Capital Structure and

Cost of Capital
LEARNING UNIT 4
Learning Outcomes
• Describe the advantages of debt finance in terms of financial risk and increased return to
shareholders

• Describe the disadvantages of debt finance in terms of financial risk and increased return to
shareholders

• Explain the traditional capital structure theory

• Explain the Miller-Modligliani theory of capital structure

• Identify the differences between the capital structure and the Miller-Modligliani model.

• Use calculations to show how to determine the optimal capital structure of an entity
Learning Outcomes
• Explain the meaning and importance of the weighted average cost of capital

• Calculate the market value of preference shares

• Calculate the cost of preference shares

• Calculate the market value of ordinary shares

• Calculate the cost of ordinary shares

• Calculate the market value of debt

• Calculate the cost of debt

• Calculate the weighted average cost of capital

Reference
Skae, FO. 2017. Managerial Finance. 8th ed.
◦ Chapter 4
Debt Finance
THEME 1
Debt Finance
• Debt advantage – benefit of using debt finance to improve the return on the shareholders’
investment
• Debt disadvantage – with the inclusion of debt into the capital structure it results in the
inclusion of finance risk into the risk of the entity and therefore the shareholders require a
greater return on their investment
• Financial gearing – describes the proportion of debt to the proportion of equity financing

Debt as part of the capital structure – the following has been established
• The cost of debt is lower than the cost of equity
• Introducing debt into the capital structure increases the finance risk and the required return
• Financial gearing improves the return in good economic times but could lower the return in
bad economic times
Capital Structure Models;
Optimal Capital Structure
THEME 2, 3
Capital Structure Models
Two schools of thought:
• Traditional theory – debt finance is acceptable and will lower the company’s overall cost of
capital up until a specific point. Companies should lower their WACC by taking on an
acceptable level of debt (NB there is an optimum amount of debt to add to the capital
structure, anything more will increase risk and anything less will not be efficient)

• Miller and Modligliani – debt finance brings additional finance risk which will result in an
increase in the required return of the shareholders. Therefore the addition of debt which
lowers the cost of capital will result in an increase equal to the reduction in the cost of capital
of the required return and therefore the net effect will be zero (so it does not matter)
Weighted Average Cost
of Capital
THEME 4
Weighted Average Cost of Capital
• The weighted average cost of capital represents the percentage of R1 that needs to be paid
out in both interest and dividends/capital growth.
• The WACC is used for discounting all cash flows back to the present value when making the
investment decision.
• WACC is usually calculated using the target capital structure of the entity and ONLY if there is
no target capital structure provided do we use market values. Therefore read your questions
very carefully to make sure that you are not given the target capital structure. The market
value of the different forms of finance is important if no target is given and therefore you
should know how to calculate all the different market values of the capital in the company.
 Examples under section

Equity Shares 4.10.1 on page 120

Market value of equity shares:

• Use the market price (ex div) to calculate the share price and times that by the
number of shares in issue (if this is supplied)
• Use Gordons Growth Model to calculate the market value (if there is enough
information) (remember that growth can be calculated by taking the historic retention
ratio and multiplying it by the current return on shareholders’ funds)

Cost of equity:
• CAPM (look out for Beta and risk free rate); or
• Gordons Growth Model (manipulated to calculate the ke)
 Examples under section

Preference Shares 4.10.3 on page 122

Market value of preference shares (non-redeemable)

• Dividend/cost of preference shares that are similar

Market value of preference shares (redeemable)

• Use your financial calculator
◦ FV = Redeemable value
◦ PMT = Dividend at coupon rate
◦ I/YR = Market related interest rate
◦ N = number of years

Cost of preference shares

• Market related interest rate
 Examples under section

Debt 4.10.4 on page 123

Market value of debt (Non-redeemable)

• Interest(after tax)/Cost of debt(market related, after tax)

Market value of debt (redeemable)

• Use your financial calculator
◦ FV = redeemable amount
◦ PMT = coupon interest amount times 1 – tax rate
◦ I/YR = market related interest rate
◦ N = number of years

Cost of debt
• IRR calculation or market related interest rate
Weighted Average Cost of Capital
Finance Market Value Weighting Cost WACC
Instrument
Equity Shares
Preference Shares
Debentures
Long-term Loan
Total

Examples under section

4.11 on page 123
Calculating Growth