Chapter 18
Capital Structure and the Cost
of Capital
© 2011 John Wiley and Sons
Chapter Outcomes




Explain how capital structure affects a
firm’s capital budgeting discount rate.
Explain how a firm can determine its
cost of debt financing and cost of
equity financing.
Explain how a firm can estimate its
cost of capital.
Describe how a firm’s growth
potential, dividend policy, and capital
structure are related.
2
Chapter Outcomes, continued




Explain how EBIT/eps analysis can assist
management in choosing a capital structure.
Describe how a firm’s business risk and
operating leverage may affect its capital
structure.
Describe how a firm’s degree of financial
leverage and degree of combined leverage
can be computed and explain how to
interpret their values.
Describe the factors that affect a firm’s
capital structure.
3
What is Capital Structure?



Capital structure is the mix of debt
and equity
An optimal debt/equity mix will
minimize the firm’s cost of capital
A lower cost of capital means a
higher firm value
4
Corporate Debt as a Percentage of GDP
60.0%
50.0%
Percent
40.0%
30.0%
20.0%
10.0%
0.0%
5
Required Rate of Return and the
Cost of Capital




Project cost = $1000
Financed by:
$600 debt at 9% interest (pre-tax)
$400 equity with a 15% return
requirement
6
Minimum Required Returns
Annual pre-tax cash flow =
$600 (0.09) + $400 (0.15) = $114
 Minimum pre-tax return
= 114/$1000 = 11.4%
or:
= $600/$1000 (9%) + $400/$1000(15%)
=11.4%

7
Three Names, Same Concept



Required rate of return—investor
Cost of capital (or weighted average
cost of capital)—firm
Discount rate—NPV calculation
8
Why a Weighted Average?




In most cases, the weighted average
cost of capital should be used in
project evaluation, NOT projectspecific financing costs
This month: accept project with IRR
of 9% and is debt-financed at 8%
Later this year: reject project with
IRR of 12% that was to be equity
financed at 15%
This is not a value-maximizing
strategy!
9
Computing Capital Costs


After-tax cash flows require the use
of after-tax financing costs
Incremental cash flows require
incremental, or marginal, financing
costs
10
Cost of Capital



Cost of debt
Cost of preferred stock
Cost of common equity
– Retained earnings
– New common stock
11
Cost of Debt


Yield to maturity (YTM) of new debt
Sources:
– current interest rates for rated
bonds
– investment bank advice
– current YTM on firm’s outstanding
bonds
– long-term bank financing rate
12
Cost of debt calculation
Interest is tax-deductible to the firm
 kd = YTM ( 1 - T)
 Example:
40 percent marginal tax rate
New debt can be issued with a 10
percent YTM
kd = 10% (1 - .4) = 6%

13
Cost of Preferred Stock

Recall:
Price of preferred stock = Dp / rp
 rp = Dp / Pps
taking flotation costs into account,
cost of preferred stock
= kp = Dp / (Pps - Fps)
14
Cost of Preferred Stock Example





Dividend = $5 per share
Price of preferred stock = $55
Flotation cost = $3 per share
kp = Dp / (Pps - Fps)
kp = $5 / ($55 - $3) = 9.62%
15
Cost of Common Equity

Two sources of common equity:
– Retained earnings
– New common stock
16
Cost of Retained Earnings



Is cost of retained earnings = zero?
No, because of opportunity cost to
shareholders
Two methods to find cost of retained
earnings
– security market line approach
– constant dividend growth model
17
Cost of Retained Earnings:
Security Market Line Approach


Recall:
E (Ri) = RFR + i ( RMKT - RFR)
This represents the opportunity cost
to shareholders of the firm’s use of
retained earnings to finance projects
so:
kRE = E (Ri) = RFR + i ( RMKT - RFR)
18
Cost of Retained Earnings:
Constant Dividend Growth Model
Recall:
Price of common stock = D1 / (rcs - g)
 Since shareholder required return =
opportunity cost if firm uses retained
earnings as a financing source,
 kRE = rcs = (D1 / P) + g

19
Cost of New Common Stock


Adapt the constant dividend growth
model to reflect flotation costs since
when new shares are sold, the firm
receives (Price - flotation costs) per
share.
kn = [D1 / (P - Fcs)] + g
20
Weighted Average Cost of Capital
WACC = wd kd + wp kp + we ke
where wd + wp + we = 1.0

Weights should reflect management’s
belief of a target capital structure which
minimizes financing costs

Measuring whether the firm is moving
toward the target capital structure:
– book value weights (balance sheet)
– market value weights (market prices)
21
WACC and Project Analysis

WACC represents the discount rate
to be used in capital budget project
analysis
– Use the project’s WACC, not
necessarily the firm’s WACC,
because of risk differences
– Higher risk projects will have
higher WACC
22
Difficulty of Making Capital
Structure Decisions

Interrelationships
–Firm’s growth rate
–Profitability
–Dividend policy
23
LTD Divided by Total Assets,
various firms 1997-2008
Long-term Debt Divided by Total Assets
70.0%
60.0%
Apple
AT&T
50.0%
Consolidated
Edison
Dell
40.0%
Percent
ExxonMobil
Google
30.0%
McDonald's
Microsoft
20.0%
Sears
Walgreens
Wal-Mart
10.0%
0.0%
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
24
Planning Growth Rates

Internal Growth Rate
– How quickly assets can grow without
raising external funds
IGR = (RR x ROA)/(1 – RR x ROA)

Sustainable Growth Rate
– How quickly assets can grow if
debt/equity ratio remains constant
SGR = (RR x ROE)/(1 – RR x ROE)
25
Effects of Unexpectedly Higher (or
Lower) Growth
Dividend policy
 Profitability
 Capital Structure

26
EBIT/eps analysis


Examine how different capital
structures affect earnings and risk
EBIT
- interest
Net income (ignore taxes)
eps = Net income / # of shares
27
Current and Proposed Capital Structures
CURRENT
PROPOSED
Total assets $100 million $100 million
Debt
0 million
50 million
Equity
100 million
50 million
Common stock
price
$25
$25
Number of
shares
4,000,000 2,000,000
Interest rate
10%
10%
28
CURRENT—No Debt, 4 Million
Shares (Millions Omitted)
EBIT 50%
BELOW
EXPECTED
EBIT $6.00
– Int 0.00
NI
$6.00
eps $ 1.50
EXPECTED
$12.00
0.00
$12.00
$ 3.00
EBIT 50%
ABOVE
EXPECTED
$18.00
0.00
$18.00
$ 4.50
29
PROPOSED—50% Debt (10%
Coupon), 2 Million Shares
(Millions Omitted)
EBIT 50%
BELOW
EXPECTED
EBIT $6.00
– Int 5.00
NI
$1.00
eps $ 0.50
EXPECTED
$12.00
5.00
$ 7.00
$ 3.50
EBIT 50%
ABOVE
EXPECTED
$18.00
5.00
$13.00
$ 6.50
30
EBIT/eps analysis
Current versus Proposed
8
eps
Proposed
6
4
Current
2
0
-2
-4
3
6
9
10
12
15
18
EBIT
31
Indifference Level


Occurs where the lines cross; at that
level of EBIT both capital structures
have the same eps
Occurs where EBIT =
interest cost (%) x total assets
or, in other words, where
EBIT/TA = interest cost (%)
32
Indifference Level
EBIT/TA = interest cost (%)
If EBIT/TA > interest cost, higher
leverage is helpful (higher eps)
If EBIT/TA < interest cost, higher
leverage is harmful (lower eps)
33
Comments on EBIT/eps analysis

Positives
– Indicates EBIT values when one capital
structure may be preferred over another
– Analysis of expected EBIT can focus on
the likelihood of actual EBIT exceeding
the indifference point

Drawbacks
– Does not capture risk
– Value-maximizing eps is probably less
than maximum eps (Figure 18.8)
34
Risk and the Income Statement
Sales
Operating
–Variable costs
Leverage
–Fixed costs
EBIT
–Interest expense
Financial
Earnings before taxes
Leverage
–Taxes
Net Income
eps =
Net Income
Number of Shares
35
Business Risk




Unit volume variability
Price-variable cost margin
Fixed cost
Degree of operating leverage (DOL)
= % change in EBIT/% change in sales
=
Sales – variable costs
Sales – variable costs – fixed costs
36
Degree of Financial Leverage
DFL =
=
percent change in eps
percent change in EBIT
EBIT / (EBIT - Interest)
37
Degree of Combined Leverage
DCL =
=
percent change in eps
percent change in sales
DOL x DFL
38
Leverage Example
THIS
YEAR
Net sales
$700,000
Less: variable costs
(60% of sales) 420,000
Less: fixed costs 200,000
EBIT
80,000
Less: interest
20,000
EBT
60,000
Less: taxes
18,000
Net income
$42,000
10% SALES
INCREASE
$770,000
462,000
200,000
108,000
20,000
88,000
26,400
$ 61,600
39
Leverage Calculations
Percent change in sales
+10.0%
Percent change in EBIT
+35.0%
Percent change in net income +46.7%
DOL = 35% / 10% = 3.50
DFL = 46.7% / 35% = 1.33
DCL = 46.7% / 10% = 4.67
DCL = DOL x DFL = 3.50 x 1.33 = 4.67
40
Insights from Theory and Practice




Taxes and Non-debt tax shields
Bankruptcy costs
Static tradeoff hypothesis
Benefits of tax-deductible interest
payments versus higher risk of
bankruptcy
Agency costs
– Cross-border differences in shareholder
protection help explain global financing
patterns
41
Insights from Theory and Practice




Type of Assets (tangible versus
intangible)
Pecking order theory
Prefer to use internal financing, then debt,
then equity to finance growth
Market timing theory
Current capital structure is the cumulative
result of past financing decisions and
attempts to issue securities when prices
are high
Pecking order and Market timing: is there
an optimal capital structure?
42
Flavors of Debt and Equity

Debt:
– convertible or straight
– maturity: can be extended/shortened
– interest: fixed or variable

Equity:
– preferred stock
– common stock
– different classes of common stock
43
Guidelines for Financing Strategy








Business risk
Taxes and non-debt tax shields
Mix of tangible and intangible assets
Financial flexibility
Control of the firm
Profitability
Financial market conditions
Management’s attitude toward debt
and risk
44
Web Links
www.ibbotson.com
www.mergent.com
www.sternstewart.com
www.stern.nyu.edu/~ealtman
www.cfo.com
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