Managerial Finance
Capital Structure: Risk and
Return in the Financing
Decision
Week 4
MF Lecture 4
• How do we finance new investments?
• Who are the players?
• What are the rules?
• What does this imply for the “value adding
process”?
• What is your cost of capital?
What is Capital?
Where does Capital
come from?
Debt
Equity
The Players
The
Entrepreneur
The
Lender
The
Investor
What is Equity?
• People/organisations that invest in your
business and own it (all or a part)
• Only way they get their money out is to sell to
someone else
• The get their “cash return” through dividends
and
• By selling their shares for more than they paid
Debt
• What is debt?
• When do you
have to pay it?
• What do you
have to pay?
Assets
Generate: Operating Cash Flow
Lenders (Debt) Take Interest
& Principal
Government Takes Taxes
Cash Flow to Equity
Types of Capital
Capital Structure
• Financial Leverage
– Using fixed financing costs to magnify effects
on earnings before interest and taxes (EBIT)
• Let’s buy a house with €100.000 using
different Debt versus Equity financings
No Financial Leverage
You finance 100% of your assets yourself
Borrow
$0
Invest
$100,000
Total
$100,000
House value increases by 50% and you sell
for $150,000
Sell
Profit
ROE
$150,000
$50,000
50%
Debt/Equity = 3.0
You finance 75% of your house through debt
Borrow
$75,000
Invest
Total
$25,000
$100,000
House value increases by 50% and you sell for $150,000
Sell
$150,000
Repay Loan
$75,000
Remaining
$75,000
Profit
$50,000
ROE
200% !!!
Debt/Equity = 3.0 and things go
sour…
You finance 75% of your assets through debt
Borrow
$75,000
Invest
$25,000
Total
$100,000
Asset value decreases by 10% and you sell for $90,000
Sell
$90,000
Repay Loan
Remaining
$75,000
$15,000
Profit
-$10,000
ROE
-40%
Optimal Capital Structure
• an optimal capital structure exists which
balances the risk of bankruptcy with the
tax savings of debt.
• Once established, this capital structure
should provide greater returns to
stockholders than they would receive from
an all-equity firm.
Capital Structure of Non-U.S.
Firms
• In general, US, UK, Canada and Japan
use less debt than France, Italy, Germany
• In most European and Pacific Rim
countries, large commercial banks are
more actively involved in the financing of
corporate activity than has been true in the
U.S.
Capital Structure
of Non-U.S. Firms (cont.)
• For example, the same industry patterns
of capital structure tend to be found
around the world.
• In addition, the capital structures of U.S.based MNCs tend to be similar to those of
foreign-based MNCs.
Cost of Capital
• Cost of Equity
• Cost of Debt
Investment decisions must:
1. Return invested capital
(whether debt or equity)
2. Offset anticipated inflation over
time
3. Compensate investors for the
risk they are taking
Risk Defined
• In the context of business
and finance, risk is defined
as the chance of suffering a
financial loss.
• Assets (real or financial)
which have a greater
chance of loss are
considered more risky than
those with a lower chance
of loss.
• Risk may be used
interchangeably with the
term uncertainty to refer to
the variability of returns
associated with a given
asset.
Cost of Equity
• To estimate a firm’s cost of equity, we
need to know two things:
Risk free rate
plus
Extra amount to compensate for
additional risk (risk premium)
Cost of Debt
• Cost of debt a bit easier to calculate:
• Current interest rate to borrow (rd), which
includes risk premium
• Tax Rate (T)
Which is more
expensive equity or debt?
Why?
Understanding WACC
The capital funding of a company is made up of
two components: debt and equity. Lenders
and equity holders each expect a certain
return on the funds or capital they have
provided. The cost of capital is the expected
return to equity owners (or shareholders) and
to debt holders, so WACC tells us the return
that both stakeholders - equity owners and
lenders - can expect. WACC, in other words,
represents the investors' opportunity cost of
taking on the risk of putting money into a
company.
Source: Investopedia.com
The Basic Concept
• Why do we need to determine a company’s
overall “weighted average cost of capital?”
Assume the ABC company has the following investment
opportunity:
- Initial Investment = $100,000
- Useful Life = 20 years
- Minimum Return = 7%
- Least cost source of financing, Debt = 6%
Given the above information, a firm’s financial manger
would be inclined to accept and undertake the investment.
The Basic Concept (cont.)
• Why do we need to determine a company’s
overall “weighted average cost of capital?”
Imagine now that only one week later, the firm has another
available investment opportunity
- Initial Investment = $100,000
- Useful Life = 20 years
- Minimum Return = 12%
- Least cost source of financing, Equity = 14%
Given the above information, the firm would reject this
second, yet clearly more desirable investment opportunity.
So…. WACC Formula
• The Weighted Average Cost of Capital is
given by:
rWACC =
Equity
Debt
× rEquity +
× rDebt ×(1 –
Equity + Debt
Equity + Debt TC)
• It is because interest expense is tax
deductible that we multiply the last term by
(1 - Tax Rate)
The Weighted Average Cost of
Capital
WACC = ra = wiri + werd(1-T)
• Capital Structure Weights
The weights in the above equation are intended to
represent a specific financing mix (where wi = % of debt
and we= % of equity).
Some Key Assumptions
• Business Risk—the risk to the firm of being unable to
cover operating costs—is assumed to be unchanged.
This means that the acceptance of a given project does
not affect the firm’s ability to meet operating costs.
• Financial Risk—the risk to the firm of being unable to
cover required financial obligations—is assumed to be
unchanged. This means that the projects are financed in
such a way that the firm’s ability to meet financing costs
is unchanged.
• After-tax costs are considered relevant—the cost of
capital is measured on an after-tax basis.
Financial Risk
Operational Risk
Risk-Return Tradeoff
• How much uncertainty?
• Risk premium
CF/Share Chart
• What is the point of this?
• Your Cashflow/Share (EBIT)
• Best mix for you (Debt/Equity)
The Value Adding Manager
Value adding means:
Every decision you make is designed to
result in a return in excess of the capital
resources used to invest in that decision
Value
Added
Cost of
Capital
Assignments Questions
• Par value should remain the same
• You decide number of shares to issue
Good Luck!