ACC 223

COST OF CAPITAL AND CAPITAL

STRUCTURE
Learning Objectives
 At the end of the session, you are expected to:
 Describe the concept of Cost of capital and Capital
structure
 Describe the underlying assumptions, rationale, and
conclusions of Modigliani and Miller’s models, in worlds
with and without tax;
 Discuss the effect of gearing
 Differentiate business and financial risk
 Compute the cost of capital, Weighted Average Cost of
Capital, and Weighted Marginal Cost of Capital

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 Cost of Capital
 The Cost of Capital is the rate of return that a
company has to offer finance providers to induce
them to buy and hold a financial security; OR
 The Cost of Capital is the required rate of return or
discount rate, which should be used by the firm in
determining the NPVs of proposed projects for
investment decisions.
 A firm has to determine the cost of every new capital
financing. Implementing projects with the rate of
return less that the cost of capital will decrease the
value of the firm

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 Cost of Capital Cont’d
 The basic assumptions when calculating the
cost of capital are:
 Business risk - is the risk that the firm will be
unable to cover its operating costs is
assumed unchanged, and
 Financial risk - the risk that the firm will be
unable to meet required financial obligations
is assumed unchanged.

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 Cost of Capital Cont’d
 Usefulness of cost of Capital;
 The concept of cost of capital is useful as a
standard for;
 Evaluating Investment decision
 Designing a firm’s debt policy
 Appraising the financial performance of top
management.

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 Cost of Capital Cont’d
 There are four (4) basic sources of long-term
funds for the business
 Long-term debt (e.g. bonds)
 Preference shares
 Ordinary shares (common stock)
 Retained earnings
 Although not all firms will use each of these
methods of financing, each firm is expected
to have funds from some of these sources in
its capital structure.

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 The Cost of Debt
 The return (interest rate) that firm’s creditors
demand on new borrowing. The assumption is
funds are raised through borrowing by issuing
bonds.
 When debt is used as a source of finance, the firm
saves a considerable amount in payment of tax as
interest is allowed as deductible expense in
computation of tax.
 Hence the effective cost of debt is reduced the
after-tax cost of raising long-term funds through
borrowing.
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 The Cost of Debt Cont’d
 Given that:
 I = Annual Interest
 V = Net proceeds from sale of debt
 N = number of years to the bonds maturity
 F = Face value of the bond

 Then, the formula for calculating the before-tax cost

of debt is given as:
 F-V 
 
n 
Cost of Debt (K d )   I
FV
2
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 The Cost of Debt Cont’d
 The specific cost of financing must be stated
on an AFTER TAX basis as said earlier. If t =
tax rate – then the formula is:

K   K d (1  t )

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 The Cost of Debt Cont’d
 Illustration: a five year Tshs 100/= debenture
of a firm can be sold for a net price of Tshs
96/50. The coupon rate of interest is 14%
p.a., and the debenture will be redeemed at
5% premium on maturity. The firm’s tax rate
is 40%. Compute the after tax cost of
debenture.

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The Cost of Preference Shares
 A fixed rate of dividend is payable on preference
shares. The cost of preference capital is a function of
dividend expected by its investor’s i.e. its stated
dividend.
Annual Dividend
Cost of Preferred (K p ) 
Net Proceeds
Dp
Kp 
Np

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 The Cost of Common Shares
 The cost of equity is the “maximum rate of
return” that the company must earn on equity
financed portion of its investment in order to
leave unchanged the market price of its
stock.

 It is a function of expected return by

investors. There are two forms of stock
financing i.e. New Issues of “Common
stock” and “Retained earnings”
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The Cost of Common Shares Cont’d
 As the first step in finding each of these costs, we
must first estimate the cost of common stock already
issued;
 The cost of common stock is the rate at which
investors discount their expected dividends in order
to determine its share price,
 We use the dividend growth model (Gordon Model)

D1
P
Ke  g

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The Cost of Common Shares Cont’d

Solving for K e , we have

D1
Ke  g
P
D1  expected dividend next year i.e. (1  g)D 0
g  grwoth rate of thee dividend

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The Cost of Common Shares Cont’d
 The cost of retained earnings is the same as cost
of equity to the firm.
 Retained earnings belongs to the shareholders.
They are part of the equity of the firm. The
shareholders could make good use of these funds
by investing in other firms and obtaining a return.
 These funds therefore have an opportunity cost.
 We should regard the cost of retained earnings as
being equal to the expected returns required by
shareholders buying new shares in a firm.

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The Cost of Common Shares Cont’d
 When calculating the cost of newly issued
common stock, floatation costs is taken into
consideration. Thereby
Solving for K e , we have
D1
Kn  g
Nn
K n  cost of newly issued shares
N n  net proceeds from the sale
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The Cost of Common Shares Cont’d
 Illustration: Expected dividend = Tshs 4/=;
price = Tshs 50/=; growth rate = 5%;
floatation costs = Tshs 2/=. Calculate the
cost of retained earnings and cost of
common stock.
4
Kn   0.05  13.3%
50 - 2
4
Kr   0.05  13.%
50
K r  cost of retained earnings
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The Weighted Avg. Cost of Capital
 After calculating the cost of specific sources
of financing, we can determine the overall
cost of capital.
 WACC is found by weighting the cost of
each specific types of capital by its
proportion in the firms capital structure
and then summing up the weighted values.
 The WACC therefore is the weighted average
of the components of debt, preferred, and
common equity.

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 WACC

WACC  K d .Wd  K e .We  K p .Wp

Assume a new business is looking to raise funds
through both debt and equity financing. Under one
financing plan, the company will sell 10,000
shares of stock at $10 per share and take out a
$50,000 loan with a 6% interest rate. The COE is
calculated to be 4%. Assume the corporate tax
 rate is 35% and no preferred shares are
issued .Calculate the value of the WACC

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Cost of Equity Using the Capital Asset
Pricing Model (CAPM)
 The value of an equity share is a function of cash
inflows expected by the investors and the risk
associated with the cash inflows.
 It is calculated by discounting the future streams of
dividends at the required rate of return called the
capitalization rate.
 This rate depends upon the element of risk
associated with investment in shares. It will be equal
to the risk free rate of interest plus the premium for
risk i.e.
K e  risk - free rate of interest  premium for risk
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Cost of Equity Using the Capital Asset
Pricing Model (CAPM) Cont’d
 According to CAPM, the premium for risk is the
difference between market return from diversified
portfolio and the risk free rate of return. It is
indicated in terms of beta coefficient – the
systematic risk of the asset relative to average
Risk Premium   (R m  R f )
 The cost of equity, according to CAPM therefore is
calculated as below
K e  R f   (R m  R f )

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 Pros & Cons the CAPM approach
 Pros
1. The model is simple to understand and use.
2. The model does not depend on dividends or growth rate. It
can be applied to companies that do not currently pay
dividends or are not expected to experience a constant
rate of growth in dividends.
 Cons
1. CAPM does not offer any guidance on the appropriate
choice for the risk-free rate. Risk-free rate may vary widely
depending on the Treasury security chosen.
2. Estimates of beta can vary widely depending upon the
market index and time period chosen.
3. Estimates of market risk premium will also vary depending
on the time period and security chosen.
Cost of Capital & Capital Structure
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 Estimating the Cost of Common Equity for
Pearson plc using the CAPM
A review of current market conditions at the end of
March 2011 reveals that the 10-year TZ. Treasury
Bond yield that we will use to measure the risk-free
rate was 2.81%, the estimated market risk premium
is 6.5%, and the beta for Pearson’s common stock is
1.20.
Determine Pearson’s cost of common equity using
the CAPM, as of March 2011.

Cost of equity = Rf + Beta x Market risk premium

Cost of Capital & Capital Structure

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 Summing Up:
Calculating the Firm’s WACC
 The final step is to calculate the firm’s overall
cost of capital by taking the weighted average
of the firm’s financing mix that we evaluated
in Steps One and Two.
 The following issues should be kept in mind:
 Determine weights based on market value
rather than book value (if possible).
 Use market (current) costs rather than
historical rates (such as coupon rates).
 Use forward looking weights and opportunity
costs.
Cost of Capital & Capital Structure
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 Estimating Project Cost of Capital

 Should the firm’s WACC be used to evaluate all

new investments?
 In theory, it is appropriate only if the risk of the new
project is equal to the overall risk of the firm. This
may generally not be the case necessitating the need
for a unique cost of capital for each project.
 However, a recent survey found that more than 50%
of the firms tend to use single, company-wide
discount rate to evaluate all of their investment
proposals.
 There are advantages and costs associated with
estimating a unique discount rate for each project.

Cost of Capital & Capital Structure

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 Part II

Capital Structure

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 What is Capital Structure?
 The terms capital structure and financial
structure do not mean the same.
 Capital structure refers to the components
of permanent sources of financing - sources
of funds used to buy non-current assets.
 Financial structure means the entire
liabilities side of the balance sheet – which
shows various types sources of financing –
components of current liabilities and long-
term liabilities (debt and equity).

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What is Capital Structure? Cont’d
 Components of long-term debt include:
 Medium term bank loans
 Long term bank loans
 Debentures
 Components of the share capital
 Preference shares
 Ordinary shares – equity
 Retained earnings – equity

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Factors Influencing Financial Structures
1. Growth rate of future sales
 Growing sales might require debt financing.
However, since growth might lead to higher
ROE and EPS, share prices would rise,
thereby facilitating equity financing
2. Stability of future sales
 Stable sales and earnings enable a firm to
finance fixed charges with less risk than
when sales and earnings are fluctuating.
Stable sales favour financial gearing

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Factors Influencing Financial Structures Cont’d

3. Competitive Structure
 An industry whose entry barriers are cheap
as well as cost of adding capacities by
competitors, can easily have a firm’s target
profit margins cut down unexpectedly.
 In such industry, debt servicing is usually
difficulty for individual firms even if sales are
steadily growing

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Factors Influencing Financial Structures Cont’d

4. Asset Structure
 Heavy investment in Non-current Assets
usually needs long-term debt
5. Management Attitudes
 If mgt wants the firm to be controlled by
owners it will go to finance growth by issuing
new shares
 If they wish to maintain ownership – they will
go for debt financing
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Factors Influencing Financial Structures Cont’d

6. Lenders attitudes
 Lenders would normally not accept granting
debts beyond normal gearing ratios for the
industry

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Capital Restructuring
 We are going to look at how changes in capital
structure affect the value of the firm, all else
equal
 Capital restructuring involves changing the
amount of leverage a firm has without changing
the firm’s assets
 Increase leverage by issuing debt and
repurchasing outstanding shares
 Decrease leverage by issuing new shares and
retiring outstanding debt
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Choosing a Capital Structure
 What is the primary goal of financial
managers?
 Maximize stockholder wealth
 We want to choose the capital structure that
will maximize stockholder wealth
 We can maximize stockholder wealth by
maximizing firm value (or equivalently
minimizing WACC).

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Optimal Capital Structure

 Objective: Choose capital structure (mix of

debt v. common equity) at which stock price
is maximized.
 Trades off higher ROE and EPS against
higher risk. The tax-related benefits of
leverage are offset by the debt’s risk-related
costs.

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 What effect does increasing debt have on
the cost of equity for the firm?
 If the level of debt increases, the riskiness of
the firm increases.
 The cost of debt will increase because bond
rating will deteriorates with higher debt level.
 Moreover, the riskiness of the firm’s equity
also increases, resulting in a higher ks.

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Finding Optimal Capital Structure

 The firm’s optimal capital structure can be

determined two ways:
 Minimizes WACC.
 Maximizes stock price.
 Both methods yield the same results.

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 Table for calculating WACC and
determining the minimum WACC

Amount D/A
borrowed ratio
ks kd (1 – T) WACC
$ 0 12.00% 0.00% 12.00%
25,000 0.00%
12.51 4.80 11.55
50,000 12.50
13.20 5.40 11.25
75,000 25.00
14.16 6.90 11.44
100,000 37.50
15.60 8.40 12.00
50.00
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Table for determining the stock price
maximizing capital structure

Amount
Borrowed EPS ks P0

$ 0 $3.00 12.00% $25.00

25,000 3.26 12.51 26.03
50,000 3.55 13.20 26.89
70,000 3.77 14.16 26.59
100,000 3.90 15.60 25.00
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What is this firm’s optimal capital
structure?
 Stock price P0 is maximized ($26.89) at D/A =
25%, so optimal D/A = 25%.
 EPS is maximized at 50%(EPS= $3.90), but
primary interest is stock price, not E(EPS).
 We could push up E(EPS) by using more
debt, but the higher risk the more than
offsets the benefit of higher E(EPS).

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Capital Structure Theory Under Five
Special Cases
 Case I – Assumptions
 No corporate or personal taxes
 No bankruptcy costs
 Case II – Assumptions
 Corporate taxes, but no personal taxes
 No bankruptcy costs
 Case III – Assumptions
 Bankruptcy costs
 Corporate taxes, but no personal taxes
 Case IV – Assumptions
 Managers have private information
 Case V – Assumptions
 Managers tend to waste firm’s money and not work hard.
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Case I: Ignoring taxes and Bankruptcy Cost
 The value of the firm is NOT affected by
changes in the capital structure
 The cash flows of the firm do not change,
therefore value doesn’t change
 The WACC of the firm is NOT affected by
capital structure

 In this case, capital structure does not matter.

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