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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