Chapter 5-Capital Structure

19/08/2020
CORPORATE FINANCE
Quyen Do Nguyen PhD
Corporate Finance Dept.
Faculty of Banking and Finance
Foreign Trade University
CHAPTER 5
COST OF CAPITAL &

Quyen Nguyen, PhD - FBF - FTU
CAPITAL STRUCTURE
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OBJECTIVES
 Cost of capital

 Capital structure
 MM theory on Capital Structure
 Tax Impact on Capital Structure
The investment decision
Assets Liabilities & equity

Current assets Current liabilities
Fixed assets Long-term debt

Preferred stock
Common equity
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The financing decision


Preferred stock
Common equity
Capital structure

Capital structure
Preferred stock
Common equity
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Cost of capital
 For investors the rate of return on a security is a benefit
of investing
 For financial managers that same rate of return is a cost

of raising funds
 The context determines which of these similar terms to
use: :
 Cost of capital
???
 Required rate of return
 Discount rate
 Interest rate
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 Yield
Cost of capital
 The minimum rate that a company must earn on
investment projects in order to satisfy the required
rates of return of its investors
 The rate of return on investments that leaves the price

of the firm’s ordinary shares unchanged
 Interchangeable terms
 Required rate of return
 Hurdle rate for new investments
 Discount rate for evaluating new investments
 Opportunity cost of funds 8
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Connecting the investment and financing decisions
Financing decisions

Cost of capital
Investment decisions
How can the firm raise capital?

 By borrowing from the bank
 By selling:
 Bonds
 Preference shares
 Ordinary shares
 Each offers a rate of return to investors
 These returns are costs to the firm
 “Cost of capital” actually refers to the weighted cost of

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capital
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Factors determining the

weighted cost of capital
 General economic conditions: Inflation, Capital
supply and demand  Interest rate fluctuation.

 Marketability conditions
 Firm’s operating and financing decisions
 Business risk
 Financial risk
 Amount of financing
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The weighted cost of capital Quyen Nguyen, PhD - FBF - FTU
WCC = wd Costd
+ wp Costp
+ we Coste
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Example …
Salinas company’s capital structure

% of capital
Type Amount structure
Debt 600,000 30
Preference shares 200,000 10
Ordinary shares 1,200,000 60
Total liabilities & equity $2,000,000 100
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… Example
Salinas company weighted cost of capital

Weight Cost of Weighted

Type % sources cost
Debt 30 10% 3.0%

Preference shares 10 12% 1.2%
Ordinary shares 60 16% 9.6%
100 13.8%
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Calculating the WCC

Compute the cost of capital for each source of
financing used by the firm

 Cost of debt
 Cost of preference
shares
 Cost of ordinary shares
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Cost of debt
The rate of return

required by
investors to buy the
bonds offered for
sale by the firm
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Adjusting for taxes
If an after tax cost of debt is required

Kd,AT = Kd,BT ( 1 – T )
where
Kd,AT = After tax percentage cost of debt
Kd,BT = Before tax percentage cost of debt
T = Relevant tax rate
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The weighted cost of capital

(Adjusting for taxes)
WCC = wd Costd ( 1 – T )
+ wp Costp
+ we Coste
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Cost of preference shares
 For an irredeemable preference share:

Kp = D / P0 = Dividend / Price
 Whether to consider flotation costs
Kp,AT = D / NP0 = Dividend / Net price

where NP0 = Price – Flotation costs
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EXAMPLE:
If a company issues preference shares with an expected

dividend of $8 per year and an issue price of $75 per
share, what is the cost to the company of the preference
shares if flotation costs amount to $1 per share?
Kp,AT = D / NP0
= $8 / ( $75 - $1 )
= 10.81%
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Cost of ordinary shares

There are two sources of ordinary equity:
1. Internal ordinary equity – retained earnings
2. External ordinary equity – new ordinary shares
issued
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Measuring the required rate of return
2 approaches:
1. The dividend-
growth model
2. The capital asset
pricing model
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Cost of equity
1. Dividend growth model

Ke,AT = Re,AT = D1 / P0 + g
2. Capital asset pricing model
Ke,AT = Re,AT = Rf +  ( Rm – Rf )
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g – growth rate
 g = ROE x r
 ROE of the company is 15%; retention rate is 35%

and will be stable in the coming years..
 g = (0.35) (15%) = 5.25%
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CAPITAL STRUCTURE
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Financial structure
Balance sheet
Current Current
Financial structure
assets liabilities
Debt and
preference
Fixed shares
assets
Shareholders’
equity 26
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Capital structure
Balance sheet

Current Current
assets liabilities
Capital structure
Debt and
preference
Fixed shares
assets
Shareholders’
equity 27
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Why is capital structure important?

 Leverage
Higher financial leverage means potentially higher
returns to shareholders, but higher risk due to higher
interest payments.
 Cost of capital
Each source of finance has a different cost. Capital
structure affects the cost of capital.
 Optimal capital structure
The structure that minimises the firm’s cost of
capital and maximises firm value 28
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Measuring the financial leverage
Using “debt-equity” ratio = Total debt/Total equity

Using “debt-to-value” ratio = Total debt/(Total
equity + total debt)
Both “debt-equity” and the “debt-to-value” ratios

can measure the book value and market value
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Using the financial leverage
Each industry uses different financial leverage

Companies operating in IT usually use less leverage
Companies operating in furniture, equipments,

airplanes use more leverage
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Modigliani/Miller THEORY (MM)
The theory on the optimal capital structure is

based on the Modigliani/Miller (MM)
propositions (American Economic Review, 1958)
The most important conclusion from their

original (1958) paper was that capital structure
choice does not matter
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Assumptions of the MM model

Homogeneous expectations
Perpetual cash flows
Perfect capital markets

Perfect competition
Firms and investors can borrow/lend at the same
rate
Equal access to all relevant information
No transaction costs
No taxes 32
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Capital Structure and the pie

 The value of a firm is defined to be
the sum of the value of the firm’s

debt and the firm’s equity
V=B+S
 If the goal of the firm’s management
is to make the firm as valuable as
possible , then the firm should pick
the debt-equity ratio that makes the
pie as big as possible. 33
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Modigliani and Miller: Proposition I

Consider the all-equity firm FTU Inc. that is contemplating
going into debt. (Proceeds are to be used to buy back shares)
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EPS and ROE under current structure

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EPS and ROE under proposed structure Quyen Nguyen, PhD - FBF - FTU
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Financial leverage and EPS

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What is the optimal capital structure? Quyen Nguyen, PhD - FBF - FTU
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MM Proposition I (no taxes)

 In the condition of no taxes, Levered firm value is equal to
Un-levered firm value

VL  VU
 Capital Structure (B/S) does not affect firm value
  There is no optimal capital structure  firms cannot
increase their value by changing capital structure
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MM Proposition II (no taxes)

 Required cost of capital has the positive correlation with the
level of financial leverage
B
RS  R0  ( )( R0  RB )
S
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Example: FTU Inc.

Question: How much are the R0 and the RWACC
for the un-levered firm?
Answer:
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Example: FTU Inc. (2)

Suppose that the firm implements its proposed
new capital structure

Q. What is the RWACC of the firm under the new
capital structure?
A.
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Example: FTU Inc. (3)

 Q. How does the RS change in the new capital structure?
 A. B
RS  R0  ( R0  RB )
S
 Q. What if the firm would attract $ 10,000 in debt financing

in order to buy back equity?
B
 A. RS  R0  ( R0  RB )
S
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Corporate taxes (1)

 MM (1963)
 Corporate taxes lead to a preference for debt
 Interest is tax deductible
 Dividends are not tax deductible
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Corporate taxes (2)

VL  VU  TC B
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MM Proposition I (with taxes)

Annual reduction in corporate taxes
TC RB B
Tax shield with perpetual cash flows
TC RB B
 TC B
RB
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MM Proposition I (with taxes) (2)

Value of the un-levered firm is:
EBIT (1  TC )

VU 
R0
Value of the levered firm is:
EBIT (1  TC ) TC RB B
VL    VU  TC B
R0 RB
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MM Proposition II (with taxes) (1)

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MM Proposition II (with taxes) (2)
Some of the increase in equity risk and return is

offset by the interest tax shield
B
RS  R0  ( )(1  TC )( R0  RB )
S
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Applying to FTU Inc.

Assume a corporate tax is 35%
Q. How much is Rs for the un-levered firm?
A.
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FTU Inc. (2)

 Q. How much is RS if the firm accepts the proposed capital
structure?

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FTU Inc. (3)

 Q. What if the firm attracts $ 10,000 of debt to buy
back $ 10,000 of equity?
 A.
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THE EFFECT OF FINANCIAL LEVERAGE

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Total cash flow to investors Quyen Nguyen, PhD - FBF - FTU
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Total cash flow to investors

 The levered firm pays less in taxes than does the all-equity
firm
 Thus, the sum of the debt plus the equity of the levered firm
is greater than the equity of the un-levered firm
 This is how cutting the pie differently can make the pie
“larger.”- the government takes a smaller slice of the pie!! 57
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Exercise:
Lauria manufacturing Inc. (unlevered)
Issuance of 2 mln. perpetual bonds in order to buy back stock

 6% coupon rate
 S = 10 mln.
 500,000 shares
EBIT = 1.5 mln.
Tc = 40%
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Exercise:
a. Calculate Rs?
b. What is the Market-value balance sheet before

announcement of the debt issue?
c. What is the Market-value balance sheet after announcement
of the debt issue?
d. How many stocks to be bought back?
e. What is the Market value balance sheet after restructuring?
f. Calculate Rs after issue?
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Conclusion from MM (1963)

MM (1963): Optimal capital structure is 99.99% debt
Miller (Journal of Economic Perspectives, 1988)
“By 1963, however (..), we seemed to face an unhappy

dilemma: either corporate managers did not know (or
perhaps care) that they were paying too much in taxes;
or something major was being left out of the model.
Either they were wrong or we were”
Solution: look at other market imperfections
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_End of chapter 5_
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19/08/2020

COST OF CAPITAL &

Quyen Nguyen, PhD - FBF - FTU

 MM theory on Capital Structure

 Tax Impact on Capital Structure

The investment decision

Assets Liabilities & equity

Current assets Current liabilities

Fixed assets Long-term debt

The financing decision

Assets Liabilities & equity

Quyen Nguyen, PhD - FBF - FTU

Fixed assets Long-term debt

Assets Liabilities & equity

Current assets Current liabilities

Quyen Nguyen, PhD - FBF - FTU

 The rate of return on investments that leaves the price

Connecting the investment and financing decisions

Quyen Nguyen, PhD - FBF - FTU

How can the firm raise capital?

 “Cost of capital” actually refers to the weighted cost of

Factors determining the

Quyen Nguyen, PhD - FBF - FTU

The weighted cost of capital Quyen Nguyen, PhD - FBF - FTU

Salinas company’s capital structure

Quyen Nguyen, PhD - FBF - FTU

Salinas company weighted cost of capital

Weight Cost of Weighted

Debt 30 10% 3.0%

Calculating the WCC

Quyen Nguyen, PhD - FBF - FTU

The rate of return

Adjusting for taxes

If an after tax cost of debt is required

Quyen Nguyen, PhD - FBF - FTU

The weighted cost of capital

Cost of preference shares

 For an irredeemable preference share:

Quyen Nguyen, PhD - FBF - FTU

 Whether to consider flotation costs

Kp,AT = D / NP0 = Dividend / Net price

If a company issues preference shares with an expected

shares if flotation costs amount to $1 per share?

Cost of ordinary shares

Quyen Nguyen, PhD - FBF - FTU

Measuring the required rate of return

1. Dividend growth model

Quyen Nguyen, PhD - FBF - FTU

2. Capital asset pricing model

 ROE of the company is 15%; retention rate is 35%

 g = (0.35) (15%) = 5.25%

Quyen Nguyen, PhD - FBF - FTU

Why is capital structure important?

Measuring the financial leverage

Using “debt-equity” ratio = Total debt/Total equity

Quyen Nguyen, PhD - FBF - FTU

Both “debt-equity” and the “debt-to-value” ratios

Using the financial leverage