Capital Structure Theory and the Opportunity Cost of Capital

Prior to this point in your studies, we have not dealt with the capital structure of the
firm the debt to equity ratio of the company. The amount of debt and the amount
of equity and the returns that are required by the debt and equity suppliers will
have an effect on the rate of return a project will be required to earn. In the first
part of the finance course (FINA2360), you were provided the discount rate that you
were to use when calculating the NPV of a project. A firm will use its capital
structure to provide the lowest possible required rate of return, weighted average
cost of capital (WACC) or opportunity cost of capital (OCC) which will, in turn,
provide the most investment opportunities for the firm. By undertaking as many
positive NPV projects as possible, the firm will grow in value and provide the most
value for its shareholders.
What is the Opportunity Cost of Capital?
The opportunity cost of capital is the rate of return a company can earn on its
investment opportunities. This rate of return will often be referred to as the
opportunity cost of capital, the weighted average rate of return, or the discount rate
for projects of average risk for the firm. These terms are readily interchanged; but
will mean the same thing. When evaluating capital budgeting problems in
FINA2360, projects were acceptable if the NPV of the project were positive or 0 and
not acceptable if the NPV was negative. If the NPV was 0, the discount rate was the
minimum rate of return a company would accept. Accepting projects that have a
positive return means that the firm is earning its normal return and the additional
value represent an abnormal return for the firms and its shareholders.
Calculating the Weighted Average Cost of Capital
The weights that are used to calculate the weighted average cost of capital are
derived from the proportion of the funding sources. Lets consider borrowing $20,000
for the startup of a new business. We have been able to secure the following funds
from the following sources
Source

Amount

Interest Rate

$9,000.00

6%

$6,000.00

8%

$5,000.00

12%

The question becomes, what is the minimum rate of return you will need to earn on
your project to be able to cover your interest rate?

Source

Amount

Interest Rate

Interest

$ 9,000.00

6%

$ 540.00

$ 6,000.00

8%

$ 480.00

$ 5,000.00

12%

$ 600.00

Total

$20,000.00

$1,620.00

$1,620.00
And the average interest rate is given as $20,000.00 = 0.081 = 8.1%
Thus, the project must earn 8.1% on average, just to cover the returns from the
sources of funding for the firm.
The average rate of return may also be calculated using the weighted average cost of
capital.

WACC WA rA WB rB WC rC Wn rn
where WACC represents the weighted average cost of borrowing or cost of capital
WA represents the proportion of the funding from source A
kA represents the cost of borrowing or required rate of return for source A
For our firm, the weighted average cost of capital is given as:

WACC WA rA WB rB WC rC
9,000
6,000
5,000
WACC
(6%)
(8%)
(12%)
20,000
20,000
20,000
WACC 2.7% 2.4% 3% 8.1%

For a company, the sources of funding are relatively straight forward. A company will
use debt and equity to raise their much needed capital requirements. When
determining the required rate of return for these sources of financing, the firm needs
to be concerned with the required rate of return on the new capital rather than the
rate of return on the old or existing sources of funding. Not to dismiss the
importance of measuring the current company operations and the rate of return the
company generates; but, in these examples, we are measuring the rate of return that
is required on future projects that the company will need additional funding.
For a large firm, debt financing comes in the form of issuing new bonds. Equity
financing may come from three different sources issuing preferred shares, using
internally generated funds or issuing new common shares.
The Basic Assumptions

One of the basic principles of finance is the notion that the financial markets are
efficient. Informed investors in an efficient market will process all information and
the prices in the market will fairly reflect the value of the firms financial
instruments (stocks and bonds). This un-biased estimate allows investors to make
decisions to invest in various stock and bonds and their action will reflect the
information that is known about the firm, the economy and their expectation of the
future performance. Thus, we look to the market and in particular market values to
provide an estimate of value. The market provides indicators of how a firm should
finance itself in its future investments and aides in determining the required rate of
return on comparable risky assets. The rate of return for the future financing may
be derived by examining the return that current investors require on their
investments in the firm. The amount of debt and the amount of equity that a
company uses to fund its future projects will be reflected in their debt to equity
ratio. For many firms, their debt to equity ratio will be crucial for their survival in a
given industry and the economic conditions the company will face.

The Cost of Borrowing Using Debt

There are many sources of debt financing mortgage bonds, second mortgage bonds,
debenture bonds, and subordinated debenture bonds or self-extinguishing loans
term loans, bank loans. For our purposes, we will be issuing bonds.
The cost or required rate of return of any new bond issue is calculated using market
information provided from a currently outstanding bond issue the company has in
the market that has similar features or risk. Or, we can use the market information
for other companys outstanding bonds that have similar features and risk. The
market price today is the discounted value of the future interest payments and the
discounted value of the maturity value of the bond. Note that in most cases, bonds
will have a nominal face value of $1,000. Thus, when a company issues bonds, the
company will issue the bonds in multiples of $1,000. A $600,000 bond issue will
result in 600 $1,000 bonds. The purpose of issuing the new bonds is to raise capital
(cash) for the funding of new capital projects; thus, companies will strive to issue the
bond at par by matching the coupon interest rate to the market rate of return. (You
will remember from for previous material with bonds that if the market rate of
interest is equal to the coupon rate of interest the bond will always sell at par.)
Lets assume that the firm has a 7% coupon that pays its coupon interest semiannually and the bond has 7 years to maturity. In the market today, the bond has a
quoted price of 92.5 (the bond is selling at 92.5% of its face value or $925.00). The
cash flows for this bond are shown in figure 1.

10

11

12

13

35 35 35 35 35 35 35
B0 = $925.00
Figure 1. Cash flows for the bond issue.

35

35

35

35

35

35

14

35
FV = $1,000

The yield to maturity is the discount rate that correctly prices the future cash flows
both the coupon interest payments and the maturity value of the bond - to the
current price. Using the bond formula in figure 2, we can substitute our known
information:

[ ]
1

B 0=

1
( 1+r )t
FV
+
r
( 1+r )t

Figure 2 Bond Formula

1
14

925.00 35
r

1,000

1 r 14

We must calculate the discount rate (kb) that will correctly value the cash flows.
This can be accomplished by using trial and error or we can use a yield to maturity
approximation and interpolation. The yield to maturity approximation will provide
an approximate discount rate for the bond and interpolation will provide a more
accurate yield to maturity. The yield to maturity approximation is given by;

FV MV
o
periods
s
FV + MV
2

coupon interest +
YTM approximation=
Figure 3 YTM Approximation

YTM approx

1,000.00 925.00
40.35714
14

.041929496
925.00 1,000.00
962.50
2

35.00

Since the cash flows were for six months, the rate you calculate is also for six
months. Coupon interest rates are quoted at a nominal annual interest rate; thus
the coupon rate for a new bond will need to be period rate x m = 4.1929496 x 2 =
8.3858992% or approximately 8.39%.
NOTE: Yields, coupons or returns are always quoted on an annual basis.
The Cost of Borrowing Using Equity
There are three sources of cash or funding using equity financing for the company.
The three sources of equity financing are issuing of new preferred shares, using
internally generated funds and issuing new shares externally generated funds.
Issuing of new shares, either preferred or common, will incur issue costs that must
be covered by the projects the company is investing.
The Cost of Borrowing Using Preferred Shares
The required rate of return on preferred shares will be determined by the market.
The market rate of return on preferred shares is calculated much the same way as
we calculated the cost of borrowing using debt. The valuation of preferred shares in
the market is the present value of the future cash flows discounted at the market
rate of return. The value of the preferred share is the present value of perpetuity of
cash flows and uses the following dividend discount model:

PP

D ps
r

Where PP is the market price of the preferred share

DPS is the annual preferred share dividend
r is the discount rate or the market rate of return for the preferred share
and to calculate the market rate of return (r), we rearrange to formula to

D ps
PP

Now, this rate of return is the return in the market for the preferred shares that the
company must be recovered in the capital projects.
It should be noted that preferred dividends are paid out of after tax earnings; thus
all calculations are on an after tax basis and no adjustment is required for the rate
of return.

Par Value of Financial Instruments

Traditionally, all financial instruments have had a par value. Bonds, preferred
shares and common stock all had a stated par value on the face of the document.
Over time, the par value of the common share was dropped because the use of the
par value really lost its meaning as stock prices would rise in the market and the
stocks would split. Each time the stock would split, the par value would also be
split. The par value kept getting smaller and smaller and smaller. It was so small
the reference to the par value of the stock was dropped. Bonds, on the other hand,
have maintained their reference to par value. Most bonds have a nominal $1,000 par
value and most bonds in the market subscribe to this nominal $1,000 par value.
However, this is not always the case. There are bonds in the market that have par
values of $100, $200, $500, $2,000, $5,000, $10,000 or even $100,000. To determine
the par or face value of the bond, the terms or conditions in the trust deed must be
reviewed. Preferred shares are considered to exist forever and are evaluated as
perpetuity much the same as a common share. However, preferred shares do not
split and the amount of their dividends do not change unless they have a
participating option. Preferred shares do have a par value. Par value for a preferred
share will be stated on the face of the preferred share or it can be found in the notes
to the financial statements of the company. It is not that unusual for preferred
shares to have par values of $2.00, $5.00, $10.00, $20.00, $25.00, $50.00, $100.00,
$200.00 or even $1,000. At one point in time, TransCanada Corporation had
preferred shares issued with a par value of $750,000. This is an exception and most
companies would have preferred shares issued at $25.00, $50.00 or $100.00.
Example. You observe that the companys shares are selling in the market at $45.50.
The preferred shares pay an annual dividend $4.50. What is the market rate of
return on these preferred shares?
Using the dividend discount model, we have the following;

D1
4.50

0.098901098 9.89%
P0 45.50

The Cost of Borrowing Using Common Equity

The final area that must be considered for raising needed capital funds is common
equity. There are two sources of funding using common equity, internally generated
funds and externally generated funds. Internally generated funds, obviously, are
generated internally by the company while externally generated funds involve
additional outside financing or the issuing of new shares.

Internally Generated Funds

Internally generated funds are the cash flows that are generated from the ongoing
operation of the company. This is the excess funds the current operations provide
the company after expenses have been paid. Any excess cash belongs to the
shareholders and in turn will be returned to the shareholders in the form of
dividends. At first glance, it would appear that this cash does not cost the company
anything. After all, this is cash the company has on hand. However, had the
company given the cash to the shareholders in the form of dividends, the
shareholders have an opportunity cost associated with their cash investments. If the
shareholders received their dividends, they could have invested the cash in
investments of similar risk and earned a market rate of return on these investments.
At the very least, the company will need to earn the market rate of return on this
source of funding that has a similar amount of risk. Thus, the shareholders will be
indifferent between earning the market rate of return with their investing and
having the company earn the market rate of return for them. The rate of return that
the company needs to earn is the market rate of return which will be supplied by the
market.
Estimating the required rate of return for the market provides some alternatives
CAPM, the dividend discount models or the bond premium plus a risk adjustment
premium.
If a company cannot provide this minimum return on the funds of the shareholders
that it is using, it should distribute the cash to the shareholders and let the
shareholders invest in other assets of similar risk to earn a rate of return.
CAPM
The capital asset pricing model provides an estimate of the required rate of return
for the equity of a company. CAPM states that investors require a rate of return that
covers the risk free rate of return plus a premium to cover the systematic market
risk as shown in figure 3.

CAPM SML re rf ( k m rf )
Where

re is the required rate of return on the companys equity

rf is the risk free rate of return (rate of return on Government T-bills)

is beta or the sensitivity of a securitys return to the market return

rm is the expected return in the market portfolio (TSX).
7

Example: Lets assume we observe that thirty day Government T-bills are being sold
at a discount to provide a rate of return of 3.5% and the return on the TSX is 12%. If
a company has a beta of 1.5, what is the expected rate of return on the companys
shares in the market?
Using

CAPM SML re rf (rm rf ) we have

CAPM SML k e 3.5% 1.5(12% 3.5%) 3.5% 1.5(8.5%) 16.25%

Thus, the common shares in the market and the internally generated funds have an
estimated required rate of return of 16.25% and this is the minimum rate of return
the company needs to earn to cover for its equity component in any capital budgeting
project.
The Dividend Discount Models (DDM)
In earlier chapters, we examined the use of the dividend discount models to calculate
the value of a share. The value of the share in the market today is the discount
value of the expected future cash flows. The discount rate represents the required
rate of return that investors require in the market. If the firm is not paying out all
their earnings in dividends, the firm will experience growth opportunities for their
shareholders and we can use the Gordon growth model to calculate the present value
of the future cash flows or the expected price in the market today. The constant
growth model is given as

P0

D (1 g )
D1
0
re g
re g

where P0 is the price of the share today

D1 is the expected dividend at the end of year 1
D0 is the latest or most recent dividend the company paid the shareholders
re is the expected return on the common shares in the market
g is the expected growth in the companys earnings and thus the future
dividends
This formula may be rearranged to become

re

D1
D (1 g )
g 0
g
Po
Po

This implies that the expected return on the shares outstanding or current equity is
the expected dividend yield plus the expected growth for the company.

Example: Lets assume that the companys shares are currently selling in the market
at a price of $20.00. The company has experienced a sustainable growth rate of 5%
which management feels it can attain forever. The company just paid its latest
dividend of $2.19. Calculate the market rate of return for the investor on the
companys shares or common equity.

re

D1
D (1 g )
2.19(1.05)
g 0
g
.05 .115 .05 .165 16.5%
Po
Po
20.00

Bond Yield Plus Expected Risk Premium

This approach incorporates the fundamentals of risk and return in estimating a
required rate of return for the companys equity or common shares. Since shares
have a long term life expectancy, we can use the rate of return on long term bonds
plus an expected risk premium for common stock over the long term bond interest
rates. This will provide us with the following:

k e long term bond yield market risk premium rD (rm rf )

Example: Lets assume that long term corporate bonds have a market rate of return
of 9% and the expected risk premium for common stocks over long term corporate
bonds is 7.5%; thus, providing an expected return of 16.5%.
This method of calculating the required rate of return is more useful when
examining the required rate of return for a company that does not pay dividends
making it difficult to use the dividend discount models or for a stock that is not
currently trading in the market and it is difficult to establish a beta for the
companys shares.
Summary
Each of these methods has their own strengths and weaknesses and in many cases
will provide different answers. However, each of the methods should be close if not
exactly the same. Judgment and understanding the requirements of the companys
shareholders will provide confidence in the calculation results for the company.
Externally Generated Funds
Raising capital through externally generated funds involves the issuing of new
shares. The issuing of new share will involve the incurring of issue costs the same
costs that were highlighted when we were looking at bonds. In order to cover these
additional costs, the required rate of return on the externally generated funds must
be higher than the returns required in the market. As a matter of fact, externally
generated funds are the most expensive form of financing for the company. There
are two methods which may be used to calculate the required rate of return for these
externally generated funds. The cost of borrowing is calculated by finding the
discount that values the cash flows back to the current market price.
Dividend Discount Model

10

Rather than valuing the cash flows to the market price, we value the cash flows to
the net proceeds of the issue. The dividend discount model becomes

re

D (1 g )
D1
g 0
g
Po
Po

Example: Lets assume that the companys shares are currently selling in the market
at a price of $20.00. The company has experienced a sustainable growth rate of 5%
which management feels it can attain forever. The company just paid its latest
dividend of $2.19. Issue costs for any new equity is $2.00 per share. Calculate the
required rate of return for the company.

rs

D1

D 0 (1 g )
g
P0

2.19(1.05)
2.2995
.05
.05 .115 .05 .165 16.5%
20.00
20.00

Financing the Future Projects

One question that constantly faces a company is how much debt or how much equity
should a company issue. Debt is the cheapest form of financing while equity is the
most expensive form of financing. If a company only issues debt, they will increase
the risk of insolvency because they need to meet ever increasing the amount of
interest that they need to pay to the bondholders. On the other hand, the company
could issue more and more equity shares. This will reduce the risk of insolvency;
but, increasing the number of shares will dilute the EPS and equity has the highest
required rate of return. Projects that may provide a positive NPV using debt
financing may not have a positive NPV if equity is used to finance the project. A
higher required rate of return renders the same cash flows less valuable to the
company. Generally, companies will have capital structure targets that will allow the
company to be able to maximize the value of the shareholders wealth. Book values
provide a historical reference for the amount of debt and the amount of equity the
company has outstanding. However, we are concerned with the required rate of
return for the future not the past. The current market values may provide more
insight into the proportions of debt and equity the firm needs to use to finance the
future of the company. Thus, the market values may provide a guide for the
proportions of debt or equity to use or the company may have a target capital

11

structure that may be based upon industry averages or a capital structure that the
firm deems to be the best for the company.
Calculating the Cost of Capital for the Firm
The lowest average cost of capital will provide the most opportunities for the
company to invest and create value for the shareholder. The determining of the
discount rate or weighted average cost of capital is not just selecting an arbitrary
rate; but a function of the proportions of the funding used to raise funds for the
project.

12

Using Book Values

Lets assume we have the following debt and equity on the books of the firm.
Debt
First mortgage bonds

500,000

Debenture Bonds

300,000

Total Long term Debt

800,000

Shareholders Equity
Preferred Shares

50,000

1,000 shares issued and outstanding

Common shares

300,000

60,000 common shares authorized, issued

and outstanding
Retained Earnings

250,000

Total Shareholders Equity

600,000

Total Debt and Shareholders Equity

1,400,000

The book value is a reflection of the past financing of the company and is a measure
of last resort for the company.
Lets examine the proportions of the balance sheet that are funded by debt, preferred
shares and common shares.
Debt
First mortgage bonds
Debenture Bonds
Total Long term Debt

500,000
300,000
800,000

800,000/1,400,000

0.5714

50,000/1,400,000

0.0357

550,000/1,400,000

0.3929

Shareholders Equity
Preferred Shares

50,000

1,000 shares issued and

outstanding
Common shares

300,000

60,000 common shares authorized,

issued and outstanding
Retained Earnings

13

250,000
Total Shareholders Equity
Total Debt and Shareholders
Equity

600,000
1,400,00
0

You can observe that the company has a debt to equity ratio of (800,000/600,000)
1.33333333. If we use book value weights for our capital funding, 57.14% of our
capital would come from debt issues, 3.57% would come from preferred share issues
and the balance of our funding 39.29% would come from common equity either in the
form of internally generated funds or externally generated funds.

14

Using Market Values

We have been provided the following debt and equity information from the books of
the firm.
Debt
First mortgage bonds

500,000

Debenture Bonds

300,000

Total Long term Debt

800,000

Shareholders Equity
Preferred Shares

50,000

1,000 shares issued and outstanding

Common shares

300,000

60,000 common shares authorized, issued

and outstanding
Retained Earnings

250,000

Total Shareholders Equity

600,000

Total Debt and Shareholders Equity

1,400,000

In the market, we have the following information about the financial instruments of
the company.
Financial
Instrument

Market
Quote

First mortgage bonds

101.2

Debenture Bonds

106.5

Preferred Shares

49.25

Common shares

20.00

The market value of these funding sources and the percentage of the total value are
given in the following table.
Total
Market
Value

Financial
Instrument

Market
Quote

Number
outstanding

First mortgage bonds

101.2

50,000

506,000

Debenture Bonds

106.5

30,000

319,500

Total Debt
Preferred Shares

49.25

1,000

15

Market
Value
Weights

825,500

0.3979

49,250

0.0237

Common shares

20.00

60,000

Total

1,200,000

0.5784

2,074,750

1.0000

Thus 39.79% of our funding should be in debt, 2.37% of our funding should be in
preferred shares and the balance of our funding 57.84% should be in the form of
equity.

Target Capital Structure

Companies evolve over time and the focus or core of the company activities change
over time. As a result, historical information may not provide the optimal
information for the firm. Firms may use a target capital structure as a method to
determine the weights of the funding to be used for new projects. By examining
other firms that are in similar industries or looking at industry averages, a firm may
decide to change from the current capital structure to a new target capital structure.
The firm may decide that the following capital structure is optimal for the firm in the
future and decide to raise capital from the following proportional sources.
Source

Proportio
n

Debt

55%

Preferred Shares

10%

Common shares

35%

The Weighted Average Cost of Capital

Once we have calculated the cost for the various sources of financing and the
proportions of the amount of financing, determining the weighted average cost of
capital is relatively straight forward. The weighted average cost of capital is the
summation of the proportion of funding from the particular source times the cost of
borrowing for the particular source. Thus, the weighted average cost of capital
becomes

WACC WD rD (1 T ) Wp rp We re
where

WACC is the weighted average cost of capital for the company

Wd is the proportion of funding using debt

rD is the before tax cost of borrowing using debt

16

Wp
rp

is the proportion of funding using preferred equity

is the cost of borrowing using preferred equity

W e is the proportion of funding using equity funds

k e is the cost of borrowing using equity funds
When we are looking at calculating the weighted average cost of capital, we are
always concerned with the marginal cost of capital the cost of capital for the next
dollar we are borrowing. A company will use internally generated funds if the
internally generated funds are available and the use of the internally generated
funds does not impair its expected cash flows in the next period. For example, lets
assume that the company has $200,000 in cash available that it can use to pay
dividends or invest in the future projects for the company. However, the company
needs $230,000 in equity funding to maintain their optimal capital structure. The
company will not use the $200,000 and then issue $30,000 in common shares
because the issue costs associated with the issuing of such a small number of shares
will make it cost prohibitive. The source of funding would come entirely from
external financing and the firm will issue $230,000 in new equity rather than use
some internally generated funds and some externally generated funds. If on the
other hand, the firm only needed $175,000 in additional equity financing, the
company would use the internally generated funds and no external funding.
Lets assume the company has a target capital structure that is 55% debt, 10%
preferred equity and 35% common equity and that the cost of borrowing for the firm
for the various sources of financing are the rates we calculated from each of the
examples. We have also assumed that the tax rate for the company is 40%. We can
now calculate the cost of capital for the firm. Remember, the cost of borrowing for
the sources of funding are as follows:
Source

Rate

Debt before tax

9.34%

Preferred shares

10.65%

Equity

16.25%

If we are using internally generated funds as the source of equity funding, the
weighted average cost of capital becomes:

WACC WD rD (1 T ) Wp rp We re
WACC (.55)(9.34%)(1 .40) (.10)(10.65%) (.35)(16.25%)

17

WACC (.55)(5.60%) (.10)(10.65%) (. 35)(16.25%)

WACC 3.08% 1.065% 5.6875% 9.8325%
If we are using externally generated funds as the source of equity funding, the
weighted average cost of capital becomes:

WACC WD rD (1 T ) Wp rp We re
WACC (.55)(9.34%)(1 .40) (.10)(10.65%) (.35)(16.25%)
WACC (.55)(5.60%) (.10)(10.65%) (. 35)(16.25%)
WACC 3.08% 1.065% 5.6875% 9.8325%
Flotation Costs
You may ask why we are looking at the calculation of the weighted average cost of
capital using internally generated funds for the equity portion of funding and the
weighted average cost of capital using externally generated funds for the equity
portion of funding. It makes no difference for the determination of the discount rate;
however, it does make a difference in the calculation of the amount of the capital that
needs to be raised for the capital projects the firm is considering. Debt funding,
preferred share funding and externally generated funds from new equity all involve
issue costs which must be recovered through the cash flows of the new capital
projects. The costs associated with the raising of the new capital are paid at the
start of the project; however, the expenses are amortized over a 5 year period
creating a tax shield benefit reduction in the amount of taxes that will be paid in
the following years.
Calculating the Issue Costs
The present value of the issue costs is to be included in the calculation of the initial
investment. We have the following target capital structure for the firm:
Weights
Debt
Preferred
Equity
Total

45%
15%
40%
100%

The company has initial cash out flows (C0 + NWC + OC) of $2,500,000 for the next
years capital projects. Lets assume that a firm has issue cost of 5 percent for bonds,
10% for preferred shares and 8 percent for common shares that are issued. If the
firm does not have enough internally generated funds available to cover the equity
requirement of the capital budget, the firm will need to use externally generated

18

funds issue new shares. New funding will be raised in proportion to the target
capital structure. That means we have the following:
Weights
Debt
Preferred
Equity
Total

45%
15%
40%

Funding
1,125,000
375,000
1,000,000

100
%

2,500,000

Note: if the firm does not have $1,000,000 of internally generated cash flows
available for investing, the firm will need to issue new common shares to raise the
necessary capital. The average flotation costs for the firm are given as:

f a=W D f D +W P f P +W e f e
If the firm uses externally generated funds for their equity funding, the average
flotation costs are:

f a=W D f D +W P f P +W e f e =( .45 )( 5 )+ (.15 )( 10 )+ ( .40 )( 8 )

2.25 +1.5 +3.2 =6.95
The issue cost must be recovered by the cash flows of the project; thus, the initial
investment will need to be grossed up using the following:

Adjusted Capital=

Initial Cash Flows 2,500,000

=
=2,686,727.57
1f a
1.0695

If the firm has enough internally generated cash available to cover the equity
requirement, the firm will not need to issue new shares and will not incur issue
costs. Thus, the average flotation costs are

f a=W D f D +W P f P +W e f e =( .45 )( 5 )+ (.15 )( 10 )+ ( .40 )( 0 )

2.25 +1.5 +0 =3.75
And the adjusted amount of capital is

Adjusted Capital=

Initial Cash Flows 2,500,000

=
=2,597,402.60
1f a
1.0375

Note: the use of internally generated funds and externally generated funds are a
mutually exclusive event.

19

Sample Problem
McGoonie Inc. is evaluating projects with a total capital cost of $8,000,000. The
projects will not alter the average risk of the firm. The financial manager has
gathered the following data.
Market:
Return on the TSX 12% Government t-bills 4% Firm beta 1.1875
Debt:
The firm has $1,000 par value, 6% coupon rate, 15 year bonds outstanding on which
semi-annual interest payments are made. The bonds are quoted at 101.5. New
bonds could be issued at par however the firm expects flotation costs of $35 per bond.
Preferred Shares:
The firm has $50 par value preferred shares with an 8 percent annual dividend
issued and outstanding in the market and the shares are selling at $45.00. The cost
of issuing and selling the new preferred shares is expected to be $7.50 per share and
the new preferred shares is expected to have a par value $75 per share.
Common Equity:
The firm expects to have $2,800,000 of reinvested profits available in the coming
year. The firms common shares currently sell for $80 per share. The most recent
dividend paid by the common shares was $5.66 per share. The firms dividends have
been growing at an annual rate of 6%, and this rate is expected to continue in the
future. Issue costs for new equity funding are expected to be 10 percent.
The firm has the following target capital structure:
Debt
60%
Preferred Equity
10%
Common Equity
30%
McGoonie Inc. has a marginal tax rate of 40%.
a.
b.
c.
d.
e.
f.

Calculate the after tax cost of debt.

Calculate the after tax cost of borrowing using preferred shares.
Calculate the after tax cost of borrowing using equity funding using the dividend
discount models (DDM).
Calculate the after tax cost of borrowing using equity funding using the CAPM
model.
Calculate the WACC if the firm uses internally generated funds for their equity
component.
Calculate the WACC if the firm uses externally generated funds for their equity
component.

20

g.
h.

Calculate the adjusted initial cash flow if the firm has $3,000,000 of internally
generated funds available for next years capital projects.
Calculate the adjusted initial cash flow if the firm has $3,000,000 of internally
generated funds available for next years capital projects.

a.

Calculate the after tax cost of borrowing using debt.

14

15
FV =

1,000
B0 = 1,015.00

30.00

30.00 30.00

30.00

30.00

1
( 1+r )t
FV
B 0=C
+
r
(1+r )t
1
1
( 1+ r )30 1,000
1,015.00=30.00
+
r
(1+ r )30
FV MV
coupon interest +
o
periods
s
YTM =
FV + MV
2
1,0001015
30.00+
30
29.50
YTM =
=
=0.029280397
1,000+1015
1,007.50
2
1

between 2 & 3 percent

The cash flows were for 6 months so this is a 6 moth rate. The coupon rate is given
as the period rate x m = 2.9280397% x 2 = 5.8560794% 5.86%
b. Calculate the after tax cost of using preferred share financing.

rp

c.

Dp

.08(50) 4.00

0.08888 8.89%
P0 = 45
45

Cost of preferred shares:

Calculate the after tax cost of borrowing using equity funding using the
dividend discount models (DDM).

re

D (1 g )
D1
5.66(1 .06)
g 0
g
.06 13.50%
P0
P0
80

21

d.

Calculate the after tax cost of borrowing using equity funding using the CAPM
model.

CAPM r e =r f + ( r m r f )=4 +1.1875 ( 12 4 ) =4 +9.5 =13.50

e.

Calculate the WACC for the company if internally generated funds are used
for the equity portion of the funding needs.

WACC WD k D 1 T WP rp We re

B
P
E
rD rP re
V
V
V

=.60(5.86%)(1-.40) + .10(8.89%) + .30(13.50%)

= 2.1096%+ 0.889%+ 4.05% = 7.0486%
f. Calculate the WACC if the firm uses externally generated funds for their equity
component.

WACC WD k D 1 T WP rp We re

g.

B
P
E
rD rP re
V
V
V

=.60(5.86%)(1-.40) + .10(8.89%) + .30(13.50%)

= 2.1096%+ 0.889%+ 4.05% = 7.0486%
Calculate the adjusted initial cash flow if the firm has $3,000,000 of internally
generated funds available for next years capital projects.
First, you need to determine if the firm will use internally generated funds or
externally generated funds for the equity component of the project.
Equity funds required = initial cash flow x equity weight
= $8,000,000 x .30 = 2,400,000
Flotation costs debt $35.00/ $1,000 = 3.5%
Flotation costs preferred $7.50/$75.00 = 10.0%
Flotation costs common = 10.0%

f a=W D f D +W P f P +W e f e =( .60 )( 3.5 )+ ( .10 )( 10 ) + ( .30 ) ( 0 )

2.10 +1.0 +0 =3.10
And the adjusted amount of capital is

Adjusted Capital=

Initial Cash Flows 8,000,000

=
=8,255,933.95
1f a
1.0310

22

Divisional and Project Specific Opportunity Cost of Capital

Copied without permission from Davis, AHR and Pinches, GE, Canadian
Financial Management, fourth edition, Addison Wesley Longman, 2002
Up to now we have determined how to calculate the firms opportunity cost of capital,
which can be employed if new projects have a risk approximately equal to the firms
overall risk. We know; however, that each project must stand on its own legs if the
firm is going to maximize its value. Firms must expect to earn a return sufficient
enough to compensate them for the risks involved that is, what they could get by
investing in an equally risky project outside the firm. To deal with differences in
risk, many medium size and large firms employ an approach that calculated the
divisional cost of capital.
Divisional Opportunity Costs of Capital
The essence of this approach is shown in figure 6.2, where the different discount
rates will be employed depending on the riskiness of the division. If a firm employs a
firm wide opportunity cost of capital when differences in risk exist, it make the
mistake of setting too high of a rate of return for low risk projects and too low of a
discount rare for high risk projects. The result is to under allocate capital to low risk
divisions and to over allocate capital to high risk divisions.
Opportunity Cost
Of Capital

High
Above Average
Average
- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -Firm wide opportunity
Below Average
cost of capital
Low
Divisional Risk

23

Figure 6.2, Relating Risk to the Divisional Opportunity costs of capital for
Capital Budgeting Purposes.
The use of a firm wide opportunity cost of capital when risk differs results in under
allocation of resources to low risk divisions and over allocation to high risk divisions.
The most widely used method in practice to implement risk adjustment is based on
the assumption that project risks within a division are somewhat similar but the
risks between divisions differ. To estimate divisional opportunity costs of capital, we
proceed as follows:

(k )

STEP 1: Determine the firms after-tax cost of debt d and use this as the cost of
debt for the division. (Slightly more precision can be obtained by using separate
after tax cost for each division but using our approach is simpler and generally
provides approximately the same answer.
STEP 2: Because we do not have any market based estimate of the risk of the
division and the cost of its equity capital, identify one or more publicly traded firms
that are similar in terms of product line to each separate division. These should be
pure-play firms publicly traded firms that are engaged solely in the same line of
business as the division with the same operating risks. If the publicly traded firm
has a different capital structure (or amount of financial risk) than the division, an
adjustment will be required because this difference will affect beta. Also, if the
effective tax rate of the pure play company and the division are often different. One
way to estimate an asset (or unlevered) beta is as follows:

asset unlevered
where

levered firm

1 (1 T ) B S

asset unlevered is the beta for an unlevered firm or unlevered set of assets
- no debt in the capital structure

levered firm

is the observed market beta for the publicly traded pure play firm
T is the pure play firms marginal tax rate
B is the market value of the pure play firms debt (this includes bonds,
loan from banks, leases and short term debt)
S is the market value of the pure play firms equity
After calculating the unlevered asset beta, we can estimate the divisional beta by
substituting in the

asset , the marginal tax rate for the division, T and the target

capital structure proportions, S and B and then solving for the levered for the
division

24

STEP 3: Employing the beta of the unlevered pure play firm (with or without
adjustments for financial risk and taxes, as explained in Step 2) calculate the each
divisional cost of equity as if each division were a separate firm. Thus, each
divisions estimated cost of common equity is:

divisional cos t of equity k e Rf divsion ( ERM Rf )

STEP 4: Estimate the divisions target or appropriate capital structure as if it were a
free standing firm. Due to difference in the basic risk and the business conditions,
some divisions may be able to employ substantially more debt than other.
STER 5: Calculate the divisions opportunity cost of capital using the costs and the
financing proportions estimated in steps 1, 3 and 4 above.

25

Example: To illustrate step 2 (how to calculate the divisions appropriate beta)

assume we have identified a pure play firm similar to the division in question. Its
beta (which is a levered beta because the pure play firm uses debt) is 1.50; its ratio of
debt to stock in market value terms (B/S) is 0.667; and its effective corporate tax rate
is 40 percent. For the division in questions, its target ratio of debt to stock (B/S) is
0.40 and its effective marginal tax rate is 30 percent. To determine the appropriate
beta for the division, we first un-lever the pure play firms beta using the following
equation

asset U

levered firm
1 (1 T ) B S

1.50
1.071275532 1.0713
1 (1 .40)(0.667)

Now that we have unlevered or asset beta, we can re-lever the beta to determine
the divisions systematic risk after adjusting for the effective tax rate and capital
structure of the division. Using the same equation from above, we can re-arrange to
formula and substitute the information for the division of the firm.

levered firm

1 (1 T ) B S becomes levered firm ( U )(1 (1 T ) B S ) and we now substitute the

divisional information to solve for our levered division.

levered firm ( U )(1 (1 T ) B S ) (1.0713)(1 (1 .30)(0.40) 1.371264 1.3713

Thus, based upon the pure play firm, the appropriate beta for estimating the
divisional cost of equity capital is 1.3713.
To illustrate the calculations of divisional opportunity costs of capital, consider
Wagner Industries. As shown in Table 6.4, with a beta of 1.25, Rf of 10 percent, ER M
= 18 percent and kd = 8 percent and using 40 percent debt and 60 percent equity, we
would estimate Wagners firm wide opportunity cost of capital to be 15.20 percent
Assumptions
After tax cost of debt, rd = 8%

Market risk, = 1.25

Risk free rate of return, rf = 10%
Expected return on the market portfolio, ERM = 18%
Cost of Equity

CAPM re rf (k m Rf ) 10% 1.25(18% 10%) 20%

The Opportunity Cost of Capital (WACC)

26

WACC Wd rd WP rp We re
(.40)(8%) 0 (. 60)( 20%) 0
3.20% 0 12.00% 0 15.20%
Table 6.4 Opportunity Cost of Capital for Wagner Industries
This firm wide opportunity cost is appropriate for divisions or projects whose risk is
approximately equal to the average risk of new projects undertaken by the firm.
This would be the appropriate rate for capital budgeting purposes if all of Wagners
divisions were equally risky.
However, what if Wagner has three very different divisions? The furniture division
is a very mature industry with low risk; the paper division that is closer to the
average risk of the firm; and the data services division is very risky. Due to the
differences in risk, the divisions have very different betas, which range from 0.75 for
furniture, 1.25 for paper and 2.0 for data services (as determined by examining
publicly traded pure play firms with similar product lines). The financing
proportions also differ, with the more risky divisions being less able to employ as
much debt financing. The furniture division will use 50 percent debt and 50 percent
equity, the paper division will use the same capital structure as the company average
of 40 percent debt and 60 percent equity, while the data systems division will use 20
percent debt and 80 percent equity.
Divisional Opportunity Cost of Capital
Furniture Division

furniture

= 0.75

CAPM k e rf (rm rf ) 10% 0.75(18% 10%) 16%

The Opportunity Cost of Capital (WACC)

WACC Wd rd WP rp We re

(.50)(8%) 0 (.50)(16%)
4.00% 0 8.00% 12.00%

Paper Division

paper

= 1.25

CAPM re rf (rm rf ) 10% 0.75(18% 10%) 16%

The Opportunity Cost of Capital (WACC)

WACC Wd rd WP rp We re

(.40)(8%) 0 (.60)( 20%)

3.20% 0 12.00% 15.20%

Data Services Division

27

 data = 2.0

CAPM re rf (rm rf ) 10% 2.0(18% 10%) 26%

The Opportunity Cost of Capital (WACC)

WACC Wd rd WP rp We re s

(.20)(8%) 0 (. 80)( 26%)

1.60% 0 20.80% 22.40%
Table 6.5 Calculation of Divisional Opportunity Cost of Capital for Wagner
Industries
Using divisional opportunity costs improves resource allocation decisions if risks
substantially between a firms divisions
As shown in table 6.5, these differences produce very different divisional opportunity
cost of capital. The furniture divisions opportunity cost of capital is 12 percent,
while 15.20 percent is appropriate for the paper division. The data services division
opportunity cost of capital is 22.4 percent, indicating that projects originating from
that division must have a substantially higher expected return to compensate for the
risks.
Estimating divisional opportunity costs of capital in practice requires a thorough
understanding of the firms divisions and identification of appropriate publicly
traded firms that are similar to the divisions, following the steps given here. The
most difficult part of this process is coming up with good pure play firms.
Why is it important for the firm to use a risk adjusted cost of capital in the
NPV decision?
One of the basic relationships in finance is the relationship between risk and return.
Most investors are risk adverse. This does not mean they will not take on risk for
they will if there is enough or an adequate rate of return. The basic relations ship is
the higher the risk, the higher the required rate of return.
Lets consider a project that is considered to be more risky than the company on
average and the rate of return for the higher risk project should have been higher
than the weighted average rate of return for the average risk project.
NPV Profile
NPV

28

+ve
0

Discount rate
WACC

Adjusted
WACC

-ve

NPV

If the project incorporated the use of the firm wide weighted average cost of capital
rather than a risk adjusted weighted average cost of capital, the firm would accept
the risky project that the NPV analysis should have rejected. This will result in the
company over allocating capital to more risky projects and the company will become
more risky over time.

29

Lets consider a project that is considered to be less risky than the company on
average and the rate of return for the lower risk project should have been lower than
the weighted average rate of return for the average risk project.
NPV Profile
NPV

+ve
0

Discount rate
Adjusted
WACC

WACC

-ve

NPV

If the project incorporated the use of the firm wide weighted average cost of capital
rather than a risk adjusted weighted average cost of capital, the firm would reject
the less risky project that the NPV analysis should have accepted. This will result in
the company under allocating capital to lower risk projects and the company will
become more risky over time.

30