COST AND CAPITAL

STRUCTURE
Prepared by: Miss Nurul Syuhada Binti Zaidi
Email: znsyuhada@unimas.my
 LEARNING OBJECTIVES:
• Understand the breakdown and composition of a firm’s cost of capital
• Determine a firm’s cost of debt capital
• Determine a firm’s cost of equity capital
• Understand the impact of beta in determining the firm’s cost of equity capital
• Determine the firm’s overall cost of capital
 COST OF CAPITAL
• The cost of fund used to finance a business
• Cost of capital also known as the investor’s required rate of return
• the rate of return that a company must earn on its investments to maintain or increase the value of the
firm
• A firm must achieve the required rate of return to cover the cost of generating funds in the marketplace
• How?
In the form of Taking debt – by
equity by issuing borrowing or
shares issuing bond

• Those who provide investment to your company also wants a return on their investment
• Therefore, cost of capital is the rate of return that investors and bondholders of a certain company
expect for their investment
• The cost of capital is a crucial metric used in evaluating potential investments and determining the
feasibility of projects, guiding financial decision-making within firms.
 IMPORTANCE OF COST OF CAPITAL
IN FINANCIAL MANAGEMENT
• Capital Budgeting: It serves as a benchmark rate for assessing the attractiveness
of various investment projects. Projects yielding returns below the cost of capital
may decrease the firm’s overall value.
• Capital Structure Decisions: Helps determine the optimal mix of debt and
equity financing. A firm's cost of capital is influenced by its capital structure,
impacting its risk profile and valuation.
• Performance Evaluation: Provides a standard for evaluating the performance of
managers and projects. Performance is measured against the hurdle rate set by the
cost of capital.
 IMPORTANCE OF COST OF CAPITAL
IN FINANCIAL MANAGEMENT
• Valuation of Assets: It is used to discount future cash flows in business valuation
models like the discounted cash flow (DCF) method, determining the present
value of assets or companies.
• Investor Expectations: Signals to investors the required return on their
investments, influencing their decisions to invest in or divest from a company.
 • The interest that the company pays
Cost of Debt

• The compensation that the investors

Cost of demand in exchange for owning the
Equity company shares
 COMPONENTS OF COST OF
CAPITAL:
• Cost of Debt:
• The cost of debt represents the expense a company incurs by borrowing funds. It includes
interest payments to debt holders and can be calculated through various methods such as the
yield to maturity, the current yield, or the coupon rate on bonds.
• Calculation Methods:
 Yield to Maturity (YTM): Reflects the total return anticipated on a bond if held till maturity,
considering its current market price, coupon payments, and time to maturity.
 Cost of Debt Formula: Often calculated as the yield on a company's existing debt or by using
the formula: Cost of Debt = (Interest Expense / Total Debt).
 COMPONENTS OF COST OF
CAPITAL:
• Cost of Equity:
• The cost of equity is the return required by shareholders to invest in a company's stock. It
signifies the opportunity cost of investing in a particular stock rather than in a risk-free
investment.

• Methods of Estimation:
 Capital Asset Pricing Model (CAPM): Utilizes the risk-free rate, market risk premium, and
beta coefficient of the stock to calculate the cost of equity.
 Dividend Discount Model (DDM): Estimates the cost of equity by discounting the expected
future dividends at an investor's required rate of return.
 COMPONENTS OF COST OF
CAPITAL:
• Weighted Average Cost of Capital (WACC):
• WACC represents the average cost of capital for a company, considering its entire capital
structure - the proportional mix of debt, equity, and sometimes preferred stock.
• Calculation of WACC: Computed by multiplying the cost of each component of capital by
its respective weight in the capital structure and summing the weighted costs.
• Application: WACC is used as a discount rate in capital budgeting to evaluate investment
opportunities, where projects with returns above the WACC are typically accepted.
 UNDERSTANDING CONCEPTS OF
COST OF CAPITAL
Factors that impact the cost of capital:

What impacts the

cost of capital?

Interest rate levels in

Riskiness of The debt to equity Financial soundness
Malaysia and Global
earnings mix of the firm of the firm
marketplace
 CAPITAL STRUCTURE
• The combination of the debt and equity a company uses to finance its long-term operations
and growth
• The OVERALL cost of capital is the weighted average of the company capital resources.
Also known as the Weighted Average Cost of Capital (WACC)

Debt Equity
 WEIGHTED AVERAGE COST OF
CAPITAL (WACC)
• The firm’s WACC – is the cost of capital for the firm’s mixture of debt and stock (preferred
and common stocks)
• Firm’s are usually geared/ leveraged using a mixture of debt and equity
• WACC is used to discount future cash flows from potential projects and estimate their Net
Present Value. Company wants and optimal financing mixed.
• Debt has advantages over equity financing, but too much debt result in high leverage leading
to high interest rate to compensate lenders for the risk of higher default
 COMPUTATION OF WACC
See the illustration below:
 WACC COMPONENTS
• Cost of Debt (Kd)—the level of return that must be provided for by a
firm to meet the required return of debt holders.
• Cost of Preferred Stock (Kps)—has higher return than bonds, but is less
costly than common stock.
• Cost of Equity (Common Stock & Retained Earnings)—the rate of
return that investors require to make an equity investment in a firm
COST OF DEBT
 COST OF DEBT-INTERPOLATION
Refer text book page 320
 COST OF DEBT AFTER TAX
• Cost of debt after tax (kd after tax)
 COST OF PREFERRED STOCK
• Preferred stock has a higher return than bonds, but is less costly than common stock because
dividends are paid to preferred stockholders first.
• kp =
• Floatation cost: the cost incurred by a publicly traded company when it issues new securities
(includes underwriting fees, legal fees, registration fees, printing prospectus and advertising)
 COST OF EQUITY/COMMON STOCK
• Cost of equity is the rate of returns
that investors require to invest in a
firm’s equity
CALCULATING WACC
 WACC – BREAKPOINTS
• Refer example in text book
 EXAMPLE
• A company's stock has a beta of 1.5, a risk-free rate of 3%, and a market risk premium of
7%. Calculate the cost of equity using the Capital Asset Pricing Model (CAPM).

• Cost of Equity (CAPM)=Risk-Free Rate+Beta×Market Risk Premium

• Cost of Equity (CAPM)=0.03+(1.5×0.07)=0.03+0.105=10.5%Cost of Equity (CAPM)=0.03
+(1.5×0.07)=0.03+0.105=10.5%
 EXAMPLE
• A company has a capital structure comprising 60% equity and 40% debt. The cost of equity
is 12%, and the cost of debt is 6%. Calculate the Weighted Average Cost of Capital (WACC).

• WACC=Weight of Equity×Cost of Equity+Weight of Debt×Cost of Debt

•
WACC=(0.6×0.12)+(0.4×0.06)=0.072+0.024=9.6%WACC=(0.6×0.12)+(0.4×0.06)=0.072+0
.024=9.6%
 EXAMPLE
• If a company increases its debt from 40% to 50% of the capital structure and the cost of debt
remains at 6%, while the cost of equity is 12%, what will be the new WACC?

• Old WACC = 9.6%

• New WACC = (0.5 * 0.06) + (0.5 * 0.12) = 0.03 + 0.06 = 9%
• The new WACC after increasing debt to 50% will be 9%.
 IMPORTANCE OF WACC IN
INVESTMENT DECISION-MAKING
• Project Evaluation:
• Benchmark for Investment: WACC serves as a benchmark rate for evaluating potential
investment projects. Projects yielding returns above the WACC are typically considered
acceptable as they are expected to create value for the company, whereas projects yielding
returns below the WACC may decrease the overall value of the firm.
• Capital Budgeting:
• Discount Rate: WACC is used as the discount rate in discounted cash flow (DCF) analysis,
such as the net present value (NPV) method. It discounts the future cash flows of projects to
their present value, aiding in ranking and selecting projects that contribute positively to
shareholder wealth.
 IMPORTANCE OF WACC IN
INVESTMENT DECISION-MAKING
• Determining Financial Viability:
• Risk and Return Trade-off: WACC accounts for the risk associated with a company's capital
structure. It reflects the firm's overall cost of capital considering both debt and equity. Thus,
it represents the minimum rate of return that an investment must generate to cover all
sources of financing.
• Impact on Cost of Capital Structure Changes:
• Capital Structure Optimization: WACC guides in making decisions regarding the firm's
capital structure. Changes in the capital mix (debt-to-equity ratio) can alter the overall cost
of capital. Companies aim to minimize WACC by determining an optimal mix of debt and
equity, thereby reducing the cost of raising funds.
 IMPORTANCE OF WACC IN
INVESTMENT DECISION-MAKING
• Market Expectations and Shareholder Value:
• Investor Perception: Investors and analysts often use WACC as a reference point to evaluate
a company's performance and future prospects. Meeting or exceeding the WACC
demonstrates a company's ability to generate returns above its cost of capital, which
positively influences shareholder value and market perception.
• Strategic Decision-making:
• Mergers, Acquisitions, and Expansion: WACC plays a crucial role in evaluating potential
acquisitions, mergers, or expansion strategies. It assists in determining whether such
initiatives are financially feasible and likely to generate returns exceeding the cost of capital.
 REAL-WORLD SCENARIOS ILLUSTRATING THE
USE OF COST OF CAPITAL AND WACC IN
DECISION-MAKING:
• Corporate Financing Decisions:
• Scenario: A growing tech startup is considering raising capital to finance its expansion plans.
It is evaluating whether to raise funds through equity issuance or taking on additional debt.
• Use of Cost of Capital: By estimating the cost of equity and cost of debt, the company
determines the impact of each financing option on its overall cost of capital (WACC). It then
chooses the financing mix that minimizes the WACC, thereby reducing the cost of raising
capita
 CASE STUDIES HIGHLIGHTING THE IMPACT OF
DIFFERENT CAPITAL STRUCTURES ON FIRMS'
OVERALL COST OF CAPITAL:
• Effect of Changing Debt-Equity Mix:

• Case Study: A mature manufacturing company analyzes the impact of shifting from an all-
equity financing to a partly debt-financed capital structure.
• Impact on WACC: The company calculates WACC for various capital structure scenarios. It
discovers that incorporating debt, if the interest rates are lower than the return on projects,
reduces the overall WACC, signaling potential value creation.
 CASE STUDIES HIGHLIGHTING THE IMPACT OF
DIFFERENT CAPITAL STRUCTURES ON FIRMS'
OVERALL COST OF CAPITAL:
• Comparative Analysis between Industries:

• Case Study: Comparative analysis between industries (e.g., utilities, technology, healthcare)
regarding their capital structures and WACC.
• Impact of Industry Dynamics: The case study showcases how industries with different risk
profiles and capital structures have varying WACC. It demonstrates that industries with
stable cash flows and lower risks tend to have lower WACC compared to those with higher
volatility.
 BUSINESS RISK AND FINANCIAL RISK

• Firm’s business risk is attributed to a firm business and investment decisions.

• Evaluating business risk—variability of EBIT
• Financial risk is a direct result of the firm’s financing decision—selection of financing mix
of debt and equity
 LEVERAGE IN GENERAL
• The extent a firm uses debt
• Can leverage up your position in an investment by taking debt.
• A firm that uses debt is called geared copmany and a firm that uses 100% equity is called an
ungeared company
• Over leveraged means you have too much debt, as in the amount of debt you have taken on
in a business/investment and cannot be covered by the cash flows resulting from that
investment.
TYPES OF LEVERAGE
OPERATING LEVERAGE
 FINANCIAL LEVERAGE
• Degree of financial leverage =
• DOLs =% change in EPS/% change in EBIT

or
• DFLs =% change in earnings attributable to common stockholders/% change in EBIT
IMPLICATIONS OF FINANCIAL LEVERAGE
 TOTAL LEVERAGE
• Degree of combined leverage from the best sales level
• = DOLs =% change in EPS/% change in sales

or
• DFLs =% change in earnings attributable to common stockholders/% change in Sales
THANK YOU