Hand Notes On Cost of Capital and Capital Structure: Composed By: H. B. Hamad

Hand notes on cost of
capital and capital

structure
Disclaimer:
This hand note shall not in any
time be regarded as a substitute for
students not to visit library, text
books and web for acquiring
knowledge on this topic, where you
find it is suitable then you can rely.
1st draft
Composed by:
H. B. Hamad
2010
1 of 55 1st Draft to be improved

Introduction
You often hear corporate officers, professional investors, and analysts
discuss a company's capital structure. You may not know what a capital
structure is or why you should even concern yourself with it, but the
concept is extremely important because it can influence not only the
return a company earns for its shareholders, but whether or not a firm
survives in a recession or depression. Sit back, relax, and prepare to learn
everything you ever wanted to know about investments and the capital
structure of the companies
There are several types of value, of which we are concerned with four:
 Book Value – The carrying value on the balance sheet of the firm’s
equity (Total Assets less Total Liabilities)
 Tangible Book Value – Book value minus intangible assets
(goodwill, patents, etc)
 Market Value - The price of an asset as determined in a
competitive marketplace
 Intrinsic Value - The present value of the expected future cash
flows discounted at the decision maker’s required rate of return
Capital Structure - What It Is and Why It Matters

The term capital structure refers to the percentage of capital (money) at
work in a business by type. Broadly speaking, there are two forms of
capital: equity capital and debt capital. Each has its own benefits and
drawbacks and a substantial part of wise corporate stewardship and
management is attempting to find the perfect capital structure in terms of
risk / reward payoff for shareholders. This is true for big companies and
for small business owners trying to determine how much of their startup
money should come from a bank loan without endangering the business.
Let's look at each in detail:
Equity Capital:

This refers to money put up and owned by the shareholders (owners).
Typically, equity capital consists of two types:
1. Contributed capital, which is the money that was originally
invested in the business in exchange for shares of stock or
ownership and
2. Retained earnings, which represents profits from past years that
have been kept by the company and used to strengthen the balance
sheet or fund growth, acquisitions, or expansion.
Many consider equity capital to be the most expensive type of capital a
company can utilize because it’s "cost" is the return the firm must earn to
attract investment. A speculative mining company that is looking for silver
in a remote region of Africa may require a much higher return on equity to
get investors to purchase the stock than a firm such as Procter &
Gamble, which sells everything from toothpaste and shampoo to
detergent and beauty products.
Debt Capital:
The debt capital in a company's capital structure refers to borrowed
money that is at work in the business. Bonds are generally considered the
safest type (long-term) because the company has years, if not decades, to
come up with the principal, while paying interest only in the meantime.
Other types of debt capital can include short-term commercial paper
utilized by giants companies that amount to billions of shillings in 24-hour
loans from the capital markets to meet day-to-day working capital
requirements such as payroll and utility bills. The cost of debt capital in
the capital structure depends on the health of the company's balance
sheet - a triple AAA rated firm is going to be able to borrow at extremely
low rates versus a speculative company with tons of debt, which may
have to pay 15% or more in exchange for debt capital.
Other Forms of Capital:

There are actually other forms of capital, such as vendor financing where
a company can sell goods before they have to pay the bill to the vendor,

which can considerably increase return on equity but don't cost the
company anything. In the case of an insurance company, the policyholder
"float" represents money that doesn't belong to the firm but that it gets to
use and earn an investment on until it has to pay it out for accidents or
medical bills, in the case of an auto insurer. The cost of other forms of
capital in the capital structure varies greatly on a case-by-case basis and
often comes down to the talent and discipline of managers.
Seeking the Optimal Capital Structure

Many middle class individuals believe that the goal in life is to be debt-free
(see should I Pay Off My Debt or Invest?). When you reach the upper
echelons of finance, however, that idea is almost anathema. Many of the
most successful companies in the world base their capital structure on one
simple consideration: the cost of capital. If you can borrow money at 7%
for 30 years in a world of 3% inflation and reinvest it in core operations at
15%, you would be wise to consider at least 40% to 50% in debt capital
in your overall capital structure. Do you agree with me? I can imagine
you are not!!.
Of course, how much debt you take on comes down to how secure the
revenues your business generates are - if you sell an indispensable
product that people simply must have, the debt will be much lower risk
than if you operate a theme park in a tourist town at the height of a boom
market. Again, this is where managerial talent, experience, and wisdom
come into play. The great managers have ability for consistently lowering
their weighted average cost of capital by increasing productivity,
seeking out higher return products, and more.
To truly understand the idea of capital structure, you need to take a few
moments to read Return on Equity: The DuPont Model to understand how
the capital structure represents one of the three components in
determining the rate of return a company will earn on the money its
owners have invested in it. Whether you own a doughnut shop or are

considering investing in publicly traded stocks, its knowledge you simply
must have.
Most investors assess a stock's promise by weighing common-sense
factors about the prospects of the company: the quality of its products or
services, its future demand and the nature and strength of the
competition. But this qualitative analysis often fails to answer the
critical question of valuation: Given the company's profit potential, is its
stock a good investment at today's market price? Professional stock
analysts use models to estimate a company's inherent worth and to
determine whether the company's stock is a bargain. These models
require many inputs. One of the most important to consider is the
company's weighted average cost of capital.
Companies are vehicles for the productive investment of capital. A typical
clothing manufacturer, for instance, may use its cash to buy cotton, pay
workers to sew the cotton into sweaters, and then pay a sales force to sell
the sweaters for a profit. In this way, the company's ability to raise capital
plays a crucial role in its ability to grow profitably.
Costs of Capital
Businesses can't make money. One choice is to borrow money, either
from a bank or through a bond sale. Another option is to sell a piece of
the business through an offering of stock, or equity.
Both of these alternatives come at a cost. For debt, the company must
make interest payments. For equity, it may make dividend payments, and
shareholders will expect capital gains. The average of the costs of these
two sources of capital, weighted for the proportion of each that the
company uses to fund itself, is called the weighted average cost of capital.
It is represented in the following formula:
We can measure cost to equity in almost three ways.
1. Dividends valuation (dividend yield) method
2. Gordon’s dividend growth model

3. risk measured analysis
Dividends valuation method

the price of stock is equal to the present value of all future dividends the
intuition behind this insight is that the cash payoff to owners of the stock
is equal to cash dividends plus capital gain or losses .Thus expected return
that an investor expects from an investment in a stock over a set period
of time is equal to:
divident + Capital gain
Expected return on stock (r) = investment
Div 1 + P1 − PO
PO
(r) =
Whereby Div1 and P1 denote the dividend and stock price in year1 when
we isolate the current stock price Po in the expected price return formula.
Div 1 +P1
(Po) = 1+r
The equation then becomes what determines next years price P 1 by
changing the subscripts next year’s price is equal to the discounted value
of the sum of dividends and expected price in year 2
Div 2 +P2
P1= 1+r
Div 1 Div 2
Div 3 + P2 Divt + Pt
+2
+ +. .. ..
Po = 1+ r (1+r ) (1+ r )3 (1+r )t
Whereby: t= horizon. It is clearly assumed that, the value to stock is
equal to present value of all dividends out of the investment at time t and
stock’s present value at time t. when you move to time horizon (t) the
present value of stock should not change and assumed to be zero.
Pt
=0
(1+r )t Hence the value of stock should be equal to present
∞ Div
∑ (1+rt)t
value of all future dividends Po = t=1

In valuing the common stock, we have made two assumptions:
 We know the dividends that will be paid in the future. Div 1
 We know how much you will be able to sell the stock for in
the future.
 Both of these assumptions are unrealistic, especially knowledge of
the future selling price.
 Furthermore, suppose that you intend on holding on to the stock
for twenty years, the calculations would be very tedious!
Assume: a share or stock is selling for Shs. 75 a share (P o =75).
Investment expect a Shs.. 3 cash dividend over the next year (Div 1=3).
They also expect the stock to sell for Shs.. 81 a year hence (P 1 = 81).
Then what is the expected return to stockholders?
Div 1 + P1 − PO
PO
Expected rate of return (r) = = (3+ 81-75)/75 = 12%
So 12% is appropriate discounted rate that investor would be like to take
on the investment other things constant. Is just a present value of future
cash flow that investment is going to generate to its owner. It is further
assumed that, this 12% and shs.. 75 are the right discounted rate and
right price of stock respectively in any fair market. So you agree with
me? I can imagine your answer in NO, ok buddy just follow me with these
two scenarios:
One: What happen when Po is above shs.. 75? Say shs.79, expected
return would be lower than 12% i.e 6.33% hence investor will run away
with these investment rushing to other investment of similar risk in the
market, they will start to sell their share hence price will drop of cause to
shs.. 75 which is market price.
Two: assume the price of stock is little bit lower than shs.. 75 say
shs..70, what happen to rate? It definitely will rise above 12% i.e 20%.
This will lead to many investors rushing in buying share forcing rise to
shs.. 75.

∞ Div
∑ (1+rt)t
In concluding, this formula is unrealistic t=1 as it is not easy to
predict all future dividend going to be paid, hence we should assume that
constant dividend paid in perpetuity then our formula should be amended
Div 1
to r = r where Div1 = Div0 +g and g is growth rate
Gordon’s dividend growth model
The Gordon Growth Model (or Constant Growth
Model) is a financial model used to determine the
“intrinsic” value of a stock, based on future
dividends, which are assumed to grow at a constant
rate. Named after Myron J. Gordon and originally
published in 1959, the model values a business as the present value of all
future dividends and leverages a required rate of return that the investor
could receive on similar alternative assets.
Po = current stock price, D1 =future dividend= Do (1+g) whereby g is
growth rate.
Arriving at Present Value
The Gordon Growth Model is the best known of a class of discounted
dividend models and is a variation of the discounted cash flow valuation
model. The Gordon approach assumes that the company pays a dividend
that grows at a constant rate. It also assumes that the investor’s required
rate of return for the stock is held constant and is equal to the cost of
equity for that company. The model sums this discounted, infinite series of
payments to the shareholder to arrive at the present value.
A Stock as Perpetuity
Note that if the stock is never sold, then it is essentially perpetuity to the
investor and its price would equal the sum of the present value of its
dividends. Because the model considers the current price of the stock to
be equal to its future cash flows, then it follows that the future sale price

of the stock would equal the sum of the cash flows subsequent to the sale
discounted by the required rate of return.
Under the Gordon Model the investor holds the stock for the sole purpose
of receiving income from company operations through dividend payments.
Investors who look at stocks as if they were buying a private business
may benefit from this valuation approach.
.
Summing the infinite series we get,
，
In practice this P is then adjusted by various factors e.g. the size of the
company.
，
K or r denotes expected return = yield + expected growth.
It is common to use the next value of D given by: D1 = D0(1 + g), thus
the Gordon's model can be stated as
.
Note that the model assumes that the earnings growth is constant for
perpetuity. In practice a very high growth rate cannot be sustained for a
long time. Often it is assumed that the high growth rate can be sustained
for only a limited number of years. After that only a sustainable growth
rate will be experienced. This corresponds to the terminal case of the
discounted cash flow model. Gordon's model is thus applicable to the
terminal case.
When the growth g is zero, that a company pays out all its earning as
dividend and nothing retained for investment, i.e g =0
.
Write this as

So the return k is the dividend divided by the price.
When g is very close to k, the price is very high, going to infinity when g is
equal to k.
Problems with the model

a) The model requires one perpetual growth rate greater than
(negative 1) and less than the cost of capital. But for many growth
stocks, the current growth rate can vary with the cost of capital
significantly year by year. In this case this model should not be
used.
b) If the stock does not currently pay a dividend, like many growth
stocks, more general versions of the discounted dividend model
must be used to value the stock. One common technique is to
assume that the Miller-Modigliani hypothesis of dividend irrelevance
is true, and therefore replace the stock’s dividend D with E earnings
per share. But this has the effect of double counting the earnings.
The model's equation recognizes the trade off between paying
dividends and the growth realized by reinvested earnings. It
incorporates both factors. By replacing the (lack of) dividend with
earnings, and multiplying by the growth from those earnings, you
double count.
c) Gordon's model is sensitive if k is close to g. For example, if
dividend = shs.1.00 cost of capital = 8% Say the growth rate = 1%
- 2% So the price of the stock assuming 1% growth= shs.14.43 =
1.00(1.01/.07) assuming 2% growth= shs.17.00 = 1.00(1.02/.06)
The difference determined in valuation is relatively small. Now say
the growth rate = 6% - 7% So the price of the stock assuming 6%
growth= shs.53 = 1.00(1.06/.02) assuming 7% growth= shs.107
= 1.00(1.07/.01) The difference determined in valuation is large.
Cost of Newly Issued Stock

Cost of Newly Issued Stock
Cost of newly issued stock (k c) is the cost of external equity, and it is
based on the cost of retained earnings increased for flotation costs (cost
of issuing common stock). For a constant-growth company, this can be
calculated as follows:

D1
+g
R= P o (1−f )
where:
f = the percentage flotation cost, or (current stock price -
funds going to company) / current stock price
Example:
cost of newly issued stock
assume the company’s stock is selling for shs. 40, its expected ROE is
10%, next year’s dividend is shs. 2 and the company expects to pay out
30% of its earnings. Additionally, assume the company has a flotation cost
of 5%. What is cost of new equity?
Capital asset pricing model

Capital asset pricing model (CAPM): This is an equation expressing the
relationship between the degree of risk of an investment and the
expected return on the investment.
The model brings together aspects of share valuations, the cost of capital
and gearing. For our purposes, we can make the assumption that there
are two basic functions associated with the
CAPM:
 Attempting to establish the ‘correct’ equilibrium market value of a
company’s shares;
 Calculating the cost of a firm’s equity (and thus the weighted
average cost of capital), as an alternative approach to the dividend
valuation model,

RISK
There is risk associated with investment in any security, the greater the
risk, the greater the required return from the investment. However, one
type of stock which has a low risk and which is assumed in portfolio theory
to be risk-free, is government stock
 The only way for an investor to avoid risk altogether is to invest
solely in government securities
 Risk comprises financial and business risk; investors tend to
diversify their portfolios to reduce their risk while maintaining their
return.
 The risk, which can be diversified away is known as unsystematic
risk and is unique to a particular company.
 The risk related to the market, however, cannot be diversified and is
known as systematic or market risk.
 Systematic risk is unavoidable risk. Systematic risk may also vary
between projects. Such risk may arise as a result of government
legislation, from adverse trends in the economy or from other
external factors over which the company has no control.
MEASURING SYSTEMATIC RISK
The CAPM splits the total risk of a security into the unsystematic risk and
the remainder. The remainder is the relevant risk for appraising
investments.
CAPM is concerned with:
 How systematic risk is measured;
 How systematic risk affects required returns and share prices.
To measure systematic risk, we use the beta factor
The CAPM is based on the assumptions those investors:
 In shares require a return in excess of the risk-free rate (i.e. a
premium) as compensation for taking the systematic risk of the
investment;
 Should not require a premium for unsystematic risk as this may be
diversified and removed from the portfolio (as discussed earlier);

 Will expect a greater return from companies with greater systematic
risk (as measured by their beta factors).
MARKET RISK AND RETURN
The CAPM was formulated principally to evaluate investments in stocks
and shares (‘the market’ meaning the stock market) rather than in
companies’ investment projects.
Market risk is almost impossible to determine accurately, as it is based on
the variability of the total market return. As the components of the market
fluctuate constantly, so the systematic risk attached to shares will also
change.
A measure of the relationship between the returns of the company and
those of the market is given by the beta factor (β) for that company.
The line of best fit, also known as the characteristic line,
Therefore, the cost of equity is basically what it costs the company to
maintain a share price that is satisfactory (at least in theory) to investors.
The most commonly accepted method for calculating cost of equity comes
from the Nobel Memorial Prize-winning capital asset pricing model
(CAPM), where:
Cost of Equity (Re) = Rf + Beta (Rm-Rf).
The formula is expressed as:
(Re - Rf) = β (Rm - Rf)
or
Re = Rf + β (Rm - Rf)
Where: Re = expected return from an individual investment
Rf = the risk-free rate of return
Rm = the market rate of return (the return on the all share index)
β = the beta factor of the investment
Let's explain what the elements of this formula are:
Rf - Risk-Free Rate - This is the amount obtained from investing in
securities considered free from credit risk, such as government bonds
from developed countries. The interest rate of Treasury bills or the long-
term bond rate is frequently used as a proxy for the risk-free rate.

ß - Beta - This measures how much a company's share price moves
against the market as a whole.
Where β > 1, the shares are described as aggressive: they outperform
the market. This means they give a bigger return than the market when
the market return is positive and a bigger loss than the market when the
market return is negative.
Where β = 1, the shares are described as neutral: their returns are in
line with the average return of the Stock Market.
Where β < 1, the shares are described as defensive: they are less risky
than the market generally.
The market as a whole has a beta factor of 1. If a company’s beta factor is
2, its return will vary twice as much as the return on the market as a
whole.
If the market return (Rm) is 5 per cent above the risk-free rate of return,
then the expected return for this company with a beta factor of 2 is 10 per
cent above the risk-free rate of return.
If the market return is 3 per cent below the risk-free return, the expected
return for the company is 6 per cent below the risk-free return. The actual
return for the company may differ from the expected return because of
variations due to the company’s unsystematic risk, which is unique to the
company.
(Rm – Rf) = Equity Market Risk Premium - The equity market risk

premium (EMRP) represents the returns investors expect, over and above
the risk-free rate, to compensate them for taking extra risk by investing in
the stock market. In other words, it is the difference between the risk-free
rate and the market rate. It is a highly contentious figure. Many
commentators argue that it has gone up due to the notion that holding
shares has become riskier.
Once the cost of equity is calculated, adjustments can be made to take
account of risk factors specific to the company, which may increase or
decrease the risk profile of the company. Such factors include the size of

the company, pending lawsuits, concentration of customer base and
dependence on key employees. Adjustments are entirely a matter of
investor judgment and they vary from company to company.
Cost of Debt
The cost of debt is simply the cost of borrowing money, or the interest
rate that the company would pay on the borrowed amount. When a
company is considered risky, it’s cost of borrowing money rises, and when
a company is considered stable, its cost of borrowing money falls. For
companies that have issued bonds previously, it's possible to estimate the
cost of debt by looking at the yield of those bonds.
The cost of debt explains the negative reaction that occurs when a
company's bonds are downgraded by a ratings agency such as Standard
& Poor's. With a lower rating, the company will have to pay higher
interest to borrow capital, raising its overall cost of capital.
Cost of bank borrowings
Bank borrowings do not have a market price with which to relate interest
and payments to in order to calculate their cost as is the case with
securitized debt. Thus, to approximate the cost of bank borrowings the
interest rate paid on the loan should be taken, making the appropriate
calculation to allow for the tax deductibility of the interest payment
Cost of preferred stock kP is the minimum required rate of return
required on newly issued preference shares
Is given by the equation kP= Dp/Pp
Where:
Dp = expected dividend per year and
Pp = per share market price of the stock
Note: the minimum required rate of return is based on the value of the
stock as perpetuity
Note: unlike interest expense on debt, preferred stock dividends are
viewed as a return to equity, hence there is not tax adjustment

For instance Zantel preferred stock is selling for shs. 95 per share and
pays a dividend of 4% of par value (shs. 100). The cost of preferred stock
is kP = 0.4(100)/95 =4.2%
The cost of debt capital which has already been issued is the rate of
interest (the internal rate of return) which equates the current market
price with the discounted future cash flow from the security.
 Irredeemable debt
For redeemable debt the cost is calculated as the interest payable
over the market value of debt.
I I (1−t c )
Po P
if tax rate is applied then 0
The tax is included because interest on loan is allowable for tax

purposes so if a company use borrowed capital there is always a
saving due to tax relief on interest paid.
 Cost of redeemable debt
These are debts with a defined period or date of repayment. The cost
of these debts will be found by using the internal rate of return.
Example:
Peet Ltd has 7% debentures in issue. The market price is shs. 95.75 ex
interest. Ignoring taxation, calculate the cost of this capital if the
denture is:
-Irredeemable.
-Redeemable at par after 5 years.
Solution
(a) The cost of irredeemable debt capital is: 7.3%
(b) The cost of debt capital is 7.3% if irredeemable. The capital profit
that will be made from now to the date of redemption is shs. 4.25

( shs. 100 – shs. 95.75). This profit will be made over five years which
gives an annualised profit of shs. 0.85.(4.25/5) which is about 0.9% of
current market value. The best trial and error figure to try first is,
therefore, 7.3% + 0.9% = 8.2% say 8% to the nearest.
discoun discoun
Yea cash t rate t rate
r flow (8) PV (10) PV
95.7 - -
0 5 1 95.75 1 95.75
1-5 7 3.993 27.95 3.791 26.54
5 100 0.681 68.10 0.621 62.1
0.30 -7.11
The approximate cost of debt capital is therefore: 8.1%

The cost of debt capital estimated above represents the cost of
continuing to use the finance rather than redeeming the debt securities
at their current market price. It would also represent the cost of raising
additional finance if we assume that the cost of additional capital would
be equal to the cost of that already issued. A company with no debt
capital can make the calculations using the information of another
company which is judged to be similar as regards to risk.
Weighted Average Cost of Capital - WACC
What Does Weighted Average Cost Of Capital - WACC Mean?

A calculation of a firm's cost of capital in which each category of capital is
proportionately weighted. All capital sources - common stock, preferred
stock, bonds and any other long-term debt - are included in a WACC
calculation. All else help equal, the WACC of a firm increases as the beta
and rate of return on equity increases, as an increase in WACC notes a
decrease in valuation and a higher risk.
The WACC equation is the cost of each capital component multiplied by its

proportional weight and then summing:

Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V=E+D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
Businesses often discount cash flows at WACC to determine the Net
Present Value (NPV) of a project, using the formula:
We should consider discount rate that is after tax, remember interest
payable in the form of corporate tax is deductible and hence reduce the
tax liabilities, but payment of dividends to shareholder is not allowable
hence does not reduce the tax liability of company, for this case in the
formula of WACC tax has to be included in debt part
D/V * rd * (1-tc)
ASSUMPTIONS WHEN USING WACC
 The cost of capital used in project evaluation is the marginal cost of
funds raised to finance the project;
 New investments must be financed from new sources of funds,
including new share issues, new debentures or loans;
 The weighted average cost of capital must reflect the long-term
future capital structure of the company.
ARGUMENTS AGAINST USING THE WACC

 Businesses may have floating rate debt whose cost changes
frequently
 The business risk of individual projects may be different from that of
the company and will thus require a different premium included in
the cost of capital.
 The finance used for the project may alter the company’s gearing
and thus its financial risk.
ASSESSMENT OF RISK IN THE DEBT VERSE EQUITY
DEBT
 Fixed interest payment in each period, whether the company makes
profit or not If redeemable, then loan amount will have to be paid
in the future
 In case of default, in interest payment the company may be forced
into liquidation
 Loans if secured is charged over fixed asset
 Interest payments are tax deductible, where a company makes
profit
 Loan will increase the company’s gearing level
EQUITY
 Ordinary shareholders are the owners of the organization, and are
paid dividends Where organisation does not make profit, dividends
may not be paid, without forcing the organisation into liquidation
 Dividends paid to shareholders are not tax deductible
 Equity will reduce the gearing (risk) level
COST OF CAPITAL FOR UNQUOTED COMPANIES

To estimate an approximate cost of capital the firm can use the cost of
equity of a similar quoted company and adjust it for difference in financial
and business risk
COST OF CAPITAL FOR NOT-FOR-PROFIT ORGANISATIONS

Government departments do not have a market value, nor do they have
business or financial risk, hence they cannot calculate the cost of capital.
They therefore use the targeted ‘real rate of return’ set by the treasury as
the cost of capital
Factors Influencing Capital Structure
Business risk
Risk associated with the nature of the industry the business operates and
if the business risk is higher the optimal capital structure is required.
Tax position
Debt capital is regarded as cheaper because interest payable is deductible
for tax purposes. Advantage not much for businesses with unrelieved tax
losses, depreciation tax shield as they already have an existing lower tax
burden.
Financial flexibility
Depends on how easy a business can arrange finance on reasonable terms
under adverse conditions. Flexibility in raising finance will be influenced by
the economic environment (availability of savers and interest rates) and
the financial position of the business.
Managerial style
How much to borrow also depend on managers approach to finance risk.
Conservative managers will usual try to keep the debt equity ratio low.
Business and Finance Risk

Business risk
The variability in operating income caused but inherent factors of the
business other than debt financing can be influenced by changes in prices,
variability of inputs, sales volume, and competition levels.
Finance risk
Additional variability in return that arises because the financial structure
contains debt. Finance risk measured through gearing/leverages ratios.
Financial gearing

Extent to which debt finances firms total capital structure
Debt equity ratio: Total debt/Total assets
Times interest earned
Measures the firm’s ability to meet its annual finance interest payments.
TIE ratio = Earnings before interest and tax
Interest charges
Operational gearing
Measures to what extent are fixed costs used in firms operations.
Breakeven point analysis will measure the relationship between sales
volume, variable cost and the fixed costs. Breakeven point is the level of
sales where the firm is neither making profits nor losses i.e. Sales value
equals costs.
Financial gearing can reach very high levels, with companies preferring to
raise additional capital for expansion by means of loans rather than
issuing new equity, but there are limits.
 Restrictions on further borrowing might be contained in the denture
trust deed for a company’s current debenture stocks in issue.
 Occasionally, there might be borrowing restriction in the articles of
association.
 Lenders might want security for extra loan which the would be
borrowers cannot provide.
 Lenders might simply be unwilling to lend more to a company with
high gearing or low interest cover.
 Extra borrowing beyond a safe level will cost more interest.
Companies might not be willing to borrow at these rates.
Apart from the limitations stated above, there are other side effects
associated with high gearing which may include the following:
Financial distress where obligations to the conditions are not met or they
are met with difficulties
Costs: -
 Loss of key suppliers

 Uncertain customers
 Low asset value
 Loss of staff moral
 Legal costs
 Agency costs in trying to negotiate additional loan facilities through
an agent.
 High interest rates
 Need to sign loan covenants thereby loosing financial freedom
 Borrowing cap
 Limits set by lenders on amount available
 Financial slack – Highly geared firms fail to seize opportunities as
they arise due to unwillingness of lenders for more fund
advancements.
 High gearing might send bad signals on company’s liquidity to
employees as well as lenders
 Loss of decision making on certain areas to lenders due to loan
covenants
Despite mentioning all the limitations and cost of high gearing mentioned
above company’s still uses debt capital. Apart from being cheaper than
share capital the following attributes compels the company to use the debt
capital.
 Motivation – Regarded as cheaper source of income
 New issue stocks may dilute holding
 Operational and strategic staff more cautious on utilization of funds
 Flexibility in arrangement than equity
Capital Structure- part 11

The purpose of this note is to examine how the value of the firm is
affected (holding investment policy and dividend policy constant) by the
way in which the firm finances its investments. For example, can the
value of the firm be increased by financing new investments with debt

rather than equity? In order to examine the effect of the firm's financing
decisions (the firm's capital structure) on the value of the firm, assume
that
 the firm's investment decision is given,
 the firm's dividend policy is given,
 there are no transaction costs involved in either the purchase or sale
of securities
 Investors can borrow and lend at the same rate that corporations
can borrow and lend.
Value of Tax Shields from the Corporate Deduction for Interest
Expense
The capital investment projects undertaken by the firm are usually

financed with some combination of debt and equity. In order to
understand the effect of this choice on the value of the firm, consider the
case where the firm is currently financed entirely (100 percent) by equity.
We will also assume that the firm's production capacity is already in place
(i.e., the investment decision by the firm is a given) so that any changes
in the firm's financing mix (such as replacing equity with debt financing)
will have no impact on the cash flows from operations.
To see how the value of the firm changes if equity financing is replaced
with debt financing, suppose that the firm issues a perpetual bond that
pays one shillings of interest each year. Assuming that the interest
payments for the bond are risk-free and that the opportunity cost for risk-
free cash flows (before personal tax) is r, the amount that is raised by
shs 1
issuing this bond is rd
The proceeds from the debt issue will be used to repurchase an equal
Shilling amount of the firm's outstanding equity shares. Although firms do

not issue perpetual debt in practice, the consequences of using debt as a
more or less permanent component of a firm's financing mix are virtually
identical.
The implications of the “recapitalization” (change in financing mix)
described above is to divert one Shilling of before-tax operating income
(profit before financing charges and taxes) from stockholders to
bondholders. If no debt had been issued, the firm would have to pay
corporate taxes on the Shilling in question at a rate of tc. The remainder

would be paid to the shareholders, either in the form of a dividend or
through reinvestment in the firm resulting in appreciation in the stock
price. Since the dividend to the shareholders would have been taxed at a
rate of te, the after-tax value of one Shilling of operating income directed
toward the stockholders in the firm is
(1 - te) (1 - tc) shs1 .
The net benefit created by corporate borrowing can be determined by

comparing the after-tax cash flows to the stockholders with the after-tax
cash flows which bondholders receive if the firm issues enough perpetual
debt so that one Shilling is diverted to the payment of interest expense.
Since corporations are allowed to deduct interest expense prior to
computing their corporate tax liability, the interest income to the
bondholders is equal to one Shilling. Since interest income is taxed at a
rate of to , the after-tax cash flow received by the bondholders is (1 - to)
shs 1
The value (if any) of diverting one Shilling of before-tax operating cash
flow from the shareholders to the bondholders can be determined by
comparing (subtracting) the after-tax cash flows that would have been
received by the stockholders to (from) the after-tax payment received by
the new bondholders,
[ ( 1 - to ) - ( 1 - te ) ( 1 - tc ) ] shs1 .

If these after-tax cash flows are capitalized in perpetuity (i.e., valued as a
perpetuity) using the after-tax return required by the bondholders, ( 1 - to
) rD , then the value which is created by diverting one Shilling of before-
tax operating income from the stockholders to the bondholders is

shs1
Rearranging the expression above shows that the value created in a
recapitalization that causes the firm to pay an additional one Shilling per
year of interest expense (in perpetuity) is
[1 - ] .
For a firm having outstanding debt in the amount of D with yearly interest
expense of rD , the total value created by replacing D Shillings of equity
(starting from a point of relying solely on equity financing) with D Shillings
of debt is obtained by simply multiplying the firm's yearly interest expense
(rD) by the value per Shilling of yearly interest expense given above.
Therefore, the incremental value created by financing with debt rather
than equity is given by
D[1 - ] .
The incremental value of the tax shields generated by debt financing is

used as an adjustment to the value of an unlevered firm (i.e., one that is
100 percent equity financed). That is the value of the recapitalized or
levered firm (i.e., the value after debt has been added to the firm's
financial structure) is equal to the value of the unlevered firm (V) plus the
value of the tax shields from debt financing
V= V+ D [1 - ].
To illustrate the application of the formula, consider the following special
cases.
Example 1 :
Suppose that the corporate tax rate (tc) is 50 percent, the tax rate on
interest income (to) is 40 percent and the tax rate on equity income ( te)

is equal to zero. Then the value of the tax shields from one Shilling of
debt (not one Shilling of interest expense) is
shs1 [1 - ] =shs1[1- ]
= shs1 [1 - ]
= shs .17.
Therefore, the value of each Shilling of debt added to the firm's financial
structure (up to some level consistent with sustained profitability for the
firm) is shs.17 per Shilling of debt (not interest expense).
Example 2:
Assume that the corporate tax rate (t c) is 50 percent and that the tax rate
on interest income (to) is 40 percent as in Example 1. However, assume
that the tax rate on equity income (t E) reflects the fact that 20 percent of
the income to stockholders is in the form of dividend income taxed at 40

percent while 80 percent is in the form of capital gains having (according
to many economists) an effective tax rate of zero. Therefore, the tax rate
on equity income is approximately 8 percent (.20x.40 + .80x0). In this
case, the value of the tax shields from one Shilling of debt is
shs1 [1 - ] = shs1 [1 - ]
= shs1 [1 - ]
= shs .23.
Note that the higher the tax rate on equity income, the greater is the
value of the tax shields from replacing equity with debt financing.

Example 3:
A particularly important example is the case where the tax rate on interest
income (to ) is equal to the tax rate on equity income (tE) . In this case
the value of the tax shields from one Shilling of debt (not one Shilling of
interest expense) is
shs1 [1 - ] = shs1 [1 - (1 - tc) ]
= shs1 (tc).
This example shows that when equity income and interest income are
taxed at identical rates the value of the tax shields from financial leverage
is determined entirely by the corporate tax rate, just as if the marketplace
ignored the effects of personal income taxes. In other words, when (te) is
equal to (to ) , the value each Shilling of debt is equal to tc so that the
value of the levered firm is given by
VL = VU + tc D .
Note that the adjustment that has been used to the value of the unlevered
firm (with no debt financing) to reflect the value of the tax shields from
debt implicitly assumes that the firm holds the level of debt to a
(“moderate”) level that allows the firm to sustain consistent (taxable)
profitability. So long as the firm is consistently profitable, the full value
of the tax shields may be realized (without resorting to tax loss carry
forwards). What is moderate will depend critically on the nature of the
industry in question. For example, firm's engaged in highly speculative
research and development activities have little assurance of utilizing the
tax deductions for the interest expense on debt (in addition to providing
poor collateral). Therefore, firm's engaged in heavy research and
development activities will tend to rely primarily on equity financing. On

the other hand, firms in mature industries (e.g., tobacco or food products)
that have relatively stable cash flows can often support relatively high
levels of debt.
The Impact of Financial Structure in a World with No Taxes

To illustrate the important impact of taxes on the value of financing
decisions, it is useful to examine the impact of a recapitalization (issue
debt and buy back equity) on the value of the firm under the (artificial)
assumption that all of the tax rates considered previously are equal to
zero. Given this assumption, the example shows that even though a
change in financial structure has no impact on the total value of the firm,
the resulting change in the risk profile of the remaining equity shares
(including an increase in the expected dividend) precipitates an increase in
the cost of equity capital.
Machinga Example:
Number of Shares = 1000

Price per Share = shs 10
Firm Value = shs 10,000
State 1 State 2 State 3
Net Operating Income shs500 Shs 1.000 Shs 2,000
Probability 1/4 1/8 5/8
Earnings per Share shs .50 shs1.00 shs2.00
Return on Equity (ROE) 5% 10% 20%
Given the three possible values for the Return on Equity, the expected
(required) rate of return on Machinga's stock is
rE = .05 + .10 + .20 ,
= .15 (15 percent).
Assume that all earnings will be paid out as a dividend (in perpetuity).
Then the expected dividend for the firm will be

E(D)= shs.50 + shs1.00 + shs2.00 ,
= shs1.50.
Given that the required rate of return on equity (the cost of equity capital)
is 15 percent, it is easy to verify that the price of one share in the firm
should be (as we have already assumed)
shs1.50
P0 = = .15 = shs 10,
Where rE is the required rate of return on equity.
Suppose now that the firm decides to
a) sell shs5000 of debt

b) Retire 500 shares of stock with the proceeds from the debt
issue.
Then the new capital structure will be
Number of Shares = 500

Price per Share = shs 10
Value of Shares = shs 5000
Value of Debt = shs 5000
To see why this must be the case, consider the possible realizations of
earnings per share and return on equity for the recapitalized or levered
firm.

Operating Income shs500 Shs 1,000 Shs 2,000
Interest Expense Shs 500 Shs 500 Shs 500
Net Income shs 0 Shs 500 shs 1500
Earnings Per Share (EPS) 0 Shs 1.00 Shs 3.00
Return on Equity (ROE) 0 10% 30%
It can be shown that the recapitalization of the firm has increased the
expected dividend for the remaining shareholders of Machinga to shs 2.00
per share. (You should be able to compute the expected dividend for the
recapitalized firm in the same way that we computed the expected
dividend for the unlevered version of Machinga). However, since the
required rate of return increases to 20 percent (you can show that the
expected Return on Equity is 20 percent), the stock price remains
unchanged at shs 10 per share. Therefore, the recapitalization has no
effect on the total value of the firm.
The increase in the expected rate of return demanded by shareholders can

be motivated by examining the respective payoff patterns for the
unlevered (the original debt-free firm) and levered (recapitalized to
include debt financing) firm. Consider our projections for ROE and EPS for
each of the possible outcomes for net operating income. Although the
recapitalization has increased the expected dividend per share, the
increase in financial leverage has also increased the range (variability) for
both dividends per share (from shs.50-shs2.00 to 0-shs3.00) and Return
on Equity (from 5%-20% to 0%-30%). In other words, financial leverage
increases the risk associated with the expected returns promised to
shareholders. Since we have assumed that there are no tax benefits
associated with debt financing (these will be discussed later), the value of
the firm's equity shares will not change (this “can be shown”).
To see why the recapitalization has no impact on the total value of the
firm, consider the position of an investor who initially owned two shares of

stock. Prior to the recapitalization, the investor's income from these two
shares would have had the following distribution across states of the world

Earnings per Share shs .50 Shs 1.00 Shs 2.00
Income from 2 Shares of Stock Shs 1.00 Shs 2.00 Shs 4.00
Given our assumption that the firm is recapitalized by issuing debt to buy
back one half of the firm's outstanding stock, an investor with two shares
prior to the recapitalization would now have one share of stock and shs 10
(from the sales of one of the shares of stock), which could be invested at
10 percent interest by purchasing shs 10 of the bonds of the recapitalized
firm. The total income to the investor from one share of stock (with a
market price of shs 10) and one bond (also worth shs 10) paying interest
at a rate of 10 percent would be

Income from 1 Levered Share 0 shs1.00 shs3.00
Income from shs10 in Bonds Shs 1.00 1.00 1.00
Total Investment Income Shs 1.00 Shs 2.00 Shs 4.00
The Table above shows that the total investment income for an investor
with shs2 0 invested in a portfolio consisting of one share of stock in the
recapitalized firm and shs 10 in bonds is identical to the pattern of returns
obtained from owning 2 shares in the all equity (unlevered) firm.
Therefore, the investor can undo the impact of the recapitalization by
simply using the proceeds from selling stock back to the firm to purchase
the newly issued bond.
Similarly, so long as an investor can borrow at the same interest rate
(roughly) as corporations, shareholders can replicate (match) the pattern
of payoffs from the levered firm by financing one-half of an investment in

2 shares of stock in an all equity firm by borrowing shs 10 at an interest
rate of 10 percent. The distribution of payoffs from this portfolio is shown
belo

Income from 2 Levered Share 0 Shs 2.00 Shs 4.00
Interest on Personal Debt of shs 10 Shs 1.00 1.00 1.00
Total Investment Income Shs 0.00 Shs 1.00 Shs 3.00
Which is identical to the dividends from an investment of shs 10 in the

shares of the recapitalized firm? In other words, the firm cannot create
value for investors by recapitalizing an all equity firm since the
shareholders are able to do this for themselves if they wish.
The implications of the analysis above, for which Merton Miller and
Franco Modigliani received the Nobel Prize in Economics, is that the
financing mix used by the firm (the capital structure) does not matter as
long as investors are able to costlessly duplicate (or reverse) the financial
implications of any financing decision which the firm might make. These
implications can be summarized as
1. The total market value of the debt and equity of a levered firm
(using debt financing in addition to equity financing) must be equal
to the market value of an unlevered (all equity) firm having the
same degree of operating risk. In other words,
VU = VL.
2. Since VL is equal to VU, the two firms must have the same blended
cost of funds or weighted average cost of capital, which requires

that the cost of equity capital for the levered firm be greater than
the cost of equity capital for the unlevered firm (since the cost of
debt will always be less than the cost of risky equity capital).

Weighted Average Cost of Capital
The weighted average cost of capital (WACC) is the firm's hurdle rate or
opportunity cost of capital. The WACC is used in capital budgeting to
compute the net present value for projects which have the same risk and
debt capacity as the firm as a whole. In general, the weighted average
cost of capital may be thought of as the required return on the portfolio of
securities that has been issued to finance the firm's operations. In
general, the firm's WACC may be computed using the formula
WACC = rD + rE
Where D is the value of the firm's debt, S is the value of the firm's equity,
VL is the total value of the firm, td is the before-tax cost of debt, re is the
cost of equity and td is the corporate tax rate.
In the previous example, we assumed that the corporate tax rate (t c) was
equal to zero. After the firm was recapitalized to include debt financing,
the outstanding value of the firm's debt was shs 5,000, the value of the
equity was shs 5,000 and the total value of the firm was shs 10,000.
Since the before-tax cost of debt is 10 percent and the required rate of
return on the equity in the recapitalized firm is 20 percent, the weighted
average cost of capital is
WACC = rD + rE
shs.5,000 shs.5,000
= shs10,000 .10 + shs10,000 .20
= .15 (15 percent).

Note that prior to the recapitalization (using debt financing), the firm
relied solely on equity financing with a cost of 15 percent. In other words,
there is only one security in the financing portfolio of the all equity firm.
Therefore, the weighted average cost of capital for an all equity firm must
be equal to the cost of equity (which is also the required return on the
firm's assets for an all equity firm), which in this case was 15 percent.
The computations above show that when there is no tax deduction for
corporate interest expense, a firm cannot change it's weighted average
cost of capital by altering the financing mix used to finance its operations.
Valuation
There are three general approaches to valuation,

1. Adjusted Present Value
2. Adjusted Discount Rate
3. Equity Capitalization
For the relatively straightforward examples illustrated here, the three

approaches give identical values for the firm and its component securities.
However, in some instances, one or more of the valuation approaches
suggested above may be difficult to implement. Therefore, it is usually
convenient to have more than one valuation technique at your disposal.
Adjusted Present Value
The adjusted present value approach to valuation is a two-step approach
requiring that we
 value the firm as if the project were to be financed entirely by
equity,
 Then add on the present value of any special benefits
associated with the financing of the project.
Examples of special financing benefits whose value should be accounted
for include

 the value of the tax shields from debt financing,
 the value of subsidized financing which may be tied to
undertaking the project (e.g., industrial development bonds or
below market loans from foreign governments),
 the flotation costs of issuing securities.
To simplify the discussion of the Adjusted Present Value (APV) approach to

valuation, consider the case where a firm generates perpetual before-tax
operating cash flows denoted by EBIT. As noted above, the first step in
the APV approach is to value the firm (or project) as if the financing were
all equity. Note that if the financing for a project is 100 percent equity
then the cost of equity capital r e is equal to the required return on assets,
ra. In other words, if there were no debt financing, then after paying
corporate taxes at a rate of tc, 100 percent of EBIT can be used to pay
dividends to the shareholders. Therefore, the value of the all
equity/unlevered firm (Vu) is equal to after-tax EBIT capitalized in
perpetuity at the required return on assets
Vu = .
The second step of the APV approach requires that we determine the
value of any financing effects associated with a firm or project separately
and then add the value of these benefits to the unlevered value of the
project. For example, if the firm issues D Shillings of debt then the value
of the “recapitalized” firm will be
VL = VU + tc D .
To illustrate the application of the Adjusted Present Value approach,

consider a firm which has perpetual EBIT of shs 1,000,000 per year.

Assume that the corporate tax (tc) rate is 46 percent and that the required
return on assets (rA) is 20 percent. If the firm issues shs 3,000,000 of
perpetual debt at an interest rate of 15 percent, then the pre- and post-
recapitalization cash flows to the stockholders and bondholders will be
Pre-Recapitalization Post-Recapitalization
(All Equity) (shs3,000,000 of Debt)
EBIT shs1,000,000 shs1,000,000
Less: Interest 0 450,000
Net Income shs1,000,000 shs550,000
Less: Tax@ .30 300,000 165,000
Equity Income Shs700,000 Shs385,000
Interest (to Bondholders) 0 450,000
Total After-Tax Payout Shs700,000 Shs 835,000
Note that when the firm is financed entirely by equity, the firm pays no
interest and the total after-tax payout from the firm is equal to
(1 - tc) EBIT = (1 - .30) shs 1,000,000,
= shs 700,000.
If the firm issues shs 3,000,000 in debt at 15 percent, then the cash flow
to the stockholders is
(1 - tc) [EBIT - rD D] = (1 - .3) [shs 1,000,000 - .15 x shs 3,000,000],
= shs 385,000.
The interest to the bondholders is equal to r D D or shs 450,000.
Therefore, the sum of the after-tax cash flow to the stockholders and
bondholders is
(1 - tc) [EBIT - rD D] + rD D = ( 1 - tc ) EBIT + tc rD D .
= (1 - .30) shs 1,000,000 + .30 x .15 x shs 3,000,000,
= shs 700,000 + shs 135,000.

The example shows that adding debt to the financial structure of the firm
increases the total after-tax cash flow paid out by shs 135,000, the tax
savings attributable to the corporate deduction for interest expense. If
this amount is capitalized in perpetuity using the cost of debt (note that

we are ignoring personal taxes here), the additional cash flow increases
the value of the firm by shs 900,000 (shs 135,000/.15).
Applying the formula for the value of the unlevered firm shows that
Vu = ,
(1−.30)shs1,000,000
= 0.20 ,
= shs 3,500,000.
So that the total value of the levered firm is

VL = Vu + tc D
= shs 3, 500,000 + .30 x shs 3, 000,000

= shs 4,400,000.
The example above raises an important fundamental question concerning
the application of the formula for the value of the levered firm. The
assumption that the firm can issue shs 3,000,000 of debt to repurchase
equity is questionable given that the initial value of the all equity firm is
only shs 3,500,000. If the primary security for the loan is the collateral
(i.e., the value of the underlying assets), then it is unlikely that the
required debt financing can be obtained. Note however that the operating
cash flow for the firm is more than twice as large as the required interest
payments on the debt. While this level of interest coverage would likely
place the rating on the firm's debt in the BB- to B+ range, the initial
willingness of fixed income investors to purchase the debt of the firm is in
doubt given the fact firms in the BBB ratings category have great difficulty
issuing debt in tight credit markets. Nevertheless, if the cash flow of the
firm is stable, then bondholders may be willing to purchase the debt of the
firm based on the adequacy of the cash flows generated by the firm's
assets.
Adjusted Discount Rate
The most important alternative to the Adjusted Present Value method of
valuation is the Adjusted Discount Rate approach. Under the Adjusted

Discount Rate approach, the present value of the “after-tax operating cash
flows” (i.e., the after-tax profits if the project were financed entirely with
equity) is determined using an “adjusted discount rate” which takes into
account any benefits from the utilization of debt in the financing of the
project. That is, the value of the firm or project may also be determined
by capitalizing the “after-tax operating cash flows” for the unlevered firm
using a discount rate that is adjusted to reflect the tax shields associated
with debt financing. This approach can be represented using the following
formula for the value of the levered firm
VL = ,
where WACC (sometimes referred to as the weighted average cost of

capital) represents the adjusted discount rate.
The adjusted discount rate is most easily defined by noting that the
adjusted present value approach and the adjusted discount rate approach
should suggest the same value for a firm with perpetual operating cash
flow of EBIT and debt financing in the amount of D. In other words, an
adjusted discount rate or weighted average cost of capital is defined by
the identity,
+ tc D = .
Note that when the corporate tax rate is equal to zero,
= ,
which implies that the value of the tax shields from debt are equal to zero,
which in turn implies that the weighted average cost of capital (the
adjusted discount rate) is equal to the required rate of return on assets.
In other words, when the tax shields from debt have no value, the cost of
financing the firm does not depend on the amount of debt in the firm's
financial structure.

It is fairly easy to show that the weighted average cost of capital defined
above is simply the average cost of the portfolio of securities used to
finance the firm's operations. For example, if the firm uses only debt and
equity to finance its operations, then the WACC is a weighted average of
the after-tax cost of debt (to account for the corporate deduction for
interest expense) and the cost of equity. The formula for the weighted
average cost of capital is
WACC = rD + rE
where the weights of debt and equity in the capital structure are
respectively D/VL and S/VL .
To use the formula above to value the firm, we need to know both the
cost of equity and the after-tax cost of debt. In the previous example, the
cost of debt was 15 percent. Although we know that the required return
on assets is 20 percent, which is the cost of equity for a firm with no debt
in its financial structure, we don't know the cost of equity for the levered
(or recapitalized) firm. We have already shown that financial leverage
increases the risk of the cash flows to the shareholders. Further, we know
that the increase in risk increases the rate of return required by the
shareholders. It turns out that the cost of equity capital is related to the
required return on assets (rA ) and the amount of debt in the firm's
financial structure by the following formula
rE = rA + .
To show how this formula works, consider the previous example. We saw
that after the firm issued shs 3,000,000 of debt (D), the total value of the
firm was shs 4,400,000, which implies that the value of the firm's equity is
shs 1,400,000. Given a required return on assets of 20 percent, a before-

tax cost of debt of 15 percent, and a corporate tax rate of 46 percent, the
cost of equity capital is
shs3,000
(1−.3)(.2−.15)
shs.1,400
rE = .20 +
= 27.5 percent) .
Given the cost of equity capital, we can now determine the weighted
average cost of capital,
WACC = rD + rE
3,000 1,400
(1−30)
= 4,400 .15 + 4,400 .27.5,
= 0.275 (approximately 27.5 percent) .
Once we know the weighted average cost of capital we can determine the
value of the firm by discounting the after-tax operating cash flow of the
firm using the weighted average cost of capital or adjusted discount rate,
VL = ,
(1−. 30)1,000 ,000

= 0 . 275
= shs 4,400,000.
The calculations above show that under ideal conditions, the Adjusted
Discount Rate approach to valuation and the Adjusted Present Value
approach give the same value for the firm. Wonderful you say. So what?
Since we needed the value of the firm and the value of the equity
(obtained using the APV approach) to determine the weights of debt and

equity required to determine the WACC, isn't the logic above circular and
therefore useless?
The answer to the question above is clearly no, the Adjusted Discount
Rate approach (WACC) to valuation is very useful. In fact, we have been
using an Adjusted Discount Rate approach to valuation all semester.
Recall that our estimates of the cash flows from capital investment
projects have never included a charge for any financing costs associated
with the project. In other words, the approach that we have followed has
always been to estimate the after-tax cash flow from operations, without
considering the costs associated with the financing of the project.
Implicitly, the costs of financing the project were always taken care of by
making the appropriate adjustment to the discount rate used to compute
the present value of the project.
With regard to the question of how we determine the relative weights of

debt and equity in the capital structure, the Adjusted Discount Rate
approach is typically used to value projects that will be financed with the
same mix of securities as the firm's existing assets. Firms usually have a
reasonable estimate of the relative importance of debt and equity in both
the mix of securities used to finance existing operations and the mix of
securities that will be required to finance projects currently in the planning
stage. Since the corporation usually has a reasonable estimate of the
weights of the various components of the financing mix, computing the
weighted average cost of capital is not usually a problem in practice.
Therefore, the choice between the Adjusted Discount Rate approach and
the Adjusted Present Value approach hinges on whether the financing
benefits associated with a project take the form of the tax savings from
issuing debt that will provide long-term financing for the project (use APV)
or whether the financing benefits include short-term financing benefits
such as subsidized financing or loan guarantees.
Equity Capitalization Approach

The equity capitalization approach to valuation calls for valuing the equity
of the firm separately using the cost of equity capital. In other words, we
value the stock by computing the present value of the after-tax cash flows
(after paying interest to the bondholders) available for distribution to the
shareholders using the cost of equity capital. The total value of the firm is
then determined by adding the value of the firm's outstanding debt to the
value of the equity.
The equity capitalization approach is most often used to value
1. Real Estate Investments
These projects are usually heavily leveraged. The fact that the
debt financing is often specific to the project makes the weighted
average cost of capital difficult to determine in some cases.
2. Joint Ventures
Since the debt associated with a joint venture is usually a liability
of the venture itself rather than of the individual partners, each
partner is concerned primarily with the value of their respective
equity shares, rather than with the value of the venture as a
whole.
3. Foreign Investments
Debt financing is often obtained in one or more foreign
countries in order to hedge political and exchange rate risk.
Other financing aspects as loan guarantees and subsidized
interest rates make the computation of an adjusted
discount rate or weighted average cost of capital difficult in
such cases.
To illustrate the equity capitalization approach, we continue the preceding

example. Since we have already determined that the cost of equity
capital for the recapitalized firm is .275 (27.5 percent), all that remains is
to determine the after-tax cash flows available for distribution to the
shareholders,

(1 - tc) [EBIT - rD D]= (1 - .30) [ shs 1,000,000- .15 x shs 3,000,000 ]
= shs 385,000.
If we discount the after-tax cash flows to the shareholders at the cost of
equity capital, the value for the firm's outstanding equity shares is
S = ,
(1−. 3)[ 1 ,000 , 000−.15∗3 , 000 , 000 ]
= .275 ,
= shs 1,400,000.
Adding the value of the firm's outstanding debt, which is shs 3,000,000;
we find that the value of the firm is shs 4,400,000 as before.
Modigliani-Miller theorem
The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller)

forms the basis for modern thinking on capital structure. The basic
theorem states that, under a certain market price process (the classical
random walk), in the absence of taxes, bankruptcy costs, and asymmetric
information, and in an efficient market, the value of a firm is unaffected
by how that firm is financed. It does not matter if the firm's capital is

raised by issuing stock or selling debt. It does not matter what the firm's
dividend policy is. Therefore, the Modigliani-Miller theorem is also often
called the capital structure irrelevance principle.
Modigliani was awarded the 1985 Nobel Prize in Economics for this and
other contributions.
The theorem was originally proven under the assumption of no taxes. It is
made up of two propositions which can also be extended to a situation
with taxes.
Consider two firms which are identical except for their financial structures.
The first (Firm U) is unlevered: that is, it is financed by equity only. The
other (Firm L) is levered: it is financed partly by equity, and partly by
debt. The Modigliani-Miller theorem states that the value of the two firms
is the same.
Without taxes, Proposition I:

where VU is the value of an unlevered firm = price of buying a
firm composed only of equity, and VL is the value of a levered firm = price
of buying a firm that is composed of some mix of debt and equity.
To see why this should be true, suppose an investor is considering buying
one of the two firms U or L. Instead of purchasing the shares of the
levered firm L, he could purchase the shares of firm U and borrow the
same amount of money B that firm L does. The eventual returns to either
of these investments would be the same. Therefore the price of L must be
the same as the price of U minus the money borrowed B, which is the
value of L's debt.
This discussion also clarifies the role of some of the theorem's
assumptions. We have implicitly assumed that the investor's cost of
borrowing money is the same as that of the firm, which need not be true
in the presence of asymmetric information or in the absence of efficient
markets.

Proposition II:
Proposition II with risky debt.
As leverage (D/E) increases,
the WACC (k0) stays constant.
 ke is the required rate of

return on equity, or cost
of equity.
 k0 is the cost of capital for an all equity firm.
 kd is the required rate of return on borrowings, or cost of debt.
 D / E is the debt-to-equity ratio.
A higher debt-to-equity ratio leads to a higher required return on equity,
because of the higher risk involved for equity-holders in a company with
debt. The formula is derived from the theory of weighted average cost of
capital (WACC).
These propositions are true assuming the following assumptions:
 no taxes exist,
 no transaction costs exist, and
 Individuals and corporations borrow at the same rates.
These results might seem irrelevant (after all, none of the conditions is
met in the real world), but the theorem is still taught and studied because
it tells something very important. That is, capital structure matters
precisely because one or more of these assumptions is violated. It tells
where to look for determinants of optimal capital structure and how those
factors might affect optimal capital structure.
With taxes
Proposition I:
where

 VL is the value of a levered firm.
 VU is the value of an unlevered firm.
 TCD is the tax rate (TC) x the value of debt (D) the term TCD
assumes debt is perpetual
This means that there are advantages for firms to be levered, since
corporations can deduct interest payments. Therefore leverage lowers tax
payments. Dividend payments are non-deductible.
Proposition II:
where
 rE is the required rate of return on equity, or cost of equity.
 r0 is the cost of capital for an all equity firm.
 rD is the required rate of return on borrowings, or cost of debt.
 D / E is the debt-to-equity ratio.
 Tc is the tax rate.
The same relationship as earlier described stating that the cost of equity
rises with leverage, because the risk to equity rises, still holds. The
formula however has implications for the difference with the WACC. Their
second attempt on capital structure included taxes has identified that as
the level of gearing increases by replacing equity with cheap debt the level
of the WACC drops and an optimal capital structure does indeed exist at a
point where debt is 100%
The following assumptions are made in the propositions with taxes:
 corporations are taxed at the rate TC on earnings after interest,
 no transaction costs exist, and
 individuals and corporations borrow at the same rate
Miller and Modigliani published a number of follow-up papers discussing
some of these issues.
The theorem was first proposed by F. Modigliani and M. Miller in 1958.

While it is difficult to determine the exact extent to which the Modigliani-
Miller theorem has impacted the capital markets, the argument can be
made that it has been used to promote and expand the use of leverage.
When misinterpreted in practice, the theorem can be used to justify near
limitless financial leverage while not properly accounting for the increased
risk, especially bankruptcy risk, that excessive leverage ratios bring. Since
the value of the theorem primarily lies in understanding the violation of
the assumptions in practice, rather than the result itself, its application
should be focused on understanding the implications that the relaxation of
those assumptions bring.
It can also be misinterpreted to justify excessive leverage in order to
extend margins for trading operations, even though this action should not
be directly comparable to the capital structure of a financial entity.
Review questions
Question no. 1
A consultant has collected the following information regarding Young
Publishing:
(m/=)
Total assets 3,000 Tax rate 40%
Operating income (EBIT) 800 Debt/ ratio 0%
Interest expense 0 WAC 10%
Net income 480 M/B ratio 1.00×
Share price (not in millions) 3.00
EPS = DPS (not in millions) 3.20
The company has no growth opportunities (g = 0), so the company pays

out all of its earnings as dividends (EPS = DPS). The consultant believes
that if the company moves to a capital structure financed with 20 percent
debt and 80 percent equity (based on market values) that the cost of
equity will increase to 11 percent and that the pre-tax cost of debt will be
10 percent. If the company makes this change, what would be the total
market value of the firm? (The answers are in millions.)

Question no. 2.
ZU Electronics currently has no debt. Its operating income is shs. 20
million and its tax rate is 40 percent. It pays out all of its net income as
dividends and has a zero growth rate. The current stock price is shs. 40
per share and it have 2.5 million shares of stock outstanding. If it moves
to a capital structure that has 40 percent debt and 60 percent equity
(based on market values), its investment bankers believe its weighted
average cost of capital would be 10 percent. What would its stock price
be if it changes to the new capital structure?
Question no. 3.
ZU Software Co. is trying to estimate its optimal capital structure. Right
now, ZU has a capital structure that consists of 20 percent debt and 80
percent equity, based on market values. (Its D/S ratio is 0.25.) The risk-
free rate is 6 percent and the market risk premium, r M – rRF, is 5 percent.
Currently the company’s cost of equity, which is based on the CAPM, is 12
percent and its tax rate is 40 percent. What would be ZU’s estimated cost
of equity if it were to change its capital structure to 50 percent debt and
50 percent equity?
Question no. 4.
JAK Enterprises Co. Ltd is trying to determine its optimal capital structure.
The company’s capital structure consists of debt and common stock. In
order to estimate the cost of debt, the company has produced the
following table:
% % Debt-to-equity Bond Before- Cost

financed financed ratio (D/S) tax of
With debt With rating debt
(wd) equity (%)
(wc)
0.10 0.90 0.10/0.90 = 0.11 AA 7
0.20 0.80 0.20/0.80 = 0.25 A 7.2
0.30 0.70 0.30/0.70 = 0.43 A 8.0
0.40 0.60 0.40/0.60 = 0.67 BB 8.8
0.50 0.50 0.50/0.50 = 1.00 B 9.6
The company’s tax rate, T, is 40 percent.

The company uses the CAPM to estimate its cost of common equity, r s.
The risk-free rate is 5 percent and the market risk premium is 6 percent.
Aaron estimates that if it had no debt its beta would be 1.0. (Its
“unlevered beta,” bU, equals 1.0.)
On the basis of this information, what is the company’s optimal capital
structure, and what is the firm’s cost of capital at this optimal capital
structure?
Question no. 5.

The A. J. Croft Company (AJC) currently has shs. 200,000 market value
(and book value) of perpetual debt outstanding carrying a coupon rate of 6
percent. Its earnings before interest and taxes (EBIT) are shs. 100,000
and it is a zero-growth company. AJC's current cost of equity is 8.8
percent, and its tax rate is 40 percent. The firm has 10,000 shares of
common stock outstanding selling at a price per share of shs. 60.00.
a) What is AJC's current total market value and weighted average cost
of capital?
b) Now assume that AJC is considering changing from its original capital
structure to a new capital structure with 50 percent debt and 50
percent equity. If it makes this change, its resulting market value
would be shs. 820,000. What would be its new stock price per share?
c) Now assume that AJC is considering changing from its original capital
structure to a new capital structure that results in a stock price of
shs. 64 per share. The resulting capital structure would have a shs.
336,000 total market value of equity and shs. 504,000 market value
of debt. How many shares would AJC repurchase in the
recapitization?
Question no. 6
Your company has decided that its capital budget during the coming year
will be shs. 20 million. Its optimal capital structure is 60 percent equity
and 40 percent debt. Its earnings before interest and taxes (EBIT) are
projected to be shs. 34.667 million for the year. The company has shs.
200 million of assets; its average interest rate on outstanding debt is 10
percent; and its tax rate is 40 percent. If the company follows the
residual dividend policy and maintains the same capital structure, what
will its dividend payout ratio be?
Question no. 7.
Chwaka Ltd. expects EBIT of shs. 2,000,000 for the current year. The
firm’s capital structure consists of 40 percent debt and 60 percent equity,
and its marginal tax rate is 40 percent. The cost of equity is 14 percent,
and the company pays a 10 percent rate on its shs. 5,000,000 of long-
term debt. One million shares of common stock are outstanding. For the
next year, the firm expects to fund one large positive NPV project costing
shs. 1,200,000, and it will fund this project in accordance with its target
capital structure. If the firm follows a residual dividend policy and has no
other projects, what is its expected dividend payout ratio?
Question no. 8.
The following facts apply to your company:
Target capital structure 50% debt; 50% equity

EBIT: shs. 200 million.
Assets shs. 500 million.
Tax rate 40%
Cost of new and old debt: 8%.

Based on the residual dividend policy, the payout ratio is 60 percent. How
large (in millions of Shillings) will the capital budget be?
Question no. 9.
S. S Bakhres & Company is planning a zero coupon bond issue. The bond
has a par value of shs. 1,000, matures in 2 years, and will be sold at a
price of shs. 826.45. The firm's marginal tax rate is 40 percent. What is
the annual after-tax cost of debt to the company on this issue?
Question no. 10
A 15-year zero coupon bond has a yield to maturity of 8 percent and a
maturity value of shs. 1,000. What is the amount of tax that an investor in
the 30 percent tax bracket would pay during the first year of owning the
bond?
Question no. 11.

Machinga Corporation is financing an ongoing construction project. The
firm needs shs. 8 million of new capital during each of the next three
years. The firm has a choice of issuing new debt and equity each year as
the funds are needed, or issuing the debt now and the equity later. The
firm's capital structure is 40 percent debt and 60 percent equity. Flotation
costs for a single debt issue would be 1.6 percent of the gross debt
proceeds. Yearly flotation costs for three separate issues of debt would be
3.0 percent of the gross amount. Ignoring time value effects due to
timing of the cash flows, what is the absolute difference in Shillings saved
by raising the needed debt all at once in a single issue rather than in three
separate issues?
Question no. 12
TTCL, a subsidiary of the Postal Service, must decide whether to issue
zero coupon bonds or quarterly payment bonds to fund construction of
new facilities. The 1,000 par value quarterly payment bonds would sell at
shs. 795.54, have a 10 percent annual coupon rate, and mature in ten
years. At what price would the zero coupon bonds with a maturity of 10
years have to sell to earn the same effective annual rate as the quarterly
payment bonds?
Question no. 13.

Lady and Bros. has 12 percent semiannual bonds outstanding which
mature in 10 years. Each bond is now eligible to be called at a call price
of shs. 1,060. If the bonds are called, the company must replace the
bonds with new 10-year bonds. The flotation cost of issuing new bonds is
estimated to be shs. 45 per bond. How low would the yield to maturity on
the new bonds have to be, in order for it to be profitable to call the bonds
today? (That is, what is the "breakeven rate"?)
Question no. 14.

For the Cook County Company, the average age of accounts receivable is
60 days, the average age of accounts payable is 45 days, and the average
age of inventory is 72 days. Assuming a 365-day year, what is the length
of the firm’s cash conversion cycle?
Question no. 15
A firm with no debt has 200,000 shares outstanding valued at shs. 20
each. Its cost of equity is 12%. The firm is considering adding shs.
1,000,000 in debt to its capital structure. The coupon rate would be 8%
and the firm’s tax rate is 34%. What would the firm be worth after adding
the debt?
a) Suppose a firm issues perpetual debt with a face value of shs. 5,000
and a coupon rate of 12%. If the firm is subject to a 40% tax rate
and the appropriate discount rate is 10%, what is the present value
of the interest tax shield?
b) A firm has 10,000 bonds outstanding, each with a face value of shs.
1,000 and a coupon payment of shs. 55 every six months. If the
corporate tax rate is 34%, what is the interest tax shield each year?
c) A firm has a WACC of 16%, a cost of debt of 10% and a cost of
equity of 22%. What is the firm’s debt-to-equity ratio? Ignore taxes.
Question no. 16
BDJ Ltd Inc. has 31,000 shares of stock outstanding with a market price of
shs. 15 per share. If net income for the year is shs. 155,000 and the
retention ratio is 80%, what is the dividend per share on BDJ Inc.’s stock?
Question no. seventeen
Lucky Mike’s, Inc. has a target debt/equity ratio of .75. After-tax earnings
for 1996 were shs. 850,000 and the firm needs shs. 1,150,000 for new
investments. If the company follows a residual dividend policy, what
dividend will be paid?
Question no. 17
Consider the firm, Alex, Inc. which is financed with 100% equity. The firm
has 100,000 shares of stock outstanding, with a market price of shs. 5 per
share. Total earnings for the most recent year are shs. 50,000. The firm
has cash of shs. 25,000 in excess of what is necessary to fund its positive
NPV projects. The firm is considering using the cash to pay an extra
dividend of shs. 25,000 or to repurchase stock in the amount of shs.
25,000. The firm has other assets worth shs. 475,000(market value). For
each of the following 6 questions, assume that there are no transaction
costs, taxes or other market imperfections.
a) Assume the firm pays the shs. 25,000 excess cash out in the form of
a cash dividend. What will the firm’s earnings per share be after the
dividend?
b) Assume the firm pays the shs. 25,000 excess cash out in the form of

a cash dividend. What will the market price of a share of Alex’s stock
be after the dividend?
c) Assume the firm pays the shs. 25,000 excess cash out in the form of
a cash dividend. Also assume you owned 1,000 shares before the
dividend was paid and that this was your total wealth. Immediately
after the dividend is paid, what is your total wealth?
d) Assume the firm uses the shs. 25,000 excess cash to buy back stock
at shs. 5 per share. What will the firm’s earnings per share be after
the repurchase?
e) Assume the firm uses the shs. 25,000 excess cash to buy back stock
at shs. 5 per share. What will the firm’s P/E ratio be after the share
repurchase?
f) Assume the firm uses the shs. 25,000 excess cash to buy back stock
at shs. 5 per share. What will the market price of a share of Alex’s
stock be after the share repurchase?
Question 18
a) It is commonly accepted that a crucial factor in the financial decisions
of a company, including the evaluation of capital investment proposals
is the cost o capital: required: explain in simple terms what is meant
by the cost of equity capital for a particular company
b) Calculate the cost of equity capital for X ltd from the data give below
using two alternative methods
 A dividend growth model
 The capital asset pricing model
Data for X Ltd
 Current price per share on the stock exchange shs. 1.20
 Current annual gross dividend per share shs. 0.10
 Expected average annual growth rate of dividends 7%
 Beta coefficient for X Ltd shares 0.5
 Expected rate of return on risk free securities 8%
 Expected return on the market portfolio 12%
Question no. 19
a) Using:
I. The weighted average cost of capital
II. The capital asset pricing model
Calculate the cost of capital for the following company
Company A
Shs shs
Fixed assets 200,000 200,000 O/ shares at 1/= @ 200,000
Current assets 150,000 Retained profit 50,000
Creditors 50,000
12% Debentures 50,000
Total 350,000 Total 350,000

Further information:
The debentures are repayable in 1995, and have a current market value
of shs. 48,490.65. the shares are currently selling a shs. 2.02. The
dividend for the current year was shs. 19.5 and its is expected that
company will grow at a rate of 5%. The risk free rate is currently 8.5%
with the return on the market being 15%. The company’s beta is 1.3
b) Discuss the usefulness and the limitation of the capital asserts

pricing model (CAPM) for capital investment decisions
Question no 20
Assume that you have graduated as a CPA holder and have just reports to
work for a company as financial officer. Your fist assignment is to study
the capital structure of the company in order to advise the company’s
management about the cost of capital that the company should use. Your
boss has developed the following questions which you must answer to
explain a number of issues.
Required: to explain briefly what you understand by:
a) Capital structure, optimal capital structure, targeted capital
structure.
b) Why do public utility companies usually have capital structures that
are different form those of retail firms?
c) How might increasingly volatile inflation rates and interest rates
affect optimal capital structure for corporation?
Question no.21.
On January 1st, the total market value of BBA Company was shs. 60
million. During the year, the company plans to raise and invest shs. 30
million in new projects. The firm’s present value capital structure, shown
below is considered to be optimal. Assume that there is not short term
debt.
Shs
Debt 30,000,000
Common stock equity 30,000,000
Total 60,000,000
New bonds will have an 8% coupon rate and they will be sold at par.
Common stock currently selling at shs. 30/= a share can be sold to net
the company shs. 27/= a share. Stockholders’ required rate of return is
estimated to be 12% consisting of a dividend yield of 4% and an
expected constant growth rate of 8% (the next dividend is shs. 1.2 so shs.
1.2/30 =4%) retained profit for the year are estimated to be shs. 3
million ( the marginal corporate tax rate is 40%)
Required:
a) To maintain the present capital structure, how much of the new
investment must be financed by common equity?
b) How much of the needed new investment funds must be generated
internally? Externally?
c) Calculate the firm’s weighted average cost of capital

Question no.22
A firm needs shs.100 to start and expects:
Sales shs.200
Expenses shs.185
Tax rate 33% of earnings
a) What are earnings if the owners put up the shs.100?
b) If the firm borrows shs.40 of the initial at 10%, what are the profits
received by the owner?
c) What is the return on the owners' investment in each case? Why do
the returns differ?
d) If expenses rise to shs.194, what will be the returns in each case?
e) In which case did the returns decline more?
f) What generalization can you draw form the above?
Question no.23
Given the following schedules:
Debt/Assets Cost of Debt Cost of Equity

0% 7% 14%
10 7 14
20 7 14
30 8 14
40 8 16
50 10 18
60 10 20
a) What is firm's cost of capital at the various combinations of debt and

equity?
b) What is the firm's optimal capital structure? Construct a balance
sheet showing that combination of debt and equity financing.
Question no. 24
A firm has three investment opportunities. Each costs shs.1,000, and the
firm's cost of capital is 10 percent. The cash inflow of each investment is as
follows:
Cash A B C
Inflow
Year
1 300 500 100
2 300 400 200
3 300 200 400
4 300 100 500

a) If the net present value method is used, which investment(s) should
the firm make?
b) What is the internal rate of return of investment A? The internal rate
of return of investment B is 10.22% and 6.15% for investment C.
Which investment(s) should the firm make?
c) What is the payback period for each investment?
Question no.25
Firm A had shs. 10,000 in assets entirely financed with equity. Firm B also
has shs.10, 000, but these assets are financed by shs.5,000 in debt (with
a 10 percent rate of interest) and shs.5,000 in equity. Both firms sell
10,000 units of output at shs.2.50 per unit. The variable costs of
production are shs.1, and fixed production costs are shs.12, 000. (To
ease the calculation, assume no income tax.)
a) What is the operating income (EBIT) for both firms?
b) What are the earnings after interest?
c) If sales increase by 10 percent to 11,000 units, by what percentage
will each firm’s earnings after interest income? To answer the
question, determine the earnings after taxed and compute the
percentage increase in these earnings from the answers you derived
in part b.
d) Why are the percentage changes different?

Hand Notes On Cost of Capital and Capital Structure: Composed By: H. B. Hamad

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Hand notes on cost of

capital and capital

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Capital Structure - What It Is and Why It Matters

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Other Forms of Capital:

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Seeking the Optimal Capital Structure

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Dividends valuation method

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Problems with the model

Cost of Newly Issued Stock

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Capital asset pricing model

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(Rm – Rf) = Equity Market Risk Premium - The equity market risk

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The tax is included because interest on loan is allowable for tax

 Cost of redeemable debt

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The approximate cost of debt capital is therefore: 8.1%

Weighted Average Cost of Capital - WACC

What Does Weighted Average Cost Of Capital - WACC Mean?

The WACC equation is the cost of each capital component multiplied by its

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ARGUMENTS AGAINST USING THE WACC

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COST OF CAPITAL FOR UNQUOTED COMPANIES

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Business and Finance Risk

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Capital Structure- part 11

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The capital investment projects undertaken by the firm are usually

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corporate taxes on the Shilling in question at a rate of tc. The remainder

(1 - te) (1 - tc) shs1 .

The net benefit created by corporate borrowing can be determined by

rate of to , the after-tax cash flow received by the bondholders is (1 - to)

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) rD , then the value which is created by diverting one Shilling of before-

tax operating income from the stockholders to the bondholders is

The incremental value of the tax shields generated by debt financing is

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on interest income (to) is 40 percent as in Example 1. However, assume

the income to stockholders is in the form of dividend income taxed at 40

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shs1 [1 - ] = shs1 [1 - (1 - tc) ]

value of the levered firm is given by

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The Impact of Financial Structure in a World with No Taxes

Number of Shares = 1000

= .15 (15 percent).