# Optimal Capital Structure The Cost of Capital Approach

P.V. Viswanath

Based on Damodaran’s Corporate Finance

V. then  Max Firm Value = Min WACC P.Cost of Capital Approach  We have already seen that  FCFF = EBIT(1-t) – (Capital Expenditures – Dep) – Change in Noncash Working Capital  The Value of the firm is the sum of the discounted present values of FCFF plus current cash.  If we can assume that the cashflows are unaffected by the choice of financing mix. Viswanath 2 .

 Compute the firm’s levered beta for different debt ratio levels and use this to figure out the cost of equity capital at the different debt ratio levels.V. Viswanath 3 . P.Cost of Equity Capital  We compute WACC at different debt/capital ratios and pick the lowest WACC.  Three inputs needed:    Cost of equity After-tax cost of debt Weights on debt and equity  Start with the current equity beta and compute the firm’s asset beta.

Add on a default spread based on the estimated rating to the risk-free rate to get the pre-tax cost of debt.Cost of debt capital  Estimate the firm’s dollar debt and interest exp at each debt ratio.  Choose the debt ratio that minimizes the WACC. Viswanath 4 . Apply the marginal tax rate to get the after-tax cost of debt. P.  At each debt ratio. use that ratio(s) to estimate a synthetic bond rating for the firm.  Weight the costs of debt and equity based on the proportions used of each type.V. keeping in mind that the marginal tax rate might decrease as we increase the amount of debt-related income deductions for tax purposes.     compute a financial ratio(s) such as the interest coverage ratio (EBIT/Interest expenses) to measure default risk.

50% 0.V.249999 1.499999 100000 A+ AA AAA 0.25 ≤ to 0.799999 1.2 0.85% 5.649999 0.00% 1.8 1.65 0.00% 12.00% 4.5 6.5 8.499999 1.249999 5.00% 0.25 1.25 2.5 1.35% P.75 2 2. Viswanath 5 .50% 1.999999 2.2499999 2.70% 0.00% 6.50% 2.49999 2.00% 3.499999 8.25% 2.50 6.749999 1.5 3 4.999999 4.00% 8.00% 10.199999 0.Interest Coverage Ratios and Spreads If interest coverage ratio is > -100000 0.499999 Rating is D C CC CCC BB B+ BB BB+ BBB AA Spread is 20.

 Lower estimates of operating income for higher debt ratios due to indirect bankruptcy costs.  To keep a limit on these costs. Viswanath 6 .Constrained Approach  The unconstrained approach is problematic because agency costs are going to increase as the debt ratio goes up and as the bond rating goes down. P. the firm might want to put a constraint on the lowest bond rating allowed.  Use normalized operating income to estimate bond ratings so that temporarily depressed income does not yield an overly low optimal debt ratio.V.

The beta for the company is 1. a California-based firm that manufactures and services digital satellite television systems.Example  Problem 12.V. Theory and Practice  You have been asked by JJ Corporation. Chapter 19 from Damodaran.000 ten-year convertible bonds. and the current risk-free rate is 6%. They currently have 70 million shares outstanding trading at \$10 per share. JJ Corporation is rated BBB. trading at \$1000 per bond. P. In addition. Viswanath 7 .2. Corporate Finance. and the interest rate on BBB straight bonds is currently 10%. it has 500. The tax rate is 40%. with a coupon rate of 8%. to evaluate its capital structure.

The 500.32 = 57. Hence total equity = 700+124.41%.V.000 convertible bonds would sell at a yield of 10% if they were straight. What is the firm's current debt-equity ratio?  Solution: The market value of the common stock is 70m. Viswanath 8 .63 per convertible bond.69m.) = 762.32m.5m.5) = 437.Debt-Equity Ratio computation  a. The market value of the debt component of the convertibles = 875.69/762. the equity component = \$124. P.37(0. Hence the debt-equity ratio = 437. x \$10 = \$700m.63(0. Hence the straight bond component of the convertibles =  Since the convertibles trade at \$1000 per bond.

055) = 12.4)10% + (1/1.6% = 10.192%.6%.2(0.5741)(1-0.5741/1.  The WACC = (. What is the firm's current weighted average cost of capital?  Solution: The required rate of return on the equity. P.06 + 1.5741)12. using the CAPM is . Viswanath 9 .WACC Computation  b. using the data from the previous section.V.

The effect of this additional borrowing will be a drop in the bond rating to B.V. What will be the firm's cost of equity after this additional borrowing? P. which currently carries an interest rate of 11%. Viswanath 10 .  c.Cost of equity after borrowing  JJ Corporation is proposing to borrow \$250 million to use for the following purposes:     Buy back \$100 million Pay \$100 million in dividends Invest \$50 million in a project with a NPV of \$25 million.

V.69+250=687. The market value of debt will be 437.5m.\$200m + \$25m. the cost of equity = .055) = 14.32m . The unlevered beta = Hence the levered beta will be equal to 0.17) = 1.  Hence the debt-equity ratio will be 1. the market value of equity will be \$762.4)1.36%.17.89(1+(1-0.52.06+1. P.Cost of equity after borrowing  Solution: After this borrowing. Viswanath 11 .69m.  Hence.52(0. = \$586.

V. What will the firm's weighted average cost of capital be after this additional borrowing?  Solution: The WACC = P.WACC after borrowing  d. Viswanath 12 .

10192-.V.17%. The WACC has decreased from 10. Viswanath 13 .36m.192% to 10.17%.68)(.36 (increase in firm value due to capital structure change) = \$ 1277. P.Value of firm after borrowing  e.36 million.1017)/(0.  New Firm Value= \$ 1.32+437.10192-.1017) = \$2.1017). we get (762. hence the annual savings in financing costs equal (1200)(.200 (original firm value) + \$ 50 (net increase in capital after capital structure changes)+ \$ 25 (NPV of new project) + \$ 2. What will the value of the firm be after this additional borrowing?  Solution: The original firm value was \$1200.  Discounting these at the new cost of capital of 10.