2023

CHAPTER 2
CAPITAL STRUCTURE

Reading
• Chapter 14, 15, 16, Fundamentals of Corporate
Finance; Stephen A. Ross, Randolph W.
th
Westerfield, Bradford D. Jordan; 12 Edition;
McGraw-Hill (2019).

Chapter Outline
• Sources of Capital
• Cost of Capital
• Capital Structure
• Financial Leverage

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Key Concepts and Skills

• Know the different sources of capital
• Know how to determine the cost of equity
capital, the cost of debt and preferred stock, a
firm’s overall cost of capital (WACC)
• Understand the relationship between capital
structure and the cost of capital
• Understand the effect of financial leverage

Sources of Capital
• Capital is wealth in the form of money or
assets, taken as a sign of the financial
strength of firm and assumed to be
available for development or investment.
• Based on the nature of ownership
o Equity Capital
o Debt Capital

Equity Capital
• Equity Capital is the capital that shareholders
contributed without any promise of
repayment.
• Sources of Equity Capital:
– Initial Contribution
– Additional Paid-in Capital
– Retained Earning
– Revaluation Reserve
– Treasury Shares.

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Debt Capital
• Debt Capital (Liabilities) refers to the
debts or obligations that arise during the
course of its business operation.
o Current Liabilities: short-term financial
obligations that are due within one year
o Non-current Liabilities: long-term
financial obligations that are due over one
year

Debt Capital
• Sources of Liabilities:
– Bank loans
– Trade Credit
– Bond

Equity Capital versus

Debt Capital
Advantages Disadvantages
- No interest and - More expensive
repayment - Sharing the
Equity requirement ownership
Capital - Reduce the debt ratio

- Cheaper - Interest and

- Tax advantage repayment
Debt - Financial leverage requirement
Capital - Not sharing the - Default risk
ownership - High debt ratio

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Cost of Capital
Why cost of capital is important?

• The return earned on assets depends on the risk

of those assets.
• The return to an investor is the same as the cost
to the company.
• Our cost of capital provides us with an indication
of how the market views the risk of our assets.
• Knowing our cost of capital can also help us
determine our required return for capital
budgeting projects.

Required Return
• The required return is the same as the
appropriate discount rate and is based on
the risk of the cash flows.
• We need to know the required return for an
investment before we can compute the
NPV and make a decision about whether or
not to take the investment.
• We need to earn at least the required
return to compensate our investors for the
financing they have provided.

Cost of Equity
Cost of equity: The return that equity
investors require on their investment in the
firm.
• There are two main methods for
determining the cost of equity:
1. Dividend growth model (DGM)
2. SML or CAPM

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The dividend growth model

approach
Assumptions:
1. Dividends grow at a constant rate
2. The constant growth rate will continue for
an infinite period
3. The required rate of return is greater than
the infinite growth rate (g)

The dividend growth model

approach
• The share price is the current value of all
expected cash flow in the future. Suppose
shareholder holds the share forever, the cash
flow would be the dividends.

Po : present value of share

Dn : expected dividend in year n
R : required return on the investment

The dividend growth model approach

• D0 : Dividend just paid

• D1 : The next period’s projected dividend
• g : The constant growth rate of dividends
• RE : Required return on the stock.

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The dividend growth model approach

Example: Suppose the ABC paid a

dividend of $4 per share last year. The
stock currently sells for $60 per share. You
estimate that the dividend will grow
steadily at a rate of 6 % per year into the
indefinite future.
What is the cost of equity capital for ABC ?

The dividend growth model approach

• The cost of equity is 13.07 %

Estimating Dividend Growth Rates

• Use historical growth rates
Example: Suppose we observe the
following for some company:

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Estimating Dividend Growth Rates

The expected growth rate, g :

(9.09 + 12.50 + 3.70 + 10.71)/4 = 9%

Advantages and disadvantages of dividend

growth model method
• Advantage:
– Easy to understand and use
• Disadvantages:
– Only applicable to companies currently paying
dividends
– Not applicable if dividends aren’t growing at a
reasonably constant rate
– Extremely sensitive to the estimated growth
rate
– Does not explicitly consider risk

The SML approach

• Compute cost of equity using the SML
– Risk-free rate, Rf
– Market risk premium, E(RM) – Rf
– Systematic risk of asset, 

RE  R   (E(R )  R ))
E M f
f

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The CAPM

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SML approach - Example

• Company’s equity beta = 1.2
• Current risk-free rate = 7%
• Expected market risk premium = 6%
What is the cost of equity capital?

RE  7  1.2( 6 )  14.2%

Advantages and disadvantages of

SML method
• Advantages
– Explicitly adjusts for systematic risk
– Applicable to all companies, as long as beta is
available
• Disadvantages
– Must estimate the expected market risk
premium, which does vary over time
– Must estimate beta, which also varies over time
– Relies on the past to predict the future, which is
not always reliable

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Cost of equity - Example

• Data:
– Beta = 1.2
– Market risk premium = 8%
– Current risk-free rate = 6%
– Analysts’ estimates of growth = 8% per year
– Last dividend = $2
– Current stock price = $30

Using SML/CAPM: RE = 6% + 1.2(8%) = 15.6%

Using DGM: RE = [2(1.08) / 30] + .08 = 15.2%

Cost of Preference shares

• Reminders
– Preference shares generally pay a constant
dividend every period.
– Dividends are expected to be paid every
period forever.
• Preference share valuation is an annuity,
so we take the annuity formula (P0 = D/ RP
), rearrange and solve for RP.
RP = D/P0

Cost of Preference shares - Example

• Your company has preference

shares that have an annual dividend
of $3. If the current price is $25,
what is the cost of a preference
share?

RP = 3 / 25 = 12%

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Cost of debt
• Cost of debt: The return that lenders
require on the firm’s debt.
• We usually focus on the cost of long-term
debt or bonds.

Cost of Debt – Corporate bonds

• Method 1 : Compute the yield to maturity
on existing debt.
– The cost of debt is NOT the coupon rate.

• Method 2 : Use estimates of current rates

based on the bond rating expected on new
debt.

• Bond valuation – Coupon Bond:

c – coupon rate
y – yield to maturity
n – maturity
FV – Face value (or par value)
A – coupon: A = FV * c

PV = A [1- (1+y)-n ]/ y + FV / (1+y)n

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Bonds:
• Regular interest payments
• Face value at maturity
• Price is payment stream discounted at current
market yield

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Cost of Debt - Example

• Suppose the General Tool Company
issued a 30-year, 7 % bond 8 years ago.
The bond is currently selling for 96 percent
of its face value, or $960.
What is General Tool’s cost of debt?

Yield to maturity = 7.37 %

General Tool’s cost of debt, RD = 7.37 %

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Weighted average cost of capital

(WACC)
• Use the individual costs of capital to
compute a weighted ‘average’ cost of
capital for the firm.
• This ‘average’ = the required return on
the firm’s assets, based on the
market’s perception of the risk of those
assets.
• The weights are determined by how
much of each type of financing is used.

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Determining the weights for the WACC

• Weights = percentages of the firm that

will be financed by each component.
WACC = wERE + wPRP + wDRD(1- TC)

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Capital structure weights

• Notation
– E = market value of equity = # of outstanding
shares times price per share
– P= market value of preferred stock = # of
outstanding shares times price per share
– D = market value of debt = # of outstanding
bonds times bond price
– V = market value of the firm = D + E
• Weights
– wE = E/V = percent financed with equity
– wp = P/V = percent financed with preferred stock
– wD = D/V = percent financed with debt
• wE + wP + wD = 1
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Capital structure weights -Example

• Suppose you have a market value of

equity equal to $500 million and a market
value of debt equal to $475 million.
– What are the capital structure weights?
• V = 500 million + 475 million = 975 million
• wE = E/D = 500 / 975 = .5128 = 51.28%
• wD = D/V = 475 / 975 = .4872 = 48.72%

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Taxes and the WACC

• We are concerned with after-tax cash flows,

so we need to consider the effect of taxes on
the various costs of capital.
• Interest expense reduces our tax liability.
– This reduction in taxes reduces our cost of
debt.
– After-tax cost of debt = RD(1-TC).
• Dividends are not tax deductible, so there is
no tax impact on the cost of equity.
WACC = (E/V) x RE + (P/V) x RP + (D/V) x RD x (1- TC)

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WACC - Example
• Equity information • Debt information
– 50 million shares – $1 billion in outstanding
– $80 per share debt (face value)
– Current quote = 110% of
– Beta = 1.15
its face value.
– Market risk premium – Coupon rate = 9%,
= 9% semiannual coupons
– Risk-free rate = 5% – 15 years to maturity
• Tax rate = 40%
Use CAPM to find RE

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WACC - Example

• What is the cost of equity?

– RE = 5 + 1.15(9) = 15.35%
• What is the cost of debt?
– RD = 7.854%
• What is the after-tax cost of debt?
– RD(1-TC) = 7.854(1-.4) = 4.712%

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WACC - Example
• What are the capital structure weights?
– E = 50 million (80) = 4 billion
– D = 1 billion (1.10) = 1.1 billion
– V = 4 + 1.1 = 5.1 billion
– wE = E/V = 4 / 5.1 = .7843
– wD = D/V = 1.1 / 5.1 = .2157

• What is the WACC?

– WACC = .7843(15.35%) + .2157(4.712%) =
13.06%

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Capital Structure and

Financial Leverage

• Capital structure: percentage of debt and

equity used to fund the firm’s assets
• Debt-Equity Ratio:
Debt-Equity Ratio = Total Debt/Total Equity

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Capital structure and

Cost of capital
• What is the primary goal of financial
managers?
– To maximize shareholder wealth
• We want to choose the capital structure that
will maximize shareholder wealth.
• We can maximize shareholder wealth by
maximizing firm value or minimizing WACC.

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Capital structure and

Cost of capital
• We will want to choose the firm’s capital
structure so that the WACC is minimized.
• A particular debt–equity ratio represents the
optimal capital structure if it results in the
lowest possible WACC.
• Optimal capital structure is sometimes called
the firm’s target capital structure.

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Financial Leverage
• Leverage: use of debt in capital
structure
• Financial leverage refers to the extent
to which a firm relies on debt.
• The more debt financing a firm uses in
its capital structure, the more financial
leverage it employs.

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The Effect of Financial

Leverage
• How does leverage affect the earnings
per share (EPS) and return on equity
(ROE) of a firm?
– Leverage amplifies the variation in both
EPS and ROE.

• When we increase the amount of debt

financing, we increase the fixed interest
expense.

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Financial Leverage, EPS and ROE -

Example

• We ignore the effect of taxes at this stage.

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Capital structure scenarios

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Financial leverage, EPS and ROE - Example

• Variability in ROE
– Current: ROE ranges from 6.25% to 18.75%
– Proposed: ROE ranges from 2.50% to 27.50%
• Variability in EPS
– Current: EPS ranges from $1.25 to $3.75
– Proposed: EPS ranges from $0.50 to $5.50
• The variability in both ROE and EPS increases
when financial leverage is increased.

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Break-even EBIT (cont.)

• If expected EBIT > break-even EBIT => leverage is beneficial to stockholders

• If expected EBIT < break-even EBIT => leverage is detrimental to
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stockholders

Break-even EBIT
Find EBIT where EPS is the same under both
the current and proposed capital structures:
EPS debt = EPS no debt

EBIT EBIT  400,000


400,000 200,000
é 400,00 0
ù( EBIT  400,000 )
EBIT ëê 200,000
ú û
EBIT  2 ´ EBIT 
800,000
EBIT  $800,000
800,000
EPS  
$2.00
400,000
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Degree of Financial Leverage (DFL)

• To estimate the effect of financial leverage to
EPS, we use the Degree of Financial Leverage
(DFL)

This illustrates how many percentages of EPS

changes when EBIT changes 1%

Capital restructuring
• Capital restructuring: changing the
amount of leverage without changing the
firm’s assets
– Increase leverage by issuing debt and
repurchasing outstanding shares
– Decrease leverage by issuing new
shares and retiring outstanding debt

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Break-even Analysis
and Operating Leverage
• Break-even analysis entails the estimation of
the safety margin for an entity based on
revenue and associated costs.
• Break-even analysis is useful in the
determination of the level of production or in
a targeted desired sales mix.

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Break-even Analysis
Q – Total units sold
P – Selling price per unit
F – Fixed cost
V – Variable cost per unit

At the break-even point:

Q*P = F+Q*V
=> Q = F / (P – V)

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Break-even Analysis

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Operating Leverage
• Operating leverage is the degree to which a
firm or project relies on fixed costs.
• A firm with low operating leverage will have
low fixed costs compared to a firm with high
operating leverage.

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Operating Leverage
• To estimate the effect of operating
leverage, we use the Degree of Operating
Leverage (DOL)

• This illustrates how many percentages of EBIT

changes when Q changes 1%

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Total Leverage
• By combining the degree of leverage with the
degree of financial leverage we obtain the
degree of total leverage (DTL)

• This illustrates how many percentages of EPS

changes when Q changes 1%
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Quick test
• Calculating WACC [LO3] Mullineaux Corporation has a
target capital structure of 60 percent common stock,
5 percent preferred stock, and 35 percent debt. Its
cost of equity is 14 percent, the cost of preferred
stock is 6
percent, and the cost of debt is 8 percent. The
relevant
– What istax rate is 35 WACC?
Mullineaux’s percent.
– The company president has approached you about
Mullineaux’s capital structure. He wants to know why the
company doesn’t use more preferred stock financing
because it costs less than debt. What would you tell the
president?

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