Capital Structure

& Cost of Capital

Introduction

Capital budgeting affects the firms

well-being
Discount rate is based on the risk of the
cash flows
Errors in capital budgeting can be
serious

Need to compensate investors for

financing
Project Expect Return
Project Cash Flows

WACC

Weighted Average Cost of Capital

Also called the hurdle rate
D
P
E

WACC (1 T )
rD rP rE
V
V
V

D = Market Value of Debt

E = Market Value of Equity
P = Market Value of Preferred Stock
V=D+E+P

Costs of Financing

Cost of Preferred Stock

Cost of Debt

Based on preset dividend rate (r = D/P)

YTM is good estimate

Cost of Common Stock

Derived from current market data Beta

Cost has 2 factors

Business or Asset Risk

Financing or Leverage Risk (Leverage increases
common stock risk)

Cost of Equity Example

Market risk premium = 9%

Current risk-free rate = 6%
Company beta = 1.5
Last dividend = $2, dividend growth =
6%/year
Stock price = $15.65

What is our cost of equity?

Example WACC

Equity Information

RE =

Cost of debt?
RD =

Debt Information

Cost of equity?

50 million shares
$80 per share
Beta = 1.15
Market risk prem.
= 9%
Risk-free rate = 5%

$1 billion
Coupon rate = 10%
YTM = 8%
20 years to
maturity

Tax rate = 40%

Example WACC

Capital structure weights?

E = 50 million shares ($80/share) = $4
billion
D = $1 billion face
V = 4 + 1 = $5 billion
w = E/V =
E

wD = D/V =

What is the WACC?

WACC =

Capital Restructuring

Capital restructuring
Adjusting leverage without changing the
firms assets
Increase leverage

Decrease leverage

Issue debt and repurchase outstanding shares

Issue new shares and retire outstanding debt

Choose capital structure to max

stockholder wealth

Maximizing firm value

Ex: Effect of Leverage

Assets
Debt
Equity
D/E
Share $
# Shares

Current
Proposed
$5,000,00 $5,000,00
0
0
$2,500,00
$0
0
$5,000,00 $2,500,00
0
0
0
1
$10
$10
500,000
250,000

EBIT $650,000

D = $0
Interest = 0, Net Income = $650,000
EPS = $650,000/500,000 = $1.30

D = $2.5 mil
Interest =
Net Income =
EPS =

(D/E = 1)

/250,000 =

EBIT $300,000

D = $0
Interest = 0, Net Income = $300,000
EPS = $300,000/500,000 = $0.60

D = $2.5 mil

(D/E = 1)

Interest = $2,500,000 * 10% = $250,000

Net Income =
EPS =
/250,000 =

Break-Even EBIT

EBIT where EPS is the same under

both the current and proposed
capital structures

If EBIT > break-even point

then leverage is beneficial to our
stockholders
If EBIT < break-even point
then leverage is detrimental to our
stockholders

Ex: Break-Even EBIT

EPS All Equity EPS With Debt
EBIT
EBIT 250,000

500,000
250,000
500,000
EBIT 250,000
EBIT

250,000
EBIT 2 * EBIT 500,000
EBIT $500,000

Cost of Equity Varies

If the level of debt increases, the

riskiness of the firm increases.
Increases the cost of debt.
However, the riskiness of the firms
equity also increases, resulting in a
higher re.

Impact of Leverage

$200,000 in assets, all equity,

10,000
shares

Pre-tax
Taxes
Net

Demand

Prob

EBIT

Interest

Income

40%

Income

ROE

EPS

Terrible

0.05

($60,000)

$0

($60,000)

($24,000)

($36,000)

-18.00%

($3.60)

Poor

0.2

($20,000)

$0

($20,000)

($8,000)

($12,000)

-6.00%

($1.20)

Normal

0.5

$40,000

$0

$40,000

$16,000

$24,000

12.00%

$2.40

Good

0.2

$100,000

$0

$100,000

$40,000

$60,000

30.00%

$6.00

Great

0.05

$140,000

$0

$140,000

$56,000

$84,000

42.00%

$8.40

$40,000

$0

$40,000

$16,000

$24,000

12.00%

$2.40

14.82%

$2.96

E(value):
StdDev:

Impact of Leverage

$200,000 in assets, half equity,

5,000
shares

Pre-tax
Taxes
Net

Demand

Prob

EBIT

Interest

Income

40%

Income

ROE

EPS

Terrible

0.05

($60,000)

$12,000

($72,000)

($28,800)

($43,200)

-43.20%

($8.64)

Poor

0.2

($20,000)

$12,000

($32,000)

($12,800)

($19,200)

-19.20%

($3.84)

Normal

0.5

$40,000

$12,000

$28,000

$11,200

$16,800

16.80%

$3.36

Good

0.2

$100,000

$12,000

$88,000

$35,200

$52,800

52.80%

$10.56

Great

0.05

$140,000

$12,000

$128,000

$51,200

$76,800

76.80%

$15.36

$40,000

$12,000

$28,000

$11,200

$16,800

16.80%

$3.36

29.64%

$5.93

E(value):
StdDev:

M&M Perfect Market

Miller and Modigliani (1958)

Fathers of capital structure theory

Proposition I
Firm value is NOT affected by the
capital structure
Since cash flows dont change, value
doesnt change

Proposition II

Firm WACC is NOT affected by capital

M&M Perfect Market

Assumes no taxes or bankruptcy

costs
WACC = (E/V)RE + (D/V)RD

No taxes

RE = RA + (RA RD)(D/E)

RA: cost of the firms business risk

(RA RD)(D/E): cost of the firms

financial risk

Risks

Business risk:
Uncertainty in future EBIT
Depends on business factors such as
competition, industry trends, etc.
Level of systematic risk in cash flows

Financial risk:
Extra risk to stockholders resulting
from leverage
Depends on the amount of leverage
NOT the same as default risk

M&M Perfect Market

Ex: Perfect Market

RA = 16%, RD = 10%; % debt = 45%

Cost of equity?

RE = 16 + (16 - 10)(.45/.55) = 20.91%

If the cost of equity is 25%, what is

D/E?
25 = 16 + (16 - 10)(D/E)
D/E =

Then, what is the % equity in the

firm?

E/V =

Capital Structure
Example
Balance Sheet
Assets (A) 100
Debt Value (D) 40
Equity Value (E) 60
Assets
100
Firm Value (V)
100

rdebt=8% & requity=15%

WACC = rassets =(D/V)* rdebt + (E/V)* requity
WACC =

Capital Structure
Example

New capital structure

Assets (A)
Assets

100
Debt Value (D) 30
Equity Value (E) 70
100
Firm Value (V) 100

Has the risk of the project changed?

Is the go-ahead decision different?

After Refinancing

Before

WACC = .4 (8%) + .6 (15%) = 12.2%

After
Imagine cost of debt dropped to 7.3%
WACC = .3 (7.3%) + .7 (r
equity) = 12.2%

requity =

Example

Debt/equity mix doesnt affect the projects

inherent risk

Required return on the package of debt and

equity is unaffected

However reducing debt level changes the

required returns

Reduced debtholder risk (rdebt fell)

Reduced equityholder risk (requity fell)

How is it, then, that reducing firm risk did

not reduce the required rate of return?

Corporate Taxes

Interest is tax deductible

Effectively, govt subsidizes part of

interest payment

Adding debt can reduce firm taxes

Reduced taxes increases the firm
cash flows

Ex: Taxes
Unlevere Levere
d
d
5000
5000
0
500

EBIT
Interest ($6250 @
8%)
5000
4500
Taxable Income
1700
1530
Taxes (34%)
3300
2970
Net Income
Bondholders
0
500
Equityholders
3300
2970
Total Cash Flows
3300
3470

Interest Tax Shield

Annual interest tax shield

Tax rate times interest payment
$6250 * .08 = $500 in interest expense
Annual tax shield = .34(500) = 170

PV of annual interest tax shield

Assume perpetual debt
PV =
PV = D(R )(T ) / R = DT =
D
C
D
C

Taxes Firm Value

Firm value increases by value of tax

shield

VL = VU + PV (interest tax shield)

If perpetuity, VU = EBIT(1-.t) / rA

Value of equity = Value of the firm Value

of debt

Ex: Unlevered cost of capital (rA)=

12%; t = 35%; EBIT = 25 mil; D = $75
mil; rD = 9%;

Taxes - WACC

WACC decreases as D/E increases

WACC = (E/V)RE + (D/V)(RD)(1-TC)

RE = RA + (RA RD)(D/E)(1-TC)

rA= 12%; t = 35%; D = $75 mil; rD =

9%; VU = $135.42 mil; VL = $161.67
mil; E = $86.67 mil

RE =

WACC=

Example: Proposition II Taxes

Firm restructures its capital so D/E

=1
rA= 12%; t = 35%; rD = 9%
New cost of equity?

RE =

New WACC?

WACC =

Taxes + Bankruptcy

Probability of bankruptcy increases

with debt

Increases the expected bankruptcy

costs

Eventually, the additional value of

the interest tax shield will be offset
by the increase in expected
bankruptcy cost
At this point, the value of the firm
will start to decrease and the WACC
will start to increase

Cost of Debt Varies

Amount
borrowed
$ rd0

D/V
ratio

D/E
ratio

250

0.125

0.1429

AA

8.0%

500

0.250

0.3333

9.0%

750

0.375

0.6000

BBB 11.5%

1,000

0.500

1.0000

BB 14.0%

--

Bond
rating
--

Times Interest Earned

TIE = EBIT / Interest
EBIT = $400,000

t=40%

80,000 shares outstanding, with price of

$25
( EBIT - k d D )( 1 - T )
D $0
EPS
Shares outstandin g
($400,000)(0.6)

80,000
$3.00

EPS & TIE:

D = $250,000, rd = 8%
$250,000
Shares repurchase d
10,000
$25
( EBIT - k d D )( 1 - T )
EPS
Shares outstandin g
($400,000 - 0.08($250,000))(0.6)

80,000 - 10,000
$3.26
EBIT
$400,000
TIE

20x
Int Exp $20,000

EPS & TIE

D = $500,000, rd = 9%
$500,000
Shares repurchased
20,000
$25
( EBIT - k d D )( 1 - T )
EPS
Shares outstanding
($400,000 - 0.09($500,000))(0.6)

80,000 - 20,000
$3.55
EBIT $400,000
TIE

8.9x
Int Exp $45,000

Bankruptcy Costs

Direct costs
Legal and administrative costs
Additional losses for bondholder

Indirect bankruptcy or financial

distress costs
Preoccupies management
Reduces sales
Lose valuable employees

Options of Distress

The right to go bankrupt

Valuable
Protects creditors from further loss of
assets

Creditors will renegotiate why?

Avoid bankruptcy costs
Voluntary debt restructuring

Tradeoff Theory

Tradeoff between the tax

benefits and the costs of
distress.
Tradeoff

determines optimal
capital structure

VL = VU + tC*D - PV (cost of distress)

With higher profits, what should

happen to debt?

In Practice

Tax benefit matters only if theres a large

tax liability
Risk and costs of financial distress vary
Capital structure does differ by industries

Lowest levels of debt

Increased risk of financial distress

Increased cost of financial distress
Pharma, Computers

Highest levels of debt

Steel, Department stores, Utilities

WACC Review

Capital budgeting affects the firms

well-being
Discount rate is based on the risk of the
cash flows
Errors in capital budgeting can be
serious

Need to compensate investors for

financing
Project Expect Return > Cost of Capital
Project Cash Flows > Return to

General Electric

6 Divisions
Commercial Finance loans, leases,
insurance
Healthcare medical technology, drug
discovery
Industrial appliances, lighting,
equipment services
Infrastructure aviation, water, oil &
gas technology
Money consumer finance (credit
cards, auto loans)

Project WACC
Using a general industry or company
cost of capital will lead to bad
decisions.

Using Firm WACC

Only for projects that mirror the

overall firm risk
Only be used if the new financing has
the same proportion of debt,
preferred, and equity
Otherwise, use the project cost of
capital

Pure Play

Find several publicly traded

companies exclusively in projects
business
Use pure play betas to proxy for
projects beta

May be difficult to find such companies

Note if the pure play is levered
Betas are non-stationary over time
Cross-sectional variation of betas, even

Leverage & Beta

Equity risk =
business risk (operating leverage)
+

financial risk (financial leverage)

L = U(1+(1-t)D/E)

L = E = Equity beta = Levered beta

U = A = Asset beta = Unlevered beta

t = Companys marginal tax rate

Capital Structure & Beta

Beta varies with capital choice

Original Capital Structure

assets (U) = portfolio = (D/V) debt + (E/V) equity

debt = .2

equity = 1.2

(40/100)*.2 + (60/100)*1.2 = assets = .8

Debt drops to 30%

Suppose the debt beta falls to .1

Then, assets(U) = .8 = (.3 * .1) + (.7 * equity)
equity = 1.1

so

Leverage & Beta

Firm with no debt decides to issue

$100 million in bonds and retire
some outstanding stock.
Historically, L = .75
Value of the equity after $100 million
is retired is $235 million. The tax
rate is 35%.
What is after the transaction?

L = U(1+(1-t)D/E), where L = lev, U= unlev

L =

Post-Acquisition Beta

1995: Disney announced it was

acquiring Capital Cities for
$120/share

At acquisition, Disney

equity (L) = 1.15

$3.186 bil

E = $31.1 bil

D=

Based on $120 offer price, Capital

Cities

= 0.95 E = $18.5 bil D = $615

Disney/Capital Cities

Step 1

Step 2

Find unlevered betas for each company

Use market values of DIS & CC to find

unlevered beta of combined firm

Step 3

Find levered beta using leverage of combined

firm

1) Unlevered Betas
L

U

1 (1 T ) * ( D )
E

2) Combined Beta

3) Levered Beta