signals to the market.
 Announcements made about a company
taking debt are typically seen as positive
news, which is known as debt signaling.

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 Determining the Optimal
Capital Structure
 If a company raises too much capital during
a given time period, the costs of debt,
preferred stock, and common equity will
begin to rise, and as this occurs, the
marginal cost of capital will also rise.

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 Determining the Optimal
Capital Structure
 To gauge how risky a company is, potential
equity investors look at the debt/equity ratio.
 They also compare the amount of leverage
other businesses in the same industry are using
—on the assumption that these companies are
operating with an optimal capital structure—to
see if the company is employing an unusual
amount of debt within its capital structure.

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 Determining the Optimal
Capital Structure
 Optimal capital structure is determined by a
debt-to-equity ratio, which should equal
around 1 for most companies.

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 Case study
 Jabang wants his company to achieve an
optimal capital structure, also known as the
target capital structure, while financing
several large infrastructure projects in the
Gambia. Jabang works for Njie Equipment,
which makes fire and rescue equipment.
The company wants to invest in new, light-
weight equipment.
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 Case study
 To make this happen the company has to
upgrade its three manufacturing sites. This is a
hefty investment for the company. Jason needs
to make use of what is called the optimal
capital structure, which is a debt-to-equity
ratio that maximizes a company's value. A
debt-to-equity ratio tells us the proportion of
a company's liabilities to equity.

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 Case study
 Liabilities are all of the short- and long-
term debts incurred by a company. Jabang's
company is a medium-sized company so he
is striving for the company's liabilities to
equal equity. This results in a ratio of 1.

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 Case study
 Finding Optimal Capital Structure
 Jabang begins his endeavor of finding the
company's optimal capital structure.
 He starts with determining his liabilities.
Examples of liabilities are loans, expenses,
taxes, warranties, deferred revenue, and
wages.

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 Case study
 Finding Optimal Capital Structure
 Jabang’s company has the following annual
liabilities:
 $100,000 in mortgages
 $25,000 in liabilities to suppliers
 $200,000 in wages
 $10,000 in taxes

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 Case study
 Finding Optimal Capital Structure
 The annual liabilities of Jabang’s company
total $335,000.
 Equity, on the other hand, is the value of all
assets minus liabilities.
 Assets are those items that a company has
that can be converted into cash within a year.

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 Case study
 Finding Optimal Capital Structure
 The debt-to-equity ratio is liabilities/equity.
Jabang wants his company’s ratio to be 1/1,
which equals 1.
 At the moment, Jabang’s company has a
debt-to-equity ratio of 335,000/665,000,
which equals 0.5.
 ratio of 1.
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 Case study
 Finding Optimal Capital Structure
 So Jabang has some room to leverage the
company's assets to reach an optimal capital
structure.
 Let's see how he restructured his debt to
finance the company's upgrades and meet
his goal of a debt-to-equity ratio of 1.

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 Case study
 Finding Optimal Capital Structure
 Examples are cash, inventory, and liquid
assets.
 Jabang’s company has $1,000,000 in assets,
which makes the company's equity
$1,000,000 - $335,000 = $665,000.

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 Case study
 Finding Optimal Capital Structure
 Jabang wants his company's ratio to be 1/1, which
equals 1. At the moment, his company has a debt-to-
equity ratio of 335,000/665,000, which equals 0.5.
 So Jabang has some room to leverage the company's
assets to reach an optimal capital structure.
 Let's see how he restructured his debt to finance the
company's upgrades and meet his goal of a debt-to-
equity ratio of 1.
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 Case study
 Finding Optimal Capital Structure
 Jabang decided to increase the company's
mortgages. He adds $330,000 to both assets
and liabilities.
 Now find out the new debt to equity ratio
and hence the company’s optimal ratio.

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PECKING ORDER Hypothesis
 If management expects good prospects:

 will not want to share with new S/H

  will not want to sell undervalued shares
  expects adequate CF’s to fund debt service

 ===> WILL ISSUE DEBT

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 Pecking Order Hypothesis,
cont.
 If management expects bad prospects:

  Will want to share with new S/H

  Will want to sell overvalued shares
  May not expect adequate CF’s for debt
service
===> WILL ISSUE EQUITY
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 Pecking Order Summary
 Firms use INTERNAL FUNDS first
– Conservative dividend policy

 If external funds, then DEBT FIRST (signaling

problem)

 When debt capacity is used, then EQUITY

 Resulting capital structure is function of firm’s

profitability relative to invest. needs
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Summary
 A firm’s capital structure is the proportion of a firm’s long-
term funding provided by long-term debt and equity.

 Capital structure influences a firm’s cost of capital through

the tax advantage to debt financing and the effect of capital
structure on firm risk.

 Because of the tradeoff between the tax advantage to debt

financing and risk, each firm has an optimal capital structure
that minimizes the WACC and maximises firm value.