Capital Structure and cost of Capital

Assets = Owner Equity + Liability

The left-hand side of the accounting equation shows a
typical business capital structure.
Owner equity is the contribution of investors to the
business. They expect profit to compensate the risk
taken.
Liability is the debt obtained from business creditors.
They expect fixed interest payment + the initial loan.

Capital Structure and cost of Capital

Depending on the portion of equity and debt,
and the required return on funds provided from
each of these two sources, every business will
have its own unique cost of capital.
The cost of this capital affects a lot of financial
decisions, such as e.g. investments in capital
projects (capital budgeting), assets allocation, and
funds acquisition.

Cost of Capital
A common way to calculate the cost of capital is using
the weighted average cost of capital (WACC)
That is the cost of each component by its weight within
the capital structure.
WACC = wd rd (1 - t ) + w p rp + we re
Wd: portion of debt; rd: cost of debt; t: tax rate
Wp: portion of preferred stock in case of corporations; rp:
cost of preferred stock
We: portion of common stock; re: cost of common stock

Example of WACC
A corporation has the following capital structure:

30% debt; 10% preferred stock; 60% common equity.

Cost of debt is 8%
Cost of preferred stock is 10%
Cost of common equity is 15%
Company tax rate is 40%

WACC = (0,3*(0,08*(1-0,4)) + (0,1*0,1)+(0,6*0,15)

= (0,0144) + (0,01) +(0,09) =11,44%

Cost of Debt (the tax issue)

Remember that interests payments are tax-exempt.
When business pay interest on debt, it reduce the taxable
income, and the ultimately the tax bill.
Thus, Net cost of debt = Paid interest effect on tax reduction
Example:Operating income
2000 2000
Financial expenses

100

Taxable income

1900

2000

Tax (40%)

760

800

Net Income

1140

1200

760 - 800 = -40

Net cost of debt = 100 40 = 60

It is not a coincidence that it is (1- t), that is 1- 0.4 = 0.6

Important Notes on WACC

When we calculate the weights of each component, we must use
the CURRENT MARKET VALUE and not historical values.
This practice is called Marking to market
For common equity, its cost can be viewed as the required rate
of return, given its level of risk, in this case, we would use beta
(b) as a measure to estimate the cost of common equity.
Alternatively, cost of equity can be estimated using the dividend
discount model. (note that each will offer different value!)

Cost of Debt (yield to maturity)

Remember when we priced bonds assets valuation, we used the
following general formula:N

C
M
V =
+
N
t
(
1
+
)
(
1
+
)
r
r
t =1

When we are dealing with cost calculation problems, the market

price is going to be given, and the grim task will be to find the yield!
It is easy to calculate using a financial calculator, or with excel. (in
exam I will not require the calculation but I will make sure the yield will be one
percent above or below the coupon rate!)
When you find the annual yield, you find the cost of debt (at least in
our simplified world)
When you have the tax rate, you can calculate the net cost of debt.

Cost of preferred Stock

Remember from Asset Valuation, Preferred stock can be treated
as a perpetuity!
Once you know the current market price of Preferred stock, given
par value and dividend, then cost of preferred stock is
theoretically a piece of cake!
DP
PP =
rP
Example:- A companys preferred stock is currently trading at 65.
Preferred stocks were issued at par 50 promising annual dividend
10% of Par.
DP
5
=
= 0,0769 = 7,69%
Solution: dividend = 5, then rP =
PP 65

Cost of common stock

The cost of common equity is the required rate of return to
compensate investor for the risk taken.
Different ways of finding that rate.
One approach is:- if we have knowledge of paid dividends, their
growth rate, and current stock price, then we can use the Gordon
model to estimate r.
D1
P0 =
r - g
Second approach:- Using beta (b) of the stock relative to market.
What is beta in the first place?????
It is the return sensitivity of stock to changes in the market
return!

Cost of common stock (Beta)

According to the Capital Asset Pricing Model (CAPM) approach,
Expected return on a stock E(Ri) is the risk free rate plus, the
premium for bearing the stocks market risk.

E (R i ) = R F + b i [E (R M ) - R F

Example on using Beta:The risk free rate in the market is currently 4,2%. Average return
on market portfolio is 18%. Stock xyz calculated beta is 1,8.
What would be the cost of equity for xyz company?

Cost of common stock (Beta)

Practical matters when estimating Beta.
When we want to find beta for a given stock, we can use one of two
statistics approaches.
1.
2.

Regression analysis e.g. the least square method

Calculation of COVARIANCE/VARIANCE

1. Regression:

Assume we have sufficient market data to work with, when can think about
stock returns as a function, or a depended variable on market, such as:

Rs = a + bRm + e

Then we try to find beta by finding the best fitting values for a and b, by
minimizing the sum of the squared errors, as possible over all the
observations.

Cost of common stock (Beta)

Practical matters when estimating Beta. (cont.)
2. COVARIANCE/VARIANCE :

Another simpler method (apart from the statistical details), beta can be
obtained using the following formula:-

b=

COVSM
VARM

Covariance is the measure that shows how two variables move together,
in this case, we are trying to measure how the stock and the market move
together.
Market Variance is the squared standard deviation (s2), or dispersion around
the mean return of the market.

Cost of common stock (Beta)

Practical matters when estimating Beta. (cont.)
2. COVARIANCE/VARIANCE :- (cont.)

Deeper look into the formula, we can see it as:-

s M r MS s S
b=
s M2
Covariance (Asset, Market)= Std. dev. (asset)*Correlation (Asset;
market) * Std. dev. (market)
Variance of Market = Std. dev. (market)*Correlation (market with itself)
* Std. dev. (market)
* In the exam, I could provide you with std. of market and stock, and
correlation between them, and ask you to estimate beta.

Putting it all together

To find the weights, you need to mark-to-market the capital
components.
To find the cost of debt, you need the to find the current YTM
of the bond, or the current interest rate on similar debt.
Always remember to adjust the cost of debt based on the tax rate
To find the cost of equity, you will either need:
To estimate beta, if you are given the statistics, or data set to estimate
them, as well as the RFR. Or!
Use the dividend discount model if you are given the growth rate, current
dividend and market price.
In case of preferred stock, it is much simpler if you are given the dividend
and current price.