COST OF CAPITAL
AND CAPITAL STRUCTURE
Lesson 6
Corporate Finance
13th
Corporate Finance
Castellanza,
October, 2010
Cost of capital
Def: is the expected rate of return that the market
requires in order to attract funds to a particular
investment. (cost of capital/rate of return)
Characteristics:
• it is it is market driven
• it is forward-looking
• it is usually measured in nominal terms
(including expected inflation)
Capital refers to the components of a capital
structure: debt and equity
Corporate Finance
Cost of equity (Ke)
indirect way
(CAPM)
opportunity cost: the cost of foregoing the next best alternative
investment at a specific level of risk
Ke = rf+ P
rf = free risk return
P = premium
Corporate Finance
Cost of debt (Kd)
Kd = i( 1-t )
i = interest rate
t = tax rate of the company (interests are taxdeductible expenses)
Kd = f. interest rate
bankruptcy risk
tax benefits
Corporate Finance
Weighted average cost of capital (WACC)
To be used when the objective is to value the entire
capital structure of a company.
WACC = [Ke E/(E+D)] + [Kd D/(E+D)]
E = equity, D = net financial debt or Net Financial
Position
Ke > WACC > Kd
Corporate Finance
Capital structure
Def: the capital structure of a firm is broadly made
up of its amounts of equity and debt
Components:
equity (shareholder’s equity, corporate reserves,
earnings)
debt (ST and LT debts, corporate bonds, commercial
papers …)
quasi-equity (convertible bonds, mezzanine
financing)
Corporate Finance
Capital structure (cont’d)
Debt versus Equity
Fixed claims
High priority on cash flows
Tax deductible
Fixed Maturity
No management control
Residual claims
Lowest priority on cash flows
No tax deductible
Infinite life
Management control
_____________________________________________
Debt
Hybrids
(Quasi-equity)
Corporate Finance
Equity
Capital structure – costs and benefits of debt (cont’d)
Benefits of debt
 Tax benefits
when you borrow money, you are allowed to deduct interest expenses
from your income to arrive a taxable income. This reduces your taxes.
When you use equity you are not allowed to deduct payments to equity
(such as dividends) to arrive at taxable income
 Adds discipline to management
if you are manager of a firm with no debt, and you generate high
income and cash flows each year, you tend to become complacent. The
complacency can lead to inefficiency and investing in poor projects
Costs of debt
 Bankruptcy costs
 Agency costs
 Loss of future flexibility
Corporate Finance
The financing mix question
In deciding to raise financing for a business,
is there an optimal mix of debt and equity?
If yes
What is the trade-off
that let us determine
the optimal mix?
Corporate Finance
Maximization of shareholders’ return (ROE)
If: taxes = 0 and extraord. rev.-exp. = 0
ROE = [ROI + (D/E) * (ROI – i)]
ROI =
EBIT
CI
ROE =
i = Interests expenses
Net Debt
E = Equity
D = Net Debt or Net Financial Position
CI = Capital invested = D + E
i = interest rate paid on Net Debt
Corporate Finance
Net profit
E
Leverage =
D
E
Relationship between ROE and ROI (cont’d)
Considering taxes:
ROE = [ROI + (D/E) * (ROI – i)] * (1-t)
t = tax rate (taxes/EBT)
Considering extraordinary revenues/expenses:
ROE = [ROI + (D/E) * (ROI – i)] * (1-t) * (1-s)
s = (net extraordinary rev.-exp./earnings before net
extraordinary rev.-exp.)
Corporate Finance
Relationship between ROE and ROI : Example
Assets
Income Statement
Sales
Operating expenses
EBITDA
Depretiation and amortization
EBIT
Interests
EBT
Taxes
Net Profit
Cash & cash equuivalent
2.000
Account receivable
7.850
Inventories
2.000
Other accounts receivable
2.000
15.000
Technical assets
14.500
-11.000
Intangible assets
950
4.000
-1.500
29.300
Liabilities
2.500
-600
1.900
-600
1.300
Short term financial loans
6.000
Account payable
3.500
Severance fund
1.500
Long term financial debt
8.000
Equity
5.000
Reserves
4.000
Profit
1.300
29.300
Corporate Finance
Relationship between ROE and ROI : Example
Net Debt
12.000
ROE
12,6%
t
Equity
10.300
ROI
11,2%
EBIT
2.500
Net Profit
1.300
Leverage
1,17
i
5,0%
31,6%
ROE = [ ROI + ( D / E ) * ( ROI – i) ] * (1 – t)
ROE = [11,2% + (12.000/10.300) * (11,2% – 5,0%)] * (1-31,6%)
ROE = [11,2% + (1,17) * (6,2%)] * (68,4%)
ROE = [11,2% + 7,2%] * (68,4%)
ROE = 18,4% * 68,4% =
12,6%
Corporate Finance
Relationship between ROE and ROI
Decrease
ROI
Decrease
ROE
Decrease
self-financing
Increase
cost of debt
Increase
of debt
14
Corporate Finance
Leverage
Leverage = D / E
D = total financial debt or Net Financial Position
E = equity
Using leverage it is possible to increase debt in order
to increase return on equity



D/E = 1
D/E > 1
D/E < 1
neutral situation
situation to monitor
situation to exploit
15
Corporate Finance
Modigliani – Miller theory
Hp: in an environment where there are no taxes, bankruptcy risk
or agency costs (no separation between stockholders and
managers), capital structure is irrelevant.
the value of a firm (V) is independent of its debt ratio (D/E).
The cost of capital of the firm will not change with leverage.
V
Va
D/E
Corporate Finance
Modigliani – Miller theory (cont’d)
The effect of taxes
V
Vi =Vu + Vats
Vi
Vi = value of levered firm
Vu = value of unlevered firm
Va
Vats = actual value of tax
shields
D/E
Corporate Finance
Trade-off theory
The effect of bankruptcy costs
V
Vi Value of levered firms
without bankruptcy costs
Vabc
Vl Value of
levered firms
Vl = Vu+Vats-Vabc
Vats
Vu Value of
unlevered firms
D/E
Vabc = actual value of bankruptcy costs
Vats = actual value of tax shields
Corporate Finance
Picking order theory
Internal
Financing
sources
External
1. Self-financing
2. Debt
3. Increase of equity
Profitability
Net Debt Level
Corporate Finance
Financing mix decision
1. Macroeconomic context (capital markets)
2. Industry (maturity, capex, risk, etc.)
3. Firm’s characteristics (market position,
financial-economic situation…)
4. Financial needs’ characteristics
Corporate Finance