cost of capital & capital structure

8/3/2019 Cost of Capital & Capital Structure

1/41


2/41

COST OF CAPITAL

The concept of cost of capital budgeting isconcerned with cost of capital. The concept of

cost of capital is significant not only for capitalbudgeting it is also indispensable in other areas offinancial management. In operational terms theCost of capital is the rate of return of a firm must

earn on its investments so that market value of theconcern remain unchanged.


3/41

DEFINITION

Cost of capital is the minimum requiredrate of earning or the cut off rate for capitalexpenditure.

Soloman Ezra


4/41

(i) Designing the optimal Capitalstructure

(ii) Assisting in investment decisions(iii) Helpful in evaluation of expansion

projects

(iv) Rational allocation of nationalresources


5/41

COMPONENTS

Cost of debt

Cost of preference capital

Cost of equity

Weighted average capital cost of capital(WACC)


6/41

Cost of Debt

The cost of debt to the firm is the effective yieldto maturity (or interest rate) paid to itsbondholders

Since interest is tax deductible to the firm, theactual cost of debt is less than the yield tomaturity:

After-tax cost of debt = yield x (1 - tax rate)

The cost of debt should also be adjusted forflotation costs (associated with issuing newbonds)


7/41

with stock with debt

EBIT 400,000 400,000

- interest expense 0 (50,000)

EBT 400,000 350,000

- taxes (34%) (136,000) (119,000)EAT 264,000 231,000

Example: Tax effects ofExample: Tax effects of

financing with debtfinancing with debt

Now, suppose the firm pays $50,000 individends to the shareholders


8/41

with stock with debt

EBIT 400,000 400,000

- interest expense 0 (50,000)EBT 400,000 350,000

- taxes (34%) (136,000) (119,000)

EAT 264,000 231,000- dividends (50,000) 0

Retained earnings 214,000 231,000

Example: Tax effects ofExample: Tax effects of

financing with debtfinancing with debt


9/41

After-tax cost Before-tax cost Tax

of Debt of Debt Savings

33,000 = 50,000 - 17,000

OR

33,000 = 50,000 ( 1 - .34)

Or, if we want to look at percentage costs:

-=


10/41

After-tax Before-tax Marginal% cost of % cost of x tax

Debt Debt rate

Kd = kd (1 - T)

.066 = .10 (1 - .34)

-= 11


11/41

Cost of irredeemable/perpetual

debtThe debt fund whose principal amt. is not to bereturned after a fixed period of time are termedas irredeemable debt.

kd = interest /price

Kd = interest/ net proceed


12/41

The debt whose principal amount is repayableafter a fixed maturity period is termed asredeemable debt

I (1-t) + RV NPkd = n

NP+RV2

I = amount of interest

t = Tax rateRV = redeemable valueNP = Net proceedsn = no. of years to maturity


13/41

Preferred stock:has a fixed dividend (similar to debt)has no maturity datedividends are not tax deductible and areexpected to be perpetual or infinite

Cost of preferred stock = dividendprice - flotation cost


14/41

Baker Corporation has preferred stock that sells for $100 per share and pays an annualdividend of $10.50. If the flotation costs are $4 per share, what is the cost of new

preferred stock?

10.94%.10944-$100

$10.50KP !!!


15/41

Unlike debt and pref. shares, equity shares donot carry a fixed cost. Hence, there is no singlemodel of computation of cost of equity which

is acceptable to all.


16/41

Why is there a cost for retainedearnings?

Earnings can be reinvested or paid outas dividends

Investors could buy other securities,and earn a return.

Thus, there is an opportunity cost ifearnings are retained


17/41

There are a number of methodsused to determine the cost of equity

We will focus on two

Dividend growth Model

CAPM


18/41

Estimating the cost of equity: the dividend growthmodel approach

According to the constant growth (Gordon) model,D1

P0 =RE - g

RearrangingD

1RE = + g

P0


19/41

PercentageYear Dividend Dollar ChangeChange

1990 $4.00 - -

1991 4.40 $0.40 10.00%

1992 4.75 0.35 7.95

1993 5.25 0.50 10.53

1994 5.65 0.40 7.62

Average Growth Rate+ + + =


20/41

This model has drawbacks:

Some firms concentrate on growth and donot pay dividends at all, or only irregularly

Growth rates may also be hard to estimate Also this model doesnt adjust for market risk

Therefore many financial managers preferthe capital asset pricing model (CAPM) - orsecurity market line (SML) - approach forestimating the cost of equity


21/41

)( fmf RRRkj !

Cost of

capital Risk-freereturn

Average rate of return

on common stocks(WIG)

Co-variance

of returns againstthe portfolio

(departure from the average)B < 1, security is safer than WIG averageB > 1, security is riskier than WIG average


22/41

The Capital Asset Pricing Model (CAPM) can be used to estimate therequired return on individual stocks. The formula:

RKRK fmjfj ! F

where

jK = Required return on stock j

fR = Risk-free rate of return (usually current rate on Treasury Bill).

jF = Beta coefficient for stock j represents risk of the stock

mK = Return in market as measured by some proxy portfolio (index)

Suppose that Baker has the following values:fR = 5.5%

jF = 1.0

mK = 12%

.


23/41

Then, using the CAPM we would get a required return of

12%5.5-121.05.5Kj

!!

.


24/41

Advantage: Evaluates risk, applicableto firms that dont pay dividends

Disadvantage: Need to estimate

Beta

the risk premium (usually based on pastdata, not future projections)

use an appropriate risk free rate of interest


25/41

WACC weights the cost of equity and thecost of debt by the percentage of each

used in a firms capital structure WACC=(E/ V) x RE + (D/ V) x RDx (1-TC)

(E/V)= Equity % of total value

(D/V)=Debt % of total value

(1-Tc)=After-tax % or reciprocal of corp tax rateTc. The after-tax rate must be consideredbecause interest on corporate debt is deductible


26/41

ABC 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 % = .8576and Debt % = .1424

Risk free rate is 4%, risk premium=7% and ABCs =.74

Return on equity perSML : RE = 4% + (7% x .74)=9.18%

Tax rate is 40%

Current yield on market debt is 11%


27/41

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

= .8576 x .0918 + (.1424 x .11 x .60)= .088126 or 8.81%


28/41

Weighted average cost of capital, WACC will be one

single number that will take into

Account the expectations of all suppliers of capital. Thismay be used as a hurdle rateThat must be overcome if the project is to be accepted.Crossing of this hurdle rate

Will imply that all capital suppliers are satisfied with the

benefits of the project.


29/41

Capital Structure refers to thecombination or mix of debt andequity which a company uses tofinance its long term operations.


30/41

Net Income (NI) Theory

Net Operating Income (NOI) Theory

Traditional Theory Modigliani-Miller(M-M) Theory


31/41

This theory was propounded by DavidDurand and is also known as Fixed KeTheory.

According to this theory a firm canincrease the value of the firm andreduce the overall cost of capital by

increasing the proportion of debt in itscapital structure to the maximumpossible extent.


32/41

It is due to the fact that debt is, generally a cheapersource of funds because:

(i) Interest rates are lower than dividend rates dueto element of risk,

(ii) The benefit of tax as the interest is deductibleexpense for income tax purpose.


33/41

The Kd is cheaper than the Ke.

Income tax has been ignored.

The Kd and Ke remain constant.


34/41

This theory was propounded by DavidDurand and is also known as IrrelevantTheory.

According to this theory, the total marketvalue of the firm (V) is not affected bythe change in the capital structure and

the overall cost of capital (Ko) remainsfixed irrespective of the debt-equity mix.


35/41

The split of total capitalization betweendebt and equity is not essential or relevant.

The equity shareholders and other investors

i.e. the market capitalizes the value of thefirm as a whole.

The business risk at each level of debt-equity mix remains constant. Therefore,

overall cost of capital also remainsconstant.

The corporate income tax does not exist.


36/41

This theory was propounded by EzraSolomon.

According to this theory, a firm can

reduce the overall cost of capital orincrease the total value of the firm byincreasing the debt proportion in itscapital structure to a certain limit.

Because debt is a cheap source ofraising funds as compared to equitycapital.


37/41

This theory was propounded by FrancoModigliani and Merton Miller.

They have given two approaches

In the Absence of Corporate Taxes

When Corporate Taxes Exist


38/41

According to this approach the V and itsKo are independent of its capitalstructure.

The debt-equity mix of the firm is irrelevant

in determining the total value of the firm. Because with increased use of debt as asource of finance, Ke increases and theadvantage of low cost debt is offset equallyby the increased Ke.

In the opinion of them, two identical firms inall respect, except their capital structure,cannot have different market value or costof capital due to Arbitrage Process.


39/41

Perfect Capital Market No Transaction Cost Homogeneous Risk Class: Expected EBIT of

all the firms have identical risk

characteristics. Risk in terms of expected EBIT should also be

identical for determination of market valueof the shares

Cent-Percent Distribution of earnings to the

shareholders No Corporate Taxes: But later on in 1969

they removed this assumption.


40/41

M-Ms original argument that the V andKo remain constant with the increase ofdebt in capital structure, does not hold

good when corporate taxes are assumedto exist.

They recognised that the V will increaseand Ko will decrease with the increase ofdebt in capital structure.

They accepted that the value of levered(VL) firm will be greater than the value ofunlevered firm (Vu).


41/41

cost of capital & capital structure

Documents