The Cost of Capital and Capital Structure
Eric Hallinan. Reeves Journal. Troy: Nov 2004.Vol.84, Iss. 11; pg. 56, 2 pgs
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Abstract (Document Summary)
The "hurdle rate," or the required rate of return, isn't equal to the cost of capital alone.
The company's cost of capital is dependent on the sources of its financing, which has a
cost that's a function of the company's risk. That risk is inherent in its investment choices
which form the basis for its value.
Full Text (1047 words)
Copyright Business News Publishing Company Nov 2004
I recently attended a financial analysis seminar that reviewed a lot of concepts I learned
in business school. One of those concepts was the capital structure decision and
understanding the cost of capital. It was explained so well I thought I'd attempt to share
with you the insights I learned about it.
Companies finance their operations with some combination of debt and equity, and any
investment decision the company makes needs to take into account the cost incurred to
obtain those dollars. Valuing financial decisions, including proposed acquisitions of
companies or investment in specific capital projects, requires a thorough understanding
of the company's cost of capital and the required rate of return (hurdle rate) applicable to
that particular investment.
Investments are made to yield returns, and because investments are risky, to evaluate
the potential of a proposed investment, an accurate estimation of the cost of capital
specific to that investment is critical. Overestimating the cost of capital leads to rejection
of potentially profitable investment opportunities, while setting the estimate too low
results in accepting projects that may reduce firm value from economic losses when
project cash flows do not earn the firm's required return on capital.
The cost of capital is an opportunity cost. Investors have a wide array of investment
choices and will commit investment dollars to a particular company only when the
returns expected are in line with the expected risk. The combination of expected returns
and risk produces an investment value.
The "hurdle rate," or the required rate of return, isn't equal to the cost of capital alone.
The company's cost of capital is dependent on the sources of its financing, which has a
cost that's a function of the company's risk. That risk is inherent in its investment choices
which form the basis for its value. The hurdle rate is project specific and may exceed the
company's cost of capital where the risk of a particular project is higher than the
company's existing set of investments. The hurdle rate can't be less than the company's
cost of capital because the company had to pay the cost of capital to raise the funds. So
in reality, the hurdle rate is equal to the cost of capital plus the risk premium associated
with the investment.
How is the cost of capital determined? Debt and equity each have separate and distinct
costs. The cost of capital is determined by combining the weighted average of the costs
of both types of capital, debt and equity, weighted according to their proportion to each
other. That is called the Weighted Average Cost of Capital.
How do we determine the cost of debt or the cost of equity? It depends on the risk
characteristics associated with each:
Debt
* Lower risk, due to legal protections and possible collateral availability.
* Interest is tax-deductible, which lowers the borrowing cost.
* Lower acquisition cost (lender agreement, note, bond, etc.).
Equity
* Higher risk because it has no legal protections and no collateral.
* Dividends aren't tax deductible
* Higher acquisition cost associated with the costs of a public offering.
Generally, debt financing is cheaper than equity financing, but not always.
The cost of debt capital is usually the company's after tax cost of interest. Interest rates
are a function of a company's risk as determined by the lenders and reflect many, but
not all risk factors inherent in the cost of equity.
The cost of preferred stock is usually the dividend yield specified with the security.
Preferred stock may be less risky than common equity due to certain features such as
mandatory redemption, conversion, or participation.
The cost of common equity financing is the most difficult to determine due to the lack of
any specific returns like those associated with debt or preferred stock. Basically, the cost
of common equity is the rate of return expected by investors in the company's common
stock, based on the company's risk characteristics in relation to other investments.
The low cost of borrowing compared to the cost of equity financing suggests that a firm's
value would be increased if they issued more debt relative to equity. In fact, with the
deductibility of interest expense to reduce taxes, absent other factors, the firm's optimal
capital structure should be 100 percent debt. Of course, firms can't or won't operate at a
100 percent debt level for several reasons:
* Legal requirements that require some minimal level of equity financing
* Excessive costs of borrowing at very high debt levels, due to the increased risk
imposed on new creditors
* High potential bankruptcy costs would prevent the firm from entering into optimal
contracts with suppliers or customers.
Finance researchers have long explored the issue of the firm's optimal capital structure,
and the issue still remains unresolved because there is uncertainty regarding the
separate costs of equity and debt as the debt percentage increases and decreases.
Originally two researchers, Modigliani and Miller (M&M), proposed that capital structure,
or the proportion of debt and equity, doesn't affect firm value because the cost of equity
would change in proportion to changing debt levels, but the weighted average cost of
capital wouldn't change. That may be true in theory, but in the real world companies
have to deal with taxes, transaction costs, and the possibility of default on debt. With
taxes, there is a tax deduction benefit, which gives debt financing an advantage. The
value of a firm will be increased until borrowing costs are so high that they outweigh the
tax advantage of debt.
So that's the cost of capital and the capital structure decision in a nutshell. Keep in mind
the differences and the benefits associated with your company's balance of debt and
equity financing, and the next time you're planning a big investment decision, evaluate
the hurdle rate according to your cost of capital along with the investment specific risks.
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[Author Affiliation]
Eric R. Hallnan is the director of finance and technology at Benefit Partners, a dba of 4B
Insurance Services, Inc., in Newport Beach, Calif. He earned a BS from UCLA and an
MBA from the Peter F. Drucker School of Management at Claremont Graduate
University. Involved in the plumbing industry since childhood, Hallinan now works for
Steve Lathrop where he specializes in financial analysis and strategic technology
planning.