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CHAPTER 3
THE COST OF CAPITAL
Nas Rabariniaina
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1. INTRODUCTION
• Cost of capital is the cost of using funds from creditors and
owners.
• To create value, you have to invest in investment projects that
provide a return greater than the project's cost of capital.
- If we consider the company as a whole, it creates value when it provides
a return greater than its cost of capital.
• Estimating the cost of capital is challenging.
- We have to estimate it because it cannot be observed.
- We have to make a number of assumptions.
- For a given project, a company's financial manager must estimate the
cost of capital.
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2. THE COST OF CAPITAL
• The cost of capital is the rate of return that providers of capital shareholders and owners - demand compensation for their capital
contributions.
- This cost reflects the opportunity costs of capital providers.
• The cost of capital is a marginal cost: the cost of raising additional capital.
• The weighted average cost of capital (WACC) is the cost of raising
additional capital, with the weights representing the proportion of
each source of finance used.
- Also known as marginal cost of capital (MCC).
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WACC
WACC = wd rd (1 t) + + we re wp rp
(3-1)
Or
wd is the proportion of debt the company uses when raising new funds.
rd is the pre-tax marginal cost of debt t is the firm's
marginal tax rate wp is the proportion of preferred stock
the firm uses when it
raises new funds.
rp is the marginal cost of preferred stock we is the
proportion of equity the firm uses when raising
new funds.
re is the marginal cost of equity
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EXAMPLE: WACC
Let's assume that Widget Company has a capital structure consisting of the
following, in billions:
Debt
€10
Ordinary equity
€40
If the pre-tax cost of debt is 9%, the required rate of return on equity is 15%,
and the marginal tax rate is 30%, what is Widget's weighted average cost of
capital?
Solution :
WACC = [(0.20)(0.09)(1 - 0.30)] + [(0.8)(0.15)]
= 0.0126 + 0.120
= 0.1325, or 13.25%.
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EXAMPLE: WACC
Interpretation:
When Widget raises an additional €1 of capital, it will do so in a ratio of 20%
debt and 80% equity, and its cost will be 13.25%.
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TAXES AND THE COST OF CAPITAL
• Interest on debt is tax deductible; therefore, the cost of debt must be
adjusted to reflect this deductibility.
- We multiply the pre-tax cost of debt (rd ) by the factor (1 - t), t being
the marginal tax rate.
- Thus, rd × (1 t) is the after-tax cost of debt. •
Payments to owners are not tax deductible, so the required rate of return
on equity (whether preferred or common) is the cost of capital.
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WEIGHT OF THE WEIGHTED AVERAGE
• Weightings should reflect how the company will raise
additional capital.
• Ideally, we would like to know the target capital structure of
the company, that is, the capital structure that matches the company's
objective, but we cannot observe this objective.
• Alternatives
- Evaluate the market value of the elements of the capital structure of
the company.
- Examine trends in the company's capital structure.
- Use the capital structures of comparable companies (e.g., the weighted
average of the capital structure of comparable companies).
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APPLICATION OF THE COST OF CAPITAL TO THE
CAPITAL BUDGETING AND EVALUATION
TITLES
• The Investment Opportunities Table (IOS) is a representation of investment performance.
• We assume that the IOS is on a downward slope: no longer a company
invests, the lower the additional opportunities.
- In other words, the company will invest first in high-return investments and then in lowreturn investments as the capital available for investment increases.
• The marginal cost of capital (MCC) table is the representation of costs
of raising additional capital.
- We generally assume that the MCC is upward sloping: more
The more funds a company raises, the higher the cost.
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OPTIMAL INVESTMENT DECISION
Marginal cost of capital
Investment Opportunities Calendar
Cost
Or
Return to
Optimal
Capital
Budget
Amount of new capital
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USE THE MCC AS CAPITAL
BUDGETING AND ANALYSIS
• The WACC is the marginal cost of additional funds and, therefore,
additional investments.
• In the investment budget
- We use the WACC, adjusted for project-specific risk, to
calculate the net present value (NPV).
- Using a company's overall WACC to evaluate a project
investment assumes that the project has a risk similar to the company's
average project.
• In analysis
- Analysts can use WACC to evaluate the company in
updating the company's cash flows.
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3. COSTS OF DIFFERENT
SOURCES OF CAPITAL
Cost of
capital
Cost of debt
Cost of preferred
shares
Yield to maturity
Debt rating
Yield of preferred
shares
Variations due to
due date, etc.
Cost of
common equity
Financial
Asset Pricing Model
Dividend
Discount Model
Bond yield plus risk
premium
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THE COST OF DEBT
Other approaches
1. Yield to Maturity Approach: Calculate the yield to
the maturity of the company's current debt.
2. Debt Rating Approach: Use Yields
bonds rated comparably and with maturities similar to those of the
company.
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EXAMPLE: COST OF DEBT
Approach to yield to maturity
Approach to debt rating
Consider a firm with $100 million in outstanding
debt, a coupon rate of 5%, a maturity of 10
years, and a price of $98. What is the
after-tax cost of the debt if the marginal tax
rate is 40%?
Consider a company with $100 million of
outstanding non-traded debt and a debt rating
of AA. The yield on AA debt is currently
6.2%. What is the after-tax cost of debt if the
marginal tax rate is 40%?
Let's assume that the interest is
semi-annual.
Solution :
rd = 0.0526 (1 - 0.4) = 3.156%.
The cost of borrowing capital is
3.156%.
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Solution :
rd = 0.062 (1 - 0.4) = 3.72%.
The cost of borrowing capital is
3.72%.
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QUESTIONS RELATING TO THE ESTIMATE OF THE
COST OF DEBT
• The cost of variable rate debt is difficult to assess because it depends not only on
current rates but also on future rates.
- Possible approach: Use the current rate structure to estimate rates
future.
• Optional-type characteristics affect the cost of debt.
- If the company already has debt with embedded options similar to those it could issue, then
we can use the yield on the current debt.
- If the company is expected to change the incorporated options, then we will have to
estimate the yield on debt with embedded options.
• Unrated debt makes it difficult to determine the yield on a debt
similar return if the company's debt is not traded.
- Possible remedy: Estimate the rating using financial ratios.
• Leases are a form of debt, but there is no return on
the deadline.
- Estimate using the yield of the company's other debts.
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THE COST OF PREFERRED SHARES
The cost of non-redeemable and non-convertible preferred shares is based on
the perpetuity formula:
ÿ (3-3)
Issue
Suppose a company has outstanding preferred stock that has a dividend
of $1.25 per share and a price of $20. What is the company's cost of
preferred stock?
Solution
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THE COST OF EQUITY
Methods for estimating the cost of equity:
1. Financial Asset Pricing Model
2. Dividend Discount Model
3. Bond yield plus risk premium
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USING CAPM TO ESTIMATE THE
COST OF EQUITY
The Capital Asset Pricing Model (CAPM) states that the expected return on equity, E(Ri ), is
the sum of the risk-free interest rate,
RF , and a market risk premium, bi [E(RM ) - RF ]:
E(Ri ) = RF + bi [E(RM ) - RF ] (3-4)
Or
bi is the sensitivity of the return of stock i to variations in the market return
E(RM ) is the expected market return.
E(RM ) - RF is the expected market risk premium or equity risk premium (ERP).
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EXAMPLE: COST OF EQUITY TO
MEDAF AID
Issue :
If the risk-free rate is 3%, the expected market risk premium is 5%, and
the beta of the company's stock is 1.2, what is the company's cost
of equity?
Solution :
Cost of equity = 0.03 + (1.2 × 0.05) = 0.03 + 0.06 = 0.09, or 9%.
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ALTERNATIVES TO CAPM
• Alternative models can be used to capture returns
expected from risk factors not incorporated in the MEDAF. For example, a factor
model can be used to estimate the cost of equity:
E(Ri ) = RF + bi11 + bi22 + ... + ÿijj (3-5)
Or
ÿij = sensitivity of stock i to changes in the jth factor
= the expected risk premium for the jth factor
I
• We can also use the historical risk premium approach
stocks, which requires estimating the average annual return over a historical
period.
- Questions :
- The risk level of stocks may change.
- Investors' risk aversion may change.
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USE OF THE EVALUATION MODEL
DIVIDENDS TO ESTIMATE THE COST OF
EQUITY
• The dividend discount model (DDM) assumes that the value of a stock today is the
present value of all future dividends, discounted at the required rate of return.
• Assuming constant dividend growth:
which we can rearrange to solve for the required rate of return:
(3-6)
• We can estimate the growth rate, g, by using third-party estimates of the company's
dividend growth or by estimating the company's sustainable growth.
• Sustainable growth is the product of return on equity (ROE) and the retention rate (1 minus
the dividend payout ratio, or ):
ROE
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USING DDM TO ESTIMATE THE
COST OF SHARES
Issue
Suppose Gadget Company has a current dividend of £2 per share. The current price of a
share in Gadget Company is £40. Gadget Company has a dividend payout ratio of 20% and an
expected return on equity of 12%. What is the cost of Gadget Company's ordinary shares?
Solution
Using the dividend payout ratio and return on equity, we calculate g:
× 0.12 = 0.96, or 9.6%.
Next, we insert g into the required rate of return formula:
0.0548 + 0.096 = 0.1508, or 15.08%.
If Gadget raises new common equity, its cost is 15.08%.
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USE THE YIELD APPROACH
BOND PLUS RISK PREMIUM FOR
ESTIMATE THE COST OF EQUITY
• The bond yield plus risk premium approach consists of
add a premium to the yield of a company's debt:
re = rd + Risk premium (3-8)
- This approach is based on the idea that the company's equity is riskier than its debt, but
that the cost of these sources evolves in tandem.
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4. ISSUES RELATED TO COST ESTIMATION
OF CAPITAL
• Estimating the beta of a project
• Estimation of country risk premiums
• Using an upward-sloping marginal cost of capital curve
• Address flotation costs
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BETA PROJECT
Questions about estimating beta:
• Estimating a company's beta requires judgment regarding the estimation period, the
periodicity of the return interval, the appropriate market index, the use of a smoothing
technique, and adjustments for stocks of smaller companies.
• If a company is not publicly traded or we are estimating the beta of a project, then we
need to look at the risk of the company or project and use comparables.
• When selecting a comparable for estimating a beta project, we
We would ideally like to find a company with a single sector of activity, and this sector
of activity corresponds to that of the project.
- This comparable ideal is pure play.
- We use the comparable company's beta to estimate an asset beta (beta reflecting only
business risk) and then use it for the project or company in question.
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USE OF COMPARABLES FOR
ESTIMATE THE BETA
Select
a
comparison
Estimate the beta
of the comparable
sample
Deduce the beta
from
the comparison
to estimate the
asset's beta
Leverage beta
for project
financial risk
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LEVERAGE AND LEVERAGE
BETA
To raise beta, one must remove the capital structure of the comparable from the
beta to arrive at the asset beta, which reflects the business risk of the company:
(3-9)
To increase the beta, the financial risk of the project must be taken into account:
(3-10)
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EXAMPLE: LIFTING AND UNLOCKING THE
BETAS
Issue
Consider the following information for the Whatsit project and its comparable,
Thatsit Company:
Debt
Whatsit Project
€10
Actions
€40
Thatsit Company
€100
€200
?
1.4
Beta of
actions
What is the asset beta
and equity beta of the Whatsit project based on
comparable company information and a 40% tax rate for both companies?
Solution
basset = 1.4 {1 [1 + (1 - 0.4)(100 200)]} = 1.4 × 0.76923 = 1.0769
quota
= 1.0769 [1 + (1 - 0.4)(10 40)] = 1.0769 × 1.15 = 1.2384
The beta of the Whatsit project is 1.2384.
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COUNTRY RISK PREMIUM
• The country risk premium is the additional risk premium associated with
doing business in a developing country.
• The additional premium, added to the required rate of return estimated from
the MEDAF, is the country's equity premium, or the country spread.
• To estimate the country risk premium:
- Use the sovereign yield spread, which is the difference between government
bond yields.
- Adjust the sovereign yield spread by a factor which is the ratio between
the state's performance gap and that of the state.
- the annualized standard deviation of the developing country stock
index relative to the developing country stock index.
- annualized standard deviation of the sovereign bond market in the
developed market currency.
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THE SLOPING MARGINAL COST SCHEME
ASCENDING
COST OF CAPITAL SCHEDULE
• The marginal cost of capital curve may slope upward, with
higher costs to raise more capital.
• The cost of capital can increase for many reasons, including:
- Restrictive clauses in bonds limiting the issuance of additional bonds.
- Deviations from the target capital schedule because capital is not raised in small increments
but rather periodically to minimize issuance costs.
- The point at which the cost of capital changes is the breakpoint:
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FLOTATION COSTS
• A flotation cost is the investment bank's commission associated with issuing securities.
• There are two treatments for flotation costs:
1. Adjust the security price in the yield calculation based on the cost of
flotation, or
2. Adjust the project NPV for the monetary cost of flotation.
• NPV adjustment is preferable because introduction costs occur immediately
instead of affecting the firm over the entire duration of the project.
Issue
Suppose a company has a project with an NPV of $100 million. If the company issues $1 billion
of stock to finance this project and the issuance costs are 1.2%, what is the NPV after adjusting for
the issuance costs?
Solution
NPV = $100 million - $12 million = $88 million.
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WHAT DO FINANCIAL DIRECTORS DO?
• Cost of equity: Single factor CAPM
• Project cost of capital: Single cost of capital, but some use a
adjustment for individual projects.
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5. SUMMARY
• The weighted average cost of capital is a weighted average of the after-tax marginal
costs of each source of capital.
• An analyst uses the WACC in the evaluation. For example, the WACC is
used to evaluate a project using the net present value method.
• The pre-tax cost of debt is generally estimated using one of two methods: yield to maturity
or bond rating.
• The yield-to-maturity method for estimating the pre-tax cost of debt uses the familiar bond
pricing equation.
• Since interest payments are generally tax deductible, the after-tax cost is the real and
effective cost of debt to the company.
• The cost of preferred stock is the preferred stock dividend divided
by the current price of the preferred shares.
• The cost of equity is the rate of return required by a company's common
shareholders. We estimate this cost using the CAPM (or its variants) or the dividend
discount method.
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SUMMARY (CONTINUED)
• MEDAF is the most commonly used approach to calculating the cost of common shares.
• When estimating the cost of equity using CAPM, when we do not have publicly traded
shares, we can use the pure-play method, in which we estimate the unlevered beta
of a company with similar business risk and then increase this beta to reflect the
financial risk of the project or company.
• It is common for country risk and currency risk to be diversified, so we can use the estimates
in the MEDAF analysis.
However, in the case where these risks cannot be diversified, we can adjust our measure
of systematic risk by a country equity premium to reflect this undiversified risk:
• The dividend discount model approach is an alternative approach to calculating the
cost of equity.
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SUMMARY (CONTINUED)
• We can estimate the growth rate in the dividend discount model using analysts' published
forecasts or by estimating the sustainable growth rate:
• To estimate the cost of equity, an alternative to the CAPM and dividend discounting
approaches is the bond yield plus risk premium approach.
• The marginal cost of capital table is an illustration of the cost of funds
for various amounts of new capital raised.
• Flotation costs are costs incurred in the process of
raising additional capital. The preferred method for including these costs in the analysis is
to consider them as an initial cash flow in the valuation analysis.
• The survey results indicate that the CAPM method is the most popular method used by
companies to estimate the cost of equity.
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CHAPTER 4
LEVERAGE MEASUREMENTS
Nas Rabariniaina
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1. INTRODUCTION
Leverage is the use of fixed costs in a company's cost structure.
- Operating leverage concerns the structure of operating costs of
the company.
- Financial leverage concerns the capital structure of the company.
Fixed
costs
Fixed
costs
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WHY WORRY ABOUT LEVERAGE?
1. A company's use of leverage affects its risk and
yield.
2. Operating leverage and financial leverage provide insight into a
company's business and its future.
3. Leverage helps us understand the future cash flows of a
business and the risk associated with these cash flows and, consequently, its valuation.
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2. OPERATE THE SITE
• Leverage increases the volatility of earnings and cash flows ÿ therefore, it increases the risk
for capital providers (creditors and owners).
• Consider two firms, Firm 1 and Firm 2, with the
following information:
Number of units produced and
sold
Selling price per unit
Undertaken Company e
1
two
1,000 1,000
€250 €250
€125 €25
Variable cost per unit
Fixed operating cost
€50,000 €100,000
Fixed financing costs
€5,000 €55,000
Debt
€50,000 €550,000
Actions
€700,000 €200,000
Total assets
€750,000 €750,000
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WHAT EXACTLY DOES LEVERAGE DO?
Company 2 uses greater operational and financial leverage than company
Company 1
Company two
€200,000
€150,000
€100,000
Net
Income
€50,000
€0
-€50,000
-€100,000
-€150,000
Number of units produced and sold
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3. COMMERCIAL RISK AND
FINANCIAL RISK
• Business risk is the risk associated with the volatility of profits
operating.
- Commercial risk consists of operating risk and risk of
sale.
• Sales risk is the uncertainty associated with the number of units produced
and sold, as well as the selling price.
Sale risk
Operational risk
Commercial risk
al
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OPERATIONAL RISK
• Operational risk is the risk associated with the mix of expenses
variable and fixed operating costs.
- Operating risk is the sensitivity (i.e. elasticity) of operating profit to variations in unit sales.
• The degree of operating leverage (DOL) is the ratio between the variation in
percentage of operating profit and percentage change in units sold.
• The contribution margin per unit is the difference between the price of
sales and variable cost per unit. This difference is available to cover fixed operating costs.
- Overall, for all units sold, the contribution margin is the difference between total revenue
and variable operating costs.
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DOL
The DOL is at Q units produced and sold:
(4-2)
Or
Q is the number of units
P is the price per unit
V is the variable operating cost per unit and
F is the fixed operating cost
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EXAMPLE: COMPANY 1 AND COMPANY 2
COMPANY TWO
COMPANY 1
,
,
,
,
1,800
1.667%
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FINANCIAL RISK
• Financial risk is the risk associated with the choice of financing
the company.
- The greater the use of fixed-cost obligations, such as debt, the higher
the financial risk.
- As with operating risk, the elasticity of financial risk is the sensitivity
of income available to owners to a variation in operating profit.
• The degree of financial leverage (DFL) is the ratio of the percentage
change in net income to the percentage change in operating
income.
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LDF
At a specific level of operating profits (and, therefore, Q):
(4-4)
where Q, P, V and F are as before, and C is the fixed financial cost.
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EXAMPLE: COMPANY 1 AND COMPANY 2
,
,
1
Company
1.071%
,
,
Company
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1.786%
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RETURN ON EQUITY AND
THE LDF
• The greater the financial leverage, the higher the financial risk.
• We can see the leverage effect by looking at the return on equity (ROE)
for different levels of units produced and sold.
• The higher the DFL, the more sensitive the ROE is to unit variations
produced and sold.
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EXAMPLE: RETURN ON CAPITAL
CLEAN
Let's take the example of company 1 and company 2:
Return on
equity
100%
80%
60%
40%
20%
0%
-20%
-40%
-60%
-80%
Company 1
Company two
Units produced and sold
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DEGREE OF TOTAL LEVERAGE
• Total leverage is the combined effect of operating leverage and financial leverage.
• The total debt ratio (DTL) is the product of the operational debt ratio
and the financial debt ratio:
(4-6)
Or, equivalently:
DTL = DOL × DTL
• If DOL is equal to 3 and DFL is equal to 2, DTL = 2 × 3 = 6.
- Thus, a variation of 1% of the units produced and sold results in a
6% variation in profit for owners.
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EXAMPLE: COMPANY 1 AND COMPANY 2
,
,
1
Company
1,786
,
,
Company
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3.214
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BREAK-EVEN QUANTITY
• The break-even point (BTP ) is the level of units produced and sold
at which costs (variable and fixed) are just covered, i.e. net income is zero.
• The break-even point is
(4-7)
• The break-even operating profit (BOP ) is the level of units produced and sold at
which operating costs are covered.
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EXAMPLE: COMPANY 1 AND COMPANY 2
Exploitation b = 400 units
1
Company
two
Business
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Exploitation b = 444 units
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RISKS FOR CREDITORS AND
OWNERS
• Business risk is affected by demand uncertainty, output price uncertainty
and cost uncertainty.
• Financial risk is added to the company's commercial risk, increasing
the risk for creditors and owners.
• Creditors' claims are fixed, while the claims of
shareholders are residual.
• In the event that creditors' claims cannot be met, there may be legal
statuses that allow claims to be settled: - Reorganization is the
restructuring of claims, in the hope that the company will be able to
continue, in some form or another, to operate.
- Liquidation is the situation in which assets are sold and the
proceeds of the sale distributed to the claimants.
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4. SUMMARY
• Leverage is the use of fixed costs in a company's cost structure
business.
• Business risk is the risk associated with operating profits and
reflects
- sales risk (uncertainty regarding price and quantity of sales)
And
- operational risk (the risk linked to the use of fixed costs in
operations).
• Financial risk is the risk associated with how a company finances its
operations (i.e., the mix of equity and debt financing of the company).
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SUMMARY (CONTINUED)
• The degree of operating leverage (DOL) is the sensitivity of
operating profit to changes in units produced and sold.
• The degree of financial leverage (DFL) is the sensitivity of cash flows to
owners to variations in operating profit.
• Total debt ratio (DTL) is the sensitivity of cash flows to
owners to variations in unit sales.
• The break-even point, QBE , is the number of units produced and sold for
which the company's net income is zero.
• The operating break-even point, QOBE , is the number of units produced and
sold for which the company's operating profit is zero.
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CHAPTER 5
CAPITAL STRUCTURE
Nas Rabariniaina
dd Month yyyy
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1. INTRODUCTION
• The decision on capital structure affects financial risk and, therefore,
the value of the company.
• Capital structure theory helps us understand the most important factors
in the relationship between capital structure and firm value.
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2. THE DECISION ON THE CAPITAL
STRUCTURE
Development of capital structure theory, starting with Miller and
Modigliani's capital structure theory:
Costs of
asymmetric
Agency
information
costs
Benefit from
Irrelevance
of
capital
Costs of
financial
distress
tax deductibility
of interest
structure
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THE WEIGHTED AVERAGE COST OF CAPITAL
The weighted average cost of capital (WACC) is the marginal cost of raising
additional capital and is affected by the costs of capital and the proportion of each source of
capital:
WACC = rWACC = (5-1)
where rd is the pre-tax marginal cost of debt
re is the marginal cost of equity t is the marginal
tax rate
D is the market value of the debt
E is the market value of equity
V=D+E
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PROPOSITION I WITHOUT TAXES:
IRRELEVANCE OF CAPITAL STRUCTURE
• Franco Modigliani and Merton Miller (MM) developed a theory that helps
us understand how taxes and financial distress affect a firm's capital
structure decision.
• The assumptions of their model are not realistic, but they help us to
analyze the effects of the capital structure decision:
1. Investors have homogeneous expectations regarding the flow of
future cash flow.
2. Bonds and stocks trade in perfect markets.
3. Investors can borrow and lend at the same rate.
4. There are no agency fees.
5. Investment and financing decisions are independent of each other.
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PROPOSITION I WITHOUT TAXES:
IRRELEVANCE OF CAPITAL STRUCTURE
MM Proposition I
The market value of a company is not affected by the company's capital structure.
• Assuming no taxes, no distress costs
financial or agency costs, investors would evaluate companies with the same cash flows in
the same way, regardless of their financing method.
• Rationale: There is no benefit to borrowing at the firm level because there is no interest
deductibility. Firms would be indifferent to the source of capital and investors
could use financial leverage if they wish.
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PROPOSITION II WITHOUT TAXES:
Greater financial leverage
MM II Proposal:
The cost of equity is a linear function of the company's debt-toequity ratio.
• Since creditors have a claim on income and assets that takes precedence over equity, the cost of
debt will be lower than the cost of equity.
• As the company uses more debt in its capital structure, the cost of equity increases due to the age
of the debt:
where r0 is the cost of equity if there is no debt financing.
• The WACC is constant because the more the cheaper source of capital is used
(i.e. debt), the higher the cost of equity.
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INTRODUCING TAXES INTO THE THEORY OF
MM
When taxes are introduced (more specifically, the tax deductibility of
interest by the company), the value of the company is reinforced by the
tax shield that this interest deduction constitutes. The tax shield:
- Reduces the cost of debt.
- Decreases the CMPC because we use more debt.
- Increases the value of the company by tD (i.e. marginal tax rate
times debt).
With taxes
Tax-free
Company
value
WACC
VL = VU
VL = VU + tD
rWACC =
rWACC =
Cost of funds
clean
Conclusion: The optimal capital structure is 99.99% debt.
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ENTER THE COSTS OF
FINANCIAL DISTRESS
• Financial distress costs are the costs associated with a business
who has difficulty meeting his obligations.
• The costs of financial distress are:
- Opportunity cost of not making optimal decisions
- Inability to negotiate long-term supply contracts.
- Loss of customers.
• The expected cost of financial distress increases as recourse
relating to loan financing increases.
- This expected cost reduces the value of the company, which partly compensates,
the advantage of interest deductibility.
- The expected cost of distress affects the cost of debt and capital
clean.
In summary: There exists an optimal capital structure for which the value
of the firm is maximized and the cost of capital is minimized.
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AGENCY COSTS
• Agency costs are the costs associated with separating owners and
of management.
• Types of agency costs:
- Monitoring costs
- Security deposit fees
- Residual loss
• The better the corporate governance, the lower the agency costs.
weak.
• Agency costs increase the cost of equity and reduce the
company value.
• The higher the use of debt relative to equity, the greater the control over the firm and, therefore,
the lower the cost of equity.
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COSTS OF ASYMMETRIC INFORMATION
• Asymmetric information is the situation in which different parties have
different information.
- In a society, leaders will have a better set
information than investors.
- The degree of information asymmetry varies between companies and
sectors.
• Pecking order theory argues that the capital structure decision is affected by management's
choice of a source of capital, giving higher priority to sources that reveal the least
information.
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THE OPTIMAL CAPITAL STRUCTURE
Costs of
financial
Taxes
distress Optimal capital structure?
No
No
No
Yes
No
Yes, 99.99% debt.
Yes
Yes
Yes, the benefits of interest deductibility are outweighed
by the expected costs of financial distress.
We cannot determine the optimal capital structure for a given firm, but we know that it
depends on the following:
:
• The company’s commercial risk.
• The company’s tax situation.
• The extent to which the company's assets are tangible.
• The company's corporate governance.
• Transparency of financial information.
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THE THEORY OF TRADE-OFFS: VALUE OF
THE COMPANY
Walk
Value
of the
Farm
Debt/Equity
Unleveraged Enterprise Value
Leveraged Enterprise Value without Distress Costs
financial
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TARGET DEVIATION
A company's capital structure may differ from its target capital structure for
the following reasons:
- Market values of current issues are constantly changing.
- Market conditions that are favorable to one type of security rather than another
other.
- Market conditions in which it is inadvisable or too costly to raise capital.
- Investment banking fees that encourage the issuance of larger and less
frequent securities.
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3. PRACTICAL QUESTIONS RELATING TO
CAPITAL STRUCTURE POLICY
Debt rating
Factors to consider
Leverage in an international
context
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DEBT RATING
• Companies consider debt rating in their capital structure decisions because the cost of debt is
affected by the rating.
Bond ratings by Moody's, Standard & Poor's and Fitch
Moody's
Aaa
Standard &
Poor's
AAA
Fitch
AAA
Aa
AA
AA
HAS
HAS
HAS
class
Middle class
Baa
BBB
BBB
Speculative
Ba
BB
BB
Highly speculative
B
B
B
Substantial risk
Caa
CCC
CCC
Extremely speculative
That
Possibly default
Default
C
Superior quality
High quality
Upper
average
Investment quality
Speculative category
D
DDD-D
• The spread between AAA and BBB rated bond yields is approximately 100 basis points.
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EVALUATION OF THE STRUCTURE POLICY
OF CAPITAL
• Analysts consider a company's capital structure
- Over time.
- Comparison with competitors presenting a commercial risk
similar.
- Consider the company's corporate governance.
• Analysts must also take into account
- The sector in which the company operates.
- The regulatory environment.
- The extent to which the company owns tangible assets.
- The degree of information asymmetry.
- The need for financial flexibility.
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LEVERAGE IN CONTEXT
INTERNATIONAL
• Country-specific factors influence the choice of a company's capital structure and the
maturity structure within that structure.
• Types of factors to consider:
- Institutional and legal environments
- Financial markets and banking sector
- Macroeconomic factors
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COUNTRY-SPECIFIC FACTORS
Country-specific factors and their supposed
impacts
on the capital structure of companies
...then the D/E ratio
Country-specific factor
If a country
...and the debt
is
maturity is
potentially
potentially
Institutional framework
Effectiveness of the
legal system
is more efficient
Lower
Longer
Origin of the legal
has common law as
Lower
Longer
system
opposed to civil law
Information
has auditors and analysts
Lower
Longer
has taxes that promote fairness
Lower
intermediaries
Taxation
p. 222
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COUNTRY-SPECIFIC FACTORS
Country-specific factors and their supposed
impacts
on the capital structure of companies
...then the D/
E ratio is
...and the debt
Specific factor to the
country
If a country
potential
ment
maturity is
potentially
Banking system, financial markets
Equity markets and bond markets and bonds
active scholarship holders
Bank-based or
has a financial system based on
market-based country
banks and large
Longer
Higher
institutional investors
Investors
Macroeconomic environment
Inflation has high inflation
Growth has high GDP growth
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Longer
Lower
Shorter
Lower
Longer
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4. SUMMARY
• The objective of the capital structure decision is to determine the financial leverage that maximizes
the value of the firm (or minimizes the weighted average cost of capital).
• In Modigliani and Miller's theory developed in the absence of taxes, capital structure is irrelevant
and has no effect on firm value.
• Interest deductibility lowers the cost of debt and the cost of capital for the firm as a whole. If we add
the tax shield provided by debt to the Modigliani and Miller framework, the optimal capital structure
is entirely debt.
• In both the Modigliani and Miller proposals with and without taxes, increasing the relative use of
debt in a firm's capital structure increases the risk for capital providers and, therefore, the cost
of equity.
• When there are bankruptcy costs, a high debt ratio increases the risk of
bankruptcy.
• The use of greater debt in a company's capital structure
reduces net agency costs of equity.
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SUMMARY (CONTINUED)
• Asymmetric information costs increase as more is used
equity than debt, suggesting the pecking order theory of leverage, which holds that issuing new
equity is the least preferred method of raising capital.
• According to the static trade-off theory of capital structure, when choosing a capital structure, a
firm weighs the value of the tax advantage of interest deductibility against the present value of the
costs of distress
financial. At the optimal target capital structure, the additional benefit of the tax shield is exactly
offset by the additional costs of financial distress.
• A company can identify its target capital structure, but its target capital structure
capital at any given time may not be equal to its target for many reasons.
• Many companies have objectives to maintain a certain credit rating, and these objectives are
influenced by the relative costs of debt financing among different rating classes.
• To assess the capital structure of a company, the financial analyst must
examine the firm's capital structure over time, the capital structure of competitors that pose similar
business risk, and firm-specific factors that may affect agency costs.
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SUMMARY (CONTINUED)
• Good corporate governance and accounting transparency should
reduce net agency costs of equity.
• When comparing the capital structures of companies from different countries,
The analyst must take into account various characteristics that may differ and affect both the
typical capital structure and the debt maturity structure.
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