Chapter 18

Capital Structure and the Cost of Capital

© 2011 John Wiley and Sons

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Chapter Outcomes Explain how capital structure affects a

firm’s 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 firm’s 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 firm’s business risk and operating leverage may affect its capital structure.

Describe how a firm’s 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 firm’s 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 firm’s cost of capital

A lower cost of capital means a higher firm value

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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

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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%

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Three Names, Same Concept

Required rate of return—investor Cost of capital (or weighted average

cost of capital)—firm Discount rate—NPV calculation

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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 firm’s 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 rateNew 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 firm’s 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 CapitalWACC = wd kd + wp kp + we ke

where wd + wp + we = 1.0

Weights should reflect management’s

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 project’s WACC, not necessarily the firm’s WACC, because of risk differences

– Higher risk projects will have higher WACC

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Difficulty of Making Capital Structure Decisions

Interrelationships

–Firm’s growth rate

–Profitability

–Dividend policy

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 millionCommon stock

price $25 $25Number of

shares 4,000,000 2,000,000Interest rate 10% 10%

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CURRENT—No Debt, 4 Million Shares (Millions Omitted)

EBIT 50%EBIT 50% EBIT 50% EBIT 50%

BELOWBELOW ABOVE ABOVE

EXPECTEDEXPECTED EXPECTEDEXPECTED EXPECTEDEXPECTED

EBIT $6.00 $12.00 $18.00

– Int 0.00 0.00 0.00

NI $6.00 $12.00 $18.00

eps $ 1.50 $ 3.00 $ 4.50

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PROPOSED—50% Debt (10% Coupon), 2 Million Shares

(Millions Omitted)

EBIT 50%EBIT 50% EBIT 50% EBIT 50%

BELOWBELOW ABOVE ABOVE

EXPECTED EXPECTED EXPECTEDEXPECTED EXPECTEDEXPECTED

EBIT $6.00 $12.00 $18.00

– Int 5.00 5.00 5.00

NI $1.00 $ 7.00 $13.00

eps $ 0.50 $ 3.50 $ 6.50

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EBIT/eps analysisCurrent versus Proposed

Proposed

Current

eps8

6

4

2

0

-2

-4

3 6 9 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

Leverage –Fixed costs

EBIT

–Interest expense

Financial Earnings before taxes

Leverage –Taxes

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% SALESYEAR INCREASE

Net sales $700,000 $770,000Less: variable costs(60% of sales) 420,000 462,000Less: fixed costs 200,000 200,000EBIT 80,000 108,000Less: interest 20,000 20,000EBT 60,000 88,000Less: taxes 18,000 26,400Net 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 Management’s 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