FINANCE 7311
Optimal Capital Structure &
Cost of Capital
1
OUTLINE

Introduction
 Cost of Capital - General
– Required return v. cost of capital
– Risk
– WACC

Capital Structure
 Costs of Capital
2
CAPITAL STRUCTURE

NO TAXES
 TAXES
 BANKRUPTCY & OTHER COSTS
 TRADE-OFF THEORY
 PECKING ORDER HYPOTHESIS
 OTHER CONSIDERATIONS
3
COMPONENT COSTS

DEBT
 PREFERRED
 EQUITY
– DISCOUNTED DIVIDENDS
– CAPM

WACC Again
4
Optimal Capital Structure

Goal: Maximize Value of Firm
 See Lecture Note on Value of Firm



V = CF/R (In General)
We Can Max. Numerator or Min. Denominator
Optimal Capital Structure - that mix of
debt and equity which maximizes the
value of the firm or minimizes the cost of
capital
5
Investors’ Required v. Cost of
Capital

Investors:
R = r + π + RP
– 1st two same for most securities
– RP => Risk Premium
Security’s required return depends on
risk of the security’s cash flows
 Cost of Capital => depends on risk of
firm’s cash flows

6
FIRM RISK V. SECURITY
RISK
FIRM RISK => CIRCLE CF’S
 SECURITY RISK => RECTANGLE
CF’S


ALL EQUITY FIRM: SECURITY RISK
= FIRM RISK
 Ra = Re = WACC
 DEBT => EQUITY RISKIER (WHY?)
7
Unlevered: Assets = Equity = 100

GOOD:
SALES 100.00
COSTS 70.00
EBIT
30.00
INT
0.00
EBT
30.00
TAX
12.00
NI
18.00
ROE
18%

BAD:
SALES 82.50
COSTS 80.00
EBIT
2.50
INT
0.00
EBT
2.50
TAX
1.00
NI
1.50
ROE
1.5%
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Levered: A = 100: D = E = 50

GOOD:
SALES 100.00
COSTS 70.00
EBIT
30.00
INT
5.00
EBT
25.00
TAX
10.00
NI
15.00
ROE
30%

BAD:
SALES
COSTS
EBIT
INT
EBT
TAX
NI
ROE
82.50
80.00
2.50
5.00
(2.50)
(1.00)
(1.50)
(3%)
9
Example:

Cash Flows to Assets same (EBIT)

Cash Flows to Equity Differ
10
COST OF CAPITAL, intro.

Cost of Capital is weighted average of cost of
debt and the cost of equity (Why?)

CAPITAL IS FUNGIBLE
– GRAIN EXAMPLE
– BATHTUB EXAMPLE

WACC = Re*[E/(D+E)] + Rd(1-t)[D/D+E]
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Cost of Capital, cont.

Weights should be market; book may be
ok
 We can write Re as follows:
Re = Ra + (1 - Tc)(Ra - Rd) * D/E
Business
Financial
Risk
Risk
12
Business Risk

Sales/Input Price Variability
 High operating leverage
 Technology
 Regulation
 Management depth/breadth
 Competition
13
FINANCIAL RISK

The additional risk imposed on S/H from
the use of debt financing.
– Debt has a prior claim
– S/H must stand in line behind B/H

Higher Risk ==> Higher Required
Return
14
Optimal Capital Structure
Benchmark Case

No Taxes

No Transaction Costs

Information is symmetric

No other market imperfections
15
Optimal Capital Structure
No Taxes
CF’s From Assets Unchanged
 Value of Firm ==> Circle
 Portfolio of Debt & Equity
 ‘PIE’ Idea


Miller & Modigliani Proposition I (M&M I)
√ The Financing Decision is Irrelevant
16
Optimal Capital Structure
No Taxes

BUT, Debt is Cheaper than Equity, so
why doesn’t WACC fall?

WACC relates to the CIRCLE

Simply ‘repackaging’ same CF stream
17
Cost of Capital, No Taxes

Re = Ra + (Ra - Rd)*D/E

Miller & Modigliani Prop. II (M&M II)
√
Re increases such that WACC is
unchanged
18
No Taxes - Summary

Value of Firm is INDEPENDENT of
financing - M&M I

Re increases as D increases SUCH THAT
WACC IS UNCHANGED - M&M II

EPS increase is offset by Re increase
19
TAXES

Interest is deductible for tax purposes

Investors still require Rd

After-tax cost to firm: = Rd * (1 - Tc)

CF’s higher by amount of tax savings
20
TAXES

Vl = Vu + PV (tax savings)

Value of levered Firm =
Value of unlevered + PV of tax advantage of
debt
Vl = EBIT(1-t)/Ra + Tc x D
21
TAXES, cont.

Now,
WACC < Re (all equity) = Ra
==> Logical Conclusion:
==> Use ‘all’ debt
22
Why Not Use All Debt?

Other Tax Shields
 COSTS OF FINANCIAL DISTRESS
 DIRECT BANKRUPTCY COSTS
Accountants
Attorneys
Others
Who Pays?
23
Costs of Financial Distress,
cont.

INDIRECT COSTS:
DISRUPTION IN MANAGEMENT
Is B/R Management Specialty?
EMPLOYEE COSTS
Morale Low
Turnover increases
24
Indirect Costs, cont.

CUSTOMERS
Quality concerns (airlines; insurance)
Service concerns (autos; computers)
25
TRADE-OFF THEORY

TRADE OFF TAX ADVANTAGE OF
DEBT AGAINST COSTS OF
FINANCIAL DISTRESS

PRACTICE: It is impossible to solve for
precisely optimal capital structure

FLAT BOTTOM BOAT - None and too
much important; between doesn’t matter
26
Handout #1 - Notes

EBIT Unchanged - No effect on assets
 Payments to B/H & S/H continually
increase
 Note that both Rd and Re increase
 EPS continually increases
 Share Price Maximized at 30% debt
 WACC Minimized at 30% debt
27
Handout #2

Vl = Vu
(No Taxes)
(M&M I)

Vl = Vu + Tc*D
(Taxes)

Re = Ru + (Ru - Rd)*D/E*(1 - Tc)
(M&M II)
 Pictures
28
Simple Numerical Example

Vu = 500;
Vl = $670
 E = 670 - 500 = 170
 Re = .20 + (.20 - .10)(1 - .34)(500/170)
= 39.41%

WACC = 14.92%
 100 / 14.92% = $670
29
PECKING ORDER Hypothesis

Relaxes symmetric information
assumption

Now assume that management knows
more about the future prospects of the
firm than do outsiders

The announcement to issue debt or equity
is a SIGNAL
30
PECKING ORDER Hypothesis

If management expects good prospects:
will not want to share with new S/H
 will not want to sell undervalued shares
 expects adequate CF’s to fund debt service
===> WILL ISSUE DEBT
31
Pecking Order Hypothesis,
cont.

If management expects bad prospects:
 Will want to share with new S/H
 Will want to sell overvalued shares
 May not expect adequate CF’s for
debt service
===> WILL ISSUE EQUITY
32
Market Reaction to Security
Issue Announcements

Announcement of new Equity Issue
Negative reaction



30% of new equity issue
3% of existing equity
Announcement of new Debt Issue
Little or no reaction

Share repurchase ==> Positive reaction
33
Pecking Order Summary

Firms use INTERNAL FUNDS first
– Conservative dividend policy

If external funds, then DEBT FIRST (signaling
problem)

When debt capacity is used, then EQUITY

Resulting capital structure is function of firm’s
profitability relative to invest. needs
34
OTHER FACTORS

CASH FLOW STABILITY
 ASSET STRUCTURE
– TANGIBLE V. INTANGIBLE

PROFITABILITY
 AGENCY PROBLEMS
– OVER & UNDER INVESTMENT
PROBLEM
– REMOVES CASH FROM MGMT
35
OTHER FACTORS, cont.

CURRENT MARKET CONDITIONS

FINANCIAL FLEXIBILITY
 RESERVE OF BORROWING POWER
 TODAY’S DECISION AFFECTS FUTURE

MANAGERIAL FLEXIBILTIY
 DEBT COVENANTS
 CASH FLOW TAKEN FROM MGMT
36
COST OF CAPITAL

DISCOUNT RATE DEPENDS ON RISK
OF CASH FLOW STREAM

The Cost of Capital Depends on the USE
of the money, not its SOURCE

When is WACC appropriate?
 Project has same risk as Firm
37
COST OF CAPITAL

EXAMPLE:

Both!

Both have IRR > Cost of Capital
Project A has IRR of 13% and is
financed with 8% debt; Project B has IRR of 15% &
financed with 16% equity. WACC is 12%. Which
should you do?
==> Why?
38
COMPONENT COSTS

DEBT => Return required by investor,
Rd
 Capital market: YTM for O/S debt of firm
 YTM for debt of ‘similar’ firms
Similar: Business Risk & Financial Risk
Same Industry: controls for business risk
 YTM of different rating ‘classes’
Standard &Poors, Moodys
Ratings: Business Risk & Financial Risk
39
Debt, Bond Ratings

STANDARD & POORS
AAA => Highest rating
BBB => adequate capacity to repay P&I
BB => Speculative (below investment grade)
Junk
CCC, D (D = default)
40
PREFERRED STOCK
Preferred is like a ‘perpetuity’
 Pp = D / Rp

==> Rp = D / Pp
Cost of preferred = Dividend Yield
41
COMMON STOCK

Three Methods

Capital Asset Pricing Model (CAPM)

Dividend Discount Model

Risk Premium Method
42
Capital Asset Pricing Model

2 TYPES OF RISK:
 SYSTEMATIC (Market-wide; GDP)
 NONSYSTEMATIC (Firm specific)

Diversification => can virtually eliminate
nonsystematic risk
43
Common Stock, CAPM

Investors should only be rewarded for
systematic risk, which is measured by Beta
 Beta => a measure of the volatility of the stock
relative to the market
Ri = Rf + B*(Rm - Rf)
Where: Rf = risk-free rate
Rm = market return
Rm - Rf = market ‘risk premium’
44
BETA

Beta of Market = 1
 Portfolio Beta = weighted average of all
betas in the portfolio
 Where do we get Beta?
 Regression analysis
 Beta of firm if publicly traded
 Beta from portfolio of ‘similar’ firms
 Similar need not include financial risk
45
Levered/Unlevered Beta

We can adjust Beta for Leverage as
follows:
Bl = Bu * [1 + D/E*(1-t)]
and:
Bu = Bl / [1 + D/E*(1 - t)]
46
Levered/Unlevered Beta

Take Levered Beta from sample portfolio

Unlever to find ‘unlevered’ or asset beta, using
D/E of sample portfolio

‘Relever’ unlevered beta using D/E of firm
Note: This is same process used to adjust Re to
reflect additional financial risk.
47
Cost of Equity: Discount
Dividends

Recall: P0 = D1 / (R - g)
 Expected returns = required in equilibrium
 We can solve above for ‘expected’ return:
R = D1/P0 + g
The trick is to estimate g (Forecasts; history;
SGR)
48
Dividend Discount - New equity

If new equity is issued, there are
transaction costs.
 Not all proceeds go to firm.
 Let c = % of proceeds as transaction
costs
Then:
R = D1/ [P0*(1-c)] + g
49
Equity Cost: Risk Premium
Method

Add risk premium to company’s
marginal cost of debt

Re = Rd + Risk Premium

Problem: Where do you get risk
premium
50
WACC SUMMARY

WACC =
Re*[E/(D+E)] + Rd*(1-t)[D/(D+E)]
Required return depends on firm risk.
Capital budgeting: Assumes project has
same risk as firm.
51