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Chapter 18

Capital Structure and the Cost


of Capital
2011 John Wiley and Sons

Chapter Outcomes

Explain how capital structure affects a


firms capital budgeting discount rate.
Explain how a firm can determine its
cost of debt financing and cost of
equity financing.
Explain how a firm can estimate its
cost of capital.
Describe how a firms growth
potential, dividend policy, and capital
structure are related.
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Chapter Outcomes, continued

Explain how EBIT/eps analysis can assist


management in choosing a capital structure.
Describe how a firms business risk and
operating leverage may affect its capital
structure.
Describe how a firms degree of financial
leverage and degree of combined leverage
can be computed and explain how to interpret
their values.
Describe the factors that affect a firms
capital structure.
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What is Capital Structure?

Capital structure is the mix of debt


and equity
An optimal debt/equity mix will
minimize the firms cost of capital
A lower cost of capital means a
higher firm value

Required Rate of Return and the


Cost of Capital

Project cost = $1000


Financed by:
$600 debt at 9% interest (pre-tax)
$400 equity with a 15% return
requirement

Minimum Required Returns


Annual pre-tax cash flow =
$600 (0.09) + $400 (0.15) = $114
Minimum pre-tax return
= 114/$1000 = 11.4%
or:
= $600/$1000 (9%) + $400/$1000(15%)
=11.4%

Three Names, Same Concept

Required rate of returninvestor


Cost of capital (or weighted average
cost of capital)firm
Discount rateNPV calculation

Why a Weighted Average?

In most cases, the weighted average


cost of capital should be used in
project evaluation, NOT project-specific
financing costs
This month: accept project with IRR of
9% and is debt-financed at 8%
Later this year: reject project with IRR
of 12% that was to be equity financed at
15%
This is not a value-maximizing
strategy!
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Computing Capital Costs

After-tax cash flows require the use


of after-tax financing costs
Incremental cash flows require
incremental, or marginal, financing
costs

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Cost of Capital

Cost of debt
Cost of preferred stock
Cost of common equity
Retained earnings
New common stock

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Cost of Debt

Yield to maturity (YTM) of new debt


Sources:
current interest rates for rated
bonds
investment bank advice
current YTM on firms outstanding
bonds
long-term bank financing rate
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Cost of debt calculation


Interest is tax-deductible to the firm
kd = YTM ( 1 - T)
Example:
40 percent marginal tax rate
New debt can be issued with a 10
percent YTM
kd = 10% (1 - .4) = 6%

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Cost of Preferred Stock

Recall:

Price of preferred stock = Dp / rp

rp = Dp / Pps
taking flotation costs into account,
cost of preferred stock
= kp = Dp / (Pps - Fps)
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Cost of Preferred Stock Example

Dividend = $5 per share


Price of preferred stock = $55
Flotation cost = $3 per share

kp = Dp / (Pps - Fps)

kp = $5 / ($55 - $3) = 9.62%

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Cost of Common Equity

Two sources of common equity:


Retained earnings
New common stock

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Cost of Retained Earnings

Is cost of retained earnings = zero?


No, because of opportunity cost to
shareholders
Two methods to find cost of retained
earnings
security market line approach
constant dividend growth model
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Cost of Retained Earnings:


Security Market Line Approach

Recall:
E (Ri) = RFR + i ( RMKT - RFR)

This represents the opportunity cost


to shareholders of the firms use of
retained earnings to finance projects
so:
kRE = E (Ri) = RFR + i ( RMKT - RFR)
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Cost of Retained Earnings:


Constant Dividend Growth Model
Recall:
Price of common stock = D1 / (rcs - g)

Since shareholder required return =


opportunity cost if firm uses retained
earnings as a financing source,
kRE = rcs = (D1 / P) + g
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Cost of New Common Stock

Adapt the constant dividend growth


model to reflect flotation costs since
when new shares are sold, the firm
receives (Price - flotation costs) per
share.
kn = [D1 / (P - Fcs)] + g

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Weighted Average Cost of Capital


WACC = wd kd + wp kp + we ke
where wd + wp + we = 1.0

Weights should reflect managements


belief of a target capital structure which
minimizes financing costs
Measuring whether the firm is moving
toward the target capital structure:
book value weights (balance sheet)
market value weights (market prices)
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WACC and Project Analysis

WACC represents the discount rate


to be used in capital budget project
analysis
Use the projects WACC, not
necessarily the firms WACC,
because of risk differences
Higher risk projects will have
higher WACC
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Difficulty of Making Capital


Structure Decisions

Interrelationships
Firms growth rate
Profitability
Dividend policy

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LTD Divided by Total Assets,


various firms 1997-2008

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Planning Growth Rates

Internal Growth Rate


How quickly assets can grow without
raising external funds
IGR = (RR x ROA)/(1 RR x ROA)

Sustainable Growth Rate


How quickly assets can grow if
debt/equity ratio remains constant
SGR = (RR x ROE)/(1 RR x ROE)
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Effects of Unexpectedly Higher (or


Lower) Growth
Dividend policy
Profitability
Capital Structure

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EBIT/eps analysis

Examine how different capital


structures affect earnings and risk
EBIT
- interest
Net income (ignore taxes)

eps = Net income / # of shares


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Current and Proposed Capital Structures


CURRENT
PROPOSED
Total assets $100 million $100 million
Debt
0 million
50 million
Equity
100 million
50 million
Common stock
price
$25
$25
Number of
shares
4,000,000 2,000,000
Interest rate
10%
10%
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CURRENTNo Debt, 4 Million


Shares (Millions Omitted)
EBIT 50%
BELOW
EXPECTED

EBIT $6.00
Int 0.00
NI
$6.00
eps $ 1.50

EXPECTED

$12.00
0.00
$12.00
$ 3.00

EBIT 50%
ABOVE
EXPECTED

$18.00
0.00
$18.00
$ 4.50
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PROPOSED50% Debt (10%


Coupon), 2 Million Shares
(Millions Omitted)
EBIT 50%
BELOW
EXPECTED

EBIT $6.00
Int 5.00
NI
$1.00
eps $ 0.50

EXPECTED

$12.00
5.00
$ 7.00
$ 3.50

EBIT 50%
ABOVE
EXPECTED

$18.00
5.00
$13.00
$ 6.50
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EBIT/eps analysis
Current versus Proposed
8 eps
Proposed

6
4

Current

2
0
-2
-4

10

12

15

18

EBIT
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Indifference Level

Occurs where the lines cross; at that


level of EBIT both capital structures
have the same eps
Occurs where EBIT =
interest cost (%) x total assets
or, in other words, where
EBIT/TA = interest cost (%)
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Indifference Level
EBIT/TA = interest cost (%)
If EBIT/TA > interest cost, higher
leverage is helpful (higher eps)
If EBIT/TA < interest cost, higher
leverage is harmful (lower eps)
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Comments on EBIT/eps analysis

Positives
Indicates EBIT values when one capital
structure may be preferred over another
Analysis of expected EBIT can focus on
the likelihood of actual EBIT exceeding
the indifference point

Drawbacks
Does not capture risk
Value-maximizing eps is probably less
than maximum eps (Figure 18.8)
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Risk and the Income Statement


Sales
Operating
Variable costs
LeverageFixed costs
EBIT
Interest expense
Financial Earnings before taxes
LeverageTaxes
Net Income
eps =
Net Income
Number of Shares
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Business Risk

Unit volume variability


Price-variable cost margin
Fixed cost
Degree of operating leverage (DOL)
= % change in EBIT/% change in sales
=
Sales variable costs
Sales variable costs fixed costs
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Degree of Financial Leverage


DFL =

percent change in eps


percent change in EBIT

EBIT / (EBIT - Interest)

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Degree of Combined Leverage


DCL =

percent change in eps


percent change in sales

DOL x DFL

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Leverage Example
THIS
10% SALES
YEAR
INCREASE
Net sales $700,000$770,000
Less: variable costs
(60% of sales) 420,000
462,000
Less: fixed costs 200,000
200,000
EBIT 80,000
108,000
Less: interest
20,000
20,000
EBT
60,000
88,000
Less: taxes
18,000
26,400
Net income
$42,000$ 61,600
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Leverage Calculations
Percent change in sales
+10.0%
Percent change in EBIT
+35.0%
Percent change in net income +46.7%
DOL = 35% / 10% = 3.50
DFL = 46.7% / 35% = 1.33
DCL = 46.7% / 10% = 4.67
DCL = DOL x DFL = 3.50 x 1.33 = 4.67
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Insights from Theory and Practice

Taxes and Non-debt tax shields


Bankruptcy costs
Static tradeoff hypothesis
Benefits of tax-deductible interest
payments versus higher risk of
bankruptcy
Agency costs
Cross-border differences in shareholder
protection help explain global financing
patterns
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Insights from Theory and Practice

Type of Assets (tangible versus intangible)


Pecking order theory
Prefer to use internal financing, then debt,
then equity to finance growth
Market timing theory
Current capital structure is the cumulative
result of past financing decisions and
attempts to issue securities when prices
are high
Pecking order and Market timing: is there
an optimal capital structure?
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Flavors of Debt and Equity

Debt:
convertible or straight
maturity: can be extended/shortened
interest: fixed or variable

Equity:
preferred stock
common stock
different classes of common stock
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Guidelines for Financing Strategy

Business risk
Taxes and non-debt tax shields
Mix of tangible and intangible assets
Financial flexibility
Control of the firm
Profitability
Financial market conditions
Managements attitude toward debt
and risk
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Web Links
www.ibbotson.com
www.mergent.com
www.sternstewart.com
www.stern.nyu.edu/~ealtman
www.cfo.com

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