Presentation: - They will later exit through a private or public sale of

HOW FIRMS RAISE CAPITAL their equity

- The duration of the cycle is typically three to seven years,
and only a small percentage of new ventures make it all
BOOTSTRAPPING
the way to the end
- How new businesses get started
1. Starting a new business
• Most businesses are started by an entrepreneur who
2. The business plan – describes what you want your
has a vision for a new business or product and a
business to become, why consumers will find your
passionate belief in the concept’s viability
business attractive, how you are going to accomplish
• The entrepreneur often fleshes out his or her ideas
your objectives, and what resources you will need
and makes them operational through informal
3. First-stage financing – after a number of meetings with
discussions with people whom the entrepreneur
you and your management team, the venture capital firm
respects and trusts, such as friends and early
may agree to fund the project, but only in stages, and for
investors
less than the full amount being requested
- Initial funding of the firm
4. How venture capitalists reduce their risk
- The process by which many entrepreneurs raise “seed”
• Venture capitalists know that only a handful of
money and obtain other resources necessary to start their
new companies will survive to become successful
businesses
firms
• The initial “seed” money usually comes from the
• They use a number of tactics when they invest in
entrepreneur or other founders
new ventures:
- The period usually lasts no more than one or two years
a. Staged funding – the venture capitalists’
investments give them an equity interest in
VENTURE CAPITALISTS
the company, typically in the form of
- Individuals or firms that help new businesses get started
convertible preferred stock
and provide much of their early-stage financing
b. Personal investment – venture capitalists
- Provide more than financing
often require an entrepreneur to make a
• One of their most important roles is to provide
substantial personal investment in the
advice
business
• Because of their industry and general knowledge
c. Syndication
about what it takes for a business to succeed, they
o It is a common practice to syndicate seed
provide counsel for entrepreneurs when a business
and early-stage venture capital
is started and during the early stages of operation
investments
o Occurs when the originating venture
INDIVIDUAL VENTURE CAPITALISTS (Angels or angel
capitalist sells a percentage of a deal to
investors) – typically wealthy individuals who invest their own
other venture capitalists
money in emerging businesses at very early stages in small
o Reduces risk in two ways:
deals
1. Increases the diversification of the
originating venture capitalist’s
VENTURE CAPITAL
investment portfolio
- Important because entrepreneurs have only limited
2. The willingness of other venture
access to traditional sources of funding
capitalists to share in the investment
- There are three primary reasons why traditional sources
provides independent corroboration
of funding do not work for new or emerging businesses
that the investment is a reasonable
1. There is a high degree of risk involved in starting a
decision
new business
d. In-depth knowledge
2. Types of productive assets – new firms whose
5. Exit strategy
primary assets are often intangible (patents or trade
• Venture capitalists are not long-term investors in
secrets) find it difficult to secure financing from
the companies, but usually exit over a period of
traditional lending sources
three to seven years
3. Information asymmetry problems – an
• Every venture capital agreement includes
entrepreneur knows more about his or her
provisions identifying who has the authority to
company’s prospects than a lender does
make critical decisions concerning the exit
process
VENTURE CAPITAL FUNDING CYCLE
• Include the following:
- Begins when the entrepreneur runs low on bootstrap
a. Timing (when to exit)
financing
- Venture capitalists then provide equity financing b. The method of exit
c. What price is acceptable
 Principal ways in which venture capital firms exit
venture-backed companies:
a. Strategic Buyer – selling part of the firm’s equity
to a strategic buyer in the private market
b. Financial Buyer – a private equity firm buying
the new firm with the intention of holding it for a
period of time, usually three to five years, and
then selling it for a higher price
c. Initial Public Offering – selling common stock
in an initial public offering
COST OF VENTURE CAPITAL FUNDING
- The cost is very high, but the high rates of return earned
by venture capitalists are not unreasonable
- A typical venture-capital fund may generate annual
returns of 15% - 25%, compared with an average annual
return for the S&P 500 of about 12%
INITIAL PUBLIC OFFERING (IPO)
- One way to raise larger sums of cash or to facilitate the
exit of a venture capitalist is through an Initial Public
Offering (IPO) of the company’s common stock
- First-time stock issues – given a special name because
the marketing and pricing of these issues are distinctly
different from those of seasoned offerings
- The amount of equity capital that can be raised in the
public equity markets is typically larger than the amount
that can be raised through private sources
- Once an IPO has been completed, additional equity
capital can usually be raised through follow-on seasoned
public offerings at a lower cost
Advantages:
1. Can enable an entrepreneur to fund a growing business
without giving up control
2. After the IPO, there is an active secondary market in
which stockholders can buy and sell its shares
3. Publicly traded firms find it easier to attract top
management talent and to better motivate current
managers if a firm’s stock is publicly traded
Disadvantages:
1. High cost of the IPO
2. The costs of complying with ongoing SEC disclosure
requirements also represent a disadvantage of going
public
3. The transparency that results from these SEC
compliances can be costly for some firms
4. Some investors argue that the SEC’s requirement of
quarterly earnings forecasts and quarterly financial
statements encourages managers to focus on short-term
profits rather than long-term wealth maximization
IPO: INVESTMENT-BANKING SERVICES
- To complete an IPO, a firm will need the services of
investment bankers, who are experts in bringing new
securities to the market
- Investment bankers provide three basic services when
bringing securities to market:
1. Origination
• Includes giving the firm financial advice and
getting the issue ready to sell
• The investment banker helps the firm
determine whether it is ready for an IPO
• Once the decision to sell stock is made, the
firm’s management must obtain a number of
approvals
• Since securities sold to the public must be
registered in advance with the SEC, the first
step in this process is to file a registration
statement with the SEC
o The preliminary prospectus is the initial
registration statement
2. Underwriting
• The risk-bearing part of investment banking
• The securities can be underwritten in two
ways:
a. On a firm-commitment basis
o More typical: the investment
banker guarantees the issuer a fixed
amount of money from the stock
sale
o The investment banker actually
buys the stock from the firm at a
fixed price and then resells it to the
public
o The underwriter bears the risk that
the resale price might be lower than
the price the underwriter pays,
called price risk
o Underwriter’s spread – the
investment banker’s compensation;
the difference between the
investment banker’s purchase price
and the offer price
o The underwriter’s spread is 7% in
the vast majority of IPOs in the U.S.
b. On a best-efforts basis
o The investment banking firm makes
no guarantee to sell the securities at
a particular price
o he investment banker does not bear
the price risk associated with
underwriting the issue, and
compensation is based on the
number of shares sold
• Underwriting Syndicates
o To share the underwriting risk and to sell
the new security issue more efficiently,
underwriters may combine to form a
group
o Participating in the syndicate entitles
each underwriter to receive a portion of
the underwriting fee as well as an
 allocation of the securities to sell to its
own customers
3. Distribution
• Once the due-diligence process is complete,
the underwriters and the issuer determine the
final offer price in a pricing call
• The pricing call typically takes place after the
market has closed for the day
• By either accepting or rejecting the
investment banker’s recommendation,
management ultimately makes the pricing
decision
• First day of trading
o The underwriter sells the shares to
investors in the market, after registration
with the SEC
o Speed of sale is important because the
offer price reflects market conditions at
the end of the previous day, and these
conditions can change quickly
Determining the offer price: One of the investment banker’s
most difficult tasks is to determine the highest price at which
the bankers will be able to quickly sell all of the shares being
offered and that will result in a stable secondary market for
the shares
Due diligence meeting:
• Before the shares are sold, representatives from the
underwriting syndicate hold a due diligence meeting
with representative of the issuer
• Investment bankers hold due diligence meeting to protect
their reputations and to reduce the risk of investor’s
lawsuits in the event the investment goes sour later on
IPO: THE CLOSING
- At the closing of a firm-commitment offering, the issuing
firm delivers the security certificates to the underwriter
and the underwriter delivers the payment for the
securities, net of the underwriting fee, to the issuer
- The closing usually takes place on the third business day
after the trading has started
IPO: THE PROCEEDS
- What are the total expected proceeds from the common
stock sale?
- How much money does the issuer expect to get from the
offering?
- What is the investment bank’s expected compensation
from the offering?
• The best approach to calculating these amounts is to
first work through the funding allocations on a per-
share basis and then compute the total dollar
amounts
INITIAL PUBLIC OFFERING PRICING AND COST
- The underpricing debate
• The issuer prefers the stock price to be as high as
realistically possible while the underwriters prefer
some degree of underpricing
• Underpricing – offering new securities for sale at a
price below their true value
• In a firm-commitment offering, the underwriters
will suffer a financial loss if the offer price is set too
high; under a best-effort agreement, the issuing firm
will lose
• If the underpricing is significant, the investment
banking firm will suffer a loss of reputation for
failing to price the new issue correctly and raising
less money for its client
- IPOs are consistently underpriced
• Data from the marketplace show that the shares sold
in an IPO are typically priced between 10% and 15%
below the price at which they close at the end of first
day of trading
• Average first-day return – measure of the amount
of underpricing
- There are three basic costs associated with issuing stock
in an IPO:
1. Underwriting spread – the difference between the
proceeds the issuer receives and the total amount
raised in the offering
2. Out-of-pocket expenses – include other investment
banking fees, legal fees, accounting expenses,
printing costs, travel expenses, SEC filing fees,
consultant fees, and taxes
3. Underpricing – the difference between the offering
price and the closing price at the end of the first day
of the IPO
GENERAL CASH OFFER BY A PUBLIC COMPANY
- Registered public offering – if a public firm has a high
credit rating, the lowest-cost source of external funds is
often a general cash offer
- A sale of debt or equity, open to all investors, by a
registered public company that has previously sold stock
to the public
- Management must decide whether to sell the securities
on a competitive or a negotiated basis
Similarities in procedures between general cash offer and
those involved in an IPO:
1. Management decides type of security and amount to be
raised
2. Approval is obtained from the board of directors to issue
securities
3. The issuer files a registration statement and satisfies all
of the securities laws enforced by the SEC
4. After assessing demand, the underwriter and the issuer
agree on an offer price
5. At the closing of a firm-commitment offering, the issuer
delivers the securities to the underwriter, and the
underwriter pays for them, net of its fees
COMPETITIVE SALE
- The firm specifies the type and amount of securities it
wants to sell and hires an investment banking firm to do
the origination work
- Once the origination is completed, the firm invites
underwriters to bid competitively to buy the issue
NEGOTIATED SALE
- The issuer selects the underwriter at the beginning of the
origination process
- At that time, the scope of the work is defined, and the
issuer negotiates the origination and underwriter’s fees
to be charged
COMPETITVE SALE vs. NEGOTIATED SALE
1. Lowest-cost method of sale
- Competitive bidding keeps everyone honest: the
greater the number of bidders, the greater the
competition for the security issue, and the lower
the cost to the issuer
- Negotiated sales lack competition and therefore
should be the more costly method of sale
2. Selecting the best method
- For debt issues, most experts believe that
competitive sales are the least-costly method of
selling so called vanilla bonds when market
conditions are stable
- For equity securities, negotiated sales provide the
lowest cost method
3. Shelf registration
- This allows a firm to register an inventory of
securities for a two-year period, during which
time the firm can take the securities “off the shelf”
and sell them as needed
- Costs associated with selling the securities are
reduced because only a single registration
statement is required.
- A shelf registration statement can cover multiple
securities, and there is no penalty if authorized
securities are not issued
Benefits of Shelf Registration:
• Greater flexibility in bringing securities to
market; securities can be taken off the shelf and
sold within minutes
• Allows firms to periodically sell small amounts of
securities, raising money as it is actually needed,
rather than banking a large amount of money from
a single security sale and spending it over time
PRIVATE MARKETS vs. PUBLIC MARKET
- Because many smaller firms and firms of lower credit
standing have limited or no access to the public markets,
the cheapest source of external funding is often the
private markets
- When market conditions are unstable, some smaller
firms that were previously able to sell securities in the
public markets no longer can
- Bootstrapping and venture capital financing are part of
the private market as well
- Many private companies that are owned by
entrepreneurs, families, or family foundations and are
sizable companies of high credit quality, prefer to sell
their securities in the private markets even though they
can access public markets
- Choice of markets is a function of:
a. The desire to avoid regulatory costs and
transparency requirements
b. Preference for working with a small group of
sophisticated investors rather than the public at large
PRIVATE PLACEMENTS
- Occur when a firm sells unregistered securities directly
to investors such as insurance companies, commercial
banks, or wealthy individuals
- About half of all corporate debt is sold through the
private placement market
- Investment banks and money center banks often assist
firms with private placements
• These banks help the issuer locate potential buyers
for their securities, put the deal together, and do the
necessary origination work, but do not underwrite
the issue
• In a traditional private placement, the issuer sells the
securities directly to investors
- Private placements have a number of advantages,
relative to public offerings, for certain issuers
• The cost of funds, net of transaction costs, may be
lower with private placements
• Private lenders are more willing to negotiate
changes to a bond contract
• If a firm suffers financial distress, the problems are
more likely to be resolved without going to a
bankruptcy court
• Other advantages include the speed of private
placement deals and flexibility in issue size
- The biggest drawback of private placements involves
restrictions on the resale of the securities
- The S C limits the sale of private placements to several
dozen “knowledgeable” investors who have the capacity
to evaluate the securities’ investment potential and risk
- To compensate for the lack of marketability, investors in
private placements require a higher yield relative to a
comparable public offering
PRIVATE EQUITY FIRMS
- Like venture capitalists, private equity firms pool money
from wealthy investors, pension funds, insurance
companies, and other sources to make investments
- Invest in more mature companies, and they often
purchase 100 percent of a business
- Private equity firm managers look to increase the value
of the firms they acquire by closely monitoring their
performance and providing better management
 - Once value is increased, they sell the firms for a profit.
Private equity firms generally hold investments for three
to five years
- Large public firms often sell businesses when they no
longer fit the firms’ strategies or when they are offered a
price they cannot refuse
- Establish private equity funds to make investments;
these funds are usually organized as limited partnerships
or limited liability companies
- Private equity firms focus on firms that have stable cash
flows because they use a lot of debt to finance their
acquisitions
- When a large amount of debt is used to take over a
company, the transaction is called a leveraged buyout
- Improve the performance of firms in which they invest
by:
• Making sure that the firms have the best possible
management teams
• Closely monitoring each firm’s performance and
providing advice and counsel to the firm’s
management team
• Facilitating mergers and acquisitions that help
improve the competitive positions of the companies
in which they invest
- Private equity firms carry a much smaller regulatory
burden and fewer financial reporting requirements than
do public firms
- Are able to avoid most of the SEC’s registration and
compliance costs and other regulatory burdens, such as
compliance with the Sarbanes-Oxley Act
PRIVATE INVESTMENTS IN PUBLIC EQUITY (PIPE)
- Transactions in which a public company sells
unregistered stock to an investor—often a hedge fund or
some other institutional investor
- Have been around for a long time, but the number of
these transactions has increased greatly since the late
1990s
- Investors purchase securities (equity or debt) directly
from a publicly traded company in a private placement
- The securities are virtually always sold to the investors
at a discount to the price at which they would sell in the
public markets to compensate the buyer for limits on the
liquidity associated with these securities and, often, for
being able to provide capital quickly
- Transactions are not registered with the SEC, they are
“restricted securities”
- Under federal securities law, they cannot be resold to
investors in the public markets for a year or two unless
the company registers them
- The company often agrees to register the restricted
securities with the SEC, usually within 90 days of the
PIPE closing
- PIPE transactions involving a healthy firm can also be
executed without the use of an investment bank, resulting
in a cost saving of 7% to 8% of the proceeds
- A PIPE transaction can be the only way for a small
financially distressed company to raise equity capital
COMMERCIAL BANK LENDING
1. Prime-rate loans
- Loans in which the borrowing rate is based on the
prime rate of interest
- The prime rate charged by a bank may be higher
than other market borrowing rates because banks
provide a range of services
2. Bank term loans
- Business loans with maturities greater than one
year
- May be secured or unsecured, and the funds can
be used to buy inventory or to finance plant and
equipment
LOAN PRICING MODEL
Formula:
ki = PR + DRP + MAT
Where:
ki – interest rate to charge on a loan
PR – prime rate
DRP – default risk above the prime rate
MAT – yield curve for term loans
ILLUSTRATION:
A bank has two customers: Firm A has the bank’s
highest credit standing and Firm B’s credit standing is
prime + 3. The bank prime rate is 4.25%.
Requirement: What is the appropriate loan rate for each
customer, assuming the loan is a term loan?
Solution:
Firm A = 4.25%
Firm B = 4.25% + 3% = 7.25%
Reading Material:
COST OF CAPITAL
INTRODUCTION
- When the firms are using different sources of finance, the
finance manager must take careful decision with regard
to the cost of capital; because it is closely associated with
the value of the firm and the earning capacity of the firm
COST OF CAPITAL
- An integral part of investment decision as it is used to
measure the worth of investment proposal provided by
the business concern
- Used as a discount rate in determining the present value
of future cash flows associated with capital projects
- Also called as cut-off rate, target rate, hurdle rate and
required rate of return
- The rate of return that a firm must earn on its project
investments to maintain its market value and attract
funds
 - The required rate of return on its investments which
belongs to equity, debt and retained earnings
- If a firm fails to earn return at the expected rate, the
market value of the shares will fall and it will result in
the reduction of overall wealth of the shareholders
- The rate of return the firm required from investment in
order to increase the value of the firm in the market place
(John J. Hampton)
- The minimum required rate of earnings or the cut-off rate
of capital expenditure (Solomon Ezra)
- A cut-off rate for the allocation of capital to investment
of projects
• It is the rate of return on a project that will leave
unchanged the market price of the stock (James C.
Van Horne)
- The rate that must be earned on the net proceeds to
provide the cost elements of the burden at the time they
are due (William and Donaldson)
ASSUMPTION OF COST OF CAPITAL
- Based on certain assumptions which are closely
associated while calculating and measuring the cost of
capital
- It is to be considered that there are three basic concepts:
1. It is not a cost as such. It is merely a hurdle rate
2. It is the minimum rate of return
3. It consists of three important risks such as zero risk
level, business risk and financial risk
FORMULA OF COST OF CAPITAL
K = rj + b + f
Where:
K – cost of capital
rj – the riskless cost of the particular type of finance
b – the business risk premium
f – the financial risk premium
IMPORTANCE OF COST OF CAPITAL
CLASSIFICATION OF COST OF CAPITAL
1. Explicit and Implicit Cost – on the basis of the
computation of capital
- Explicit Cost – the rate that the firm pays to
procure financing
Formula:
n
COt
CIo = ∑ t of cash inflow must be more than the present value of
t=1 (t+C)
Where:
CIo – initial cash inflow
C – outflow in the period concerned
N – duration for which the funds are provided
T – tax rate
- Implicit cost – the rate of return associated with
the best investment opportunity for the firm and
its shareholders that will be forgone if the projects
presently under consideration by the firm were
accepted
2. Average and Marginal Cost
- Average cost of capital
• The weighted average cost of each
component of capital employed by the
company
• Considers weighted average cost of all
kinds of financing such as equity, debt,
retained earnings etc.
- Marginal cost
• The weighted average cost of new finance
raised by the company
• The additional cost of capital when the
company goes for further raising of finance
3. Historical and Future Cost
- Historical cost
• Cost which as already been incurred for
financing a particular project
• Based on the actual cost incurred in the
previous project
- Future cost – the expected cost of financing in the
proposed project
• Expected cost is calculated on the basis of
previous experience
4. Specific and Combined Cost
- Specific cost of capital
• The cost of each sources of capital such as
equity, debt, retained earnings and loans
• Very useful to determine the each and every
specific source of capital
- Composite or combined cost of capital (overall
cost of capital)
• The combination of all sources of capita
• Used to understand the total cost
associated with the total finance of the firm
- Computation of cost of capital is a very important part of
the financial management to decide the capital structure
of the business concern
Importance to Capital Budgeting Decision
• Capital budget decision largely depends on the cost of
capital of each source
• According to net present value method, present value
cash outflow
• Cost of capital is used to capital budgeting decision
Importance to Structure Decision
• Capital structure is the mix or proportion of the
different kinds of long term securities
• A firm uses particular type of sources if the cost of
capital is suitable
• Cost of capital helps to take decision regarding
structure
Importance to Evolution of Financial Performance
• Cost of capital is one of the important determine which
affects the capital budgeting, capital structure and
value of the firm
 • It helps to evaluate the financial performance of the Formula:
D
firm Ke = N + g
Importance to Other Financial Decisions p
Where:
• Apart from the above points, cost of capital is also used
Ke – Cost of equity capital
in some other areas such as, market value of share,
D – Dividend per equity share
earning capacity of securities etc. hence, it plays a
Np – Net proceeds of an equity share
major part in the financial management
g – Net proceeds of an equity share
ILLUSTRATION:
COMPUTATION OF COST OF CAPITAL
I. A company plans to issue 10000 new
1. Measurement of specific costs
shares of Rs. 100 each at a par. The
2. Measurement of overall cost of capital
floatation costs are expected to be 4%
of the share price. The company pays
MEASUREMENT OF COST OF CAPITAL – refers to the
a dividend of Rs. 12 per share initially
cost of each specific sources of finance like:
and growth in dividends is expected to
1. Cost of Equity
be 5%.
- The rate at which investors discount the expected
Requirement:
dividends of the firm to determine its share value
1. Compute the cost of new issue of
- Minimum rate of return that a firm must earn on
equity shares
the equity financed portion of an investment
Solution:
project in order to leave unchanged the market D
price of the shares Ke = N + g
p
- Can be calculated from the following approach: 12
Ke = 100−4 + 5 = 17.5%
a. Dividend price (D/P) approach
2. If the current market price of an
• The cost of equity capital will be that rate
equity share is Rs. 120, calculate
of expected dividend which will
the cost of existing equity share
maintain the present market price of
capital
equity shares
Solution:
Formula: D
D Ke = N + g
Ke = N x 100 p
p 12
Where: Ke = 120 + 5 = 15%
Ke – Cost of equity capital II. The current market price of the shares
D – Dividend per equity share of A Ltd. is Rs. 95. The floatation costs
Np – Net proceeds of an equity share are Rs. 5 per share amounts to Rs. 4.50
ILLUSTRATION: and is expected to grow at a rate of 7%.
A company issues 10,000 equity Requirement: Calculate the cost of
shares of Rs. 100 each at a premium of equity share capital
10%. The company has been paying 25% Solution:
dividend to equity shareholders for the past D
Ke = N x 100 + g
five years and expects to maintain the same p
4.50
in the future also. Ke = ( 95 x 100) + 7 = 11.73%
Requirement: c. Earning price (E/P) approach
1. Compute the cost of equity capital • Cost of equity determines the market
Solution: price of the shares
D
Ke = N x 100 • Based on the future earning prospects of
p
25 the equity
Ke = 100 x 100 = 22.72% Formula:
2. Will it make any difference if the E
Ke = N
market price of equity share is Rs. p

175? Where:
Solution: Ke – Cost of equity capital
D E – Earning per share
Ke = N x 100
p Np – Net proceeds of an equity share
25
Ke = 175 x 100 = 14.28% ILLUSTRATION:
b. Dividend price plus growth (D/P + g) A firm is considering an expenditure
approach – the cost of equity is calculated on of Rs. 75 lakhs for expanding its
the basis of the expected dividend rate per operations. The relevant information is as
share plus growth in dividend follows:
 No. of existing shares 10 lakhs Solution:
Market value of I = 100,000 x 8% = 8,000
Rs. 100
existing share I
Kda = N (1 − t) x 100
Net earnings Rs. 100 lakhs p
8,000
Requirement: Kda = 100,000 (1 − 50%) x 100 = 4%
a. Compute the cost of existing equity II. B Ltd. issues Rs. 100,000, 8% debentures at
share capital a premium of 10%. The tax rate applicable to
Solution: the company is 60%
E 100
Ke = N = 10 = 10 Requirement: Compute the cost of debt
p
b. Earnings per share capital
Solution: Solution:
E 10 I = 100,000 x 8% = 8,000
Ke = N = 100 x 10 = 10%
p Np = Face value + Premium = 100,000 +
c. New equity capital assuming that new (100,000 x 10%) = 110,000
I
shares will be issued at a price of Rs. Kda = N (1 − t) x 100
92 per share and the costs of new issue p
8,000
will be Rs. 2 per share. Kda = 110,000 (1 − 60%) x 100 = 2.91%
Solution: III. A Ltd. issues Rs. 100,000, 8% debentures at
E 10
Ke = N = 92−2 x 100 = 11.11% a discount of 5%. The tax rate is 60%.
p
Requirement: Compute the cost of debt
d. Realized yield approach
capital
• It is the easy method for calculating cost
Solution:
of equity capital
I = 100,000 x 8% = 8,000
• Cost of equity is calculated on the basis Np = 100,000 – (100,000 x 5%) = 95,000
of return actually realized by the investor I
Kda = (1 − t) x 100
in a company on their equity capital Np
Formula: 8,000
Kda = 95,000 (1 − 60%) x 100 = 3.37%
Ke = PVf x D
IV. B Ltd. issues Rs. 1,000,000, 9% debentures at
Where:
a premium of 10%. The costs of floatation are
Ke – Cost of equity capital
2%. The tax rate applicable is 50%
PVf – Present value of discount factor
Requirement: Compute the cost of debt-
D – Dividend per share
capital
2. Cost of Debt – the after-tax cost of long-term funds
Solution:
through borrowing
I = 1,000,000 x 9% = 90,000
a. Debt Issued at Par – debt is issued at the face value
Premium = 1,000,000 x 10% = 100,000
of the debt
Np = (1,000,000 + 100,000) – [(1,000,000
Formula: 2
Kd = ( 1 − t) R + 100,000) x 100 = 1,078,000
I
Where: Kda = N (1 − t) x 100
p
Kd – Cost of debt capital 90,000
t – tax rate Kda = 1,078,000 (1 − 50%) x 100 = 4.17%
R – debenture interest rate c. Cost of Perpetual Debt and Redeemable Debt
b. Debt issued at Premium or Discount • Rate of return which the lenders expect
Formula: • The debt carries a certain rate of interest
I
Kda = N (1 − t) Formula:
p I+1
Where: n(P−Np)n
Kdb = 1
Kd – Cost of debt capital n(P−Np)
I – Annual interest payable 2

Np – Net proceeds of debenture Where:

t – tax rate Kdb – Cost of debt before tax
ILLUSTRATION: I – Annual interest payable
I. A Ltd. issues Rs. 100,000, 8% debentures at P – Par value of debt
par. The tax rate applicable to the company is Np – Net proceeds of debenture
50% n – No. of years to maturity
Requirement: Compute the cost of debt t – tax rate
capital
 Kda = Kdb x (1 – t) Kp =
160,000
x 100 = 8.69% or 8.70%
1,840,000
Where:
b. Cost of irredeemable preference share capital
Kda – Cost of debt after tax
Formula:
Kdb – Cost of debt before tax (P−Np )
Dp +
t – tax rate Kp = n
x 100
(P+ Np )
ILLUSTRATION: 2
A company issues Rs. 20,00,000, 10% Where:
redeemable debentures at a discount of 5%. The Kp – Cost of preference share
costs of floatation amount to Rs. 50,000. The Dp – Fixed preference dividend
debentures are redeemable after 8 years. Cost of P – Par value of debt
debt assuring a tax rate of 55% Np – Net proceeds of an equity share
Requirement: Calculate n – No. of maturity period
a. Before tax ILLUSTRATION:
Solution: I. ABC Ltd. issues 20,000, 8% preference
Np = 2,000,000 shares of Rs. 100 each. Redeemable after 8
I+1
n(P−Np)n
I+1
8(2,000,000−Np)n
years at a premium of 10%. The cost of issue
Kdb = 1 = 1 is Rs. 2 per share.
n(P−Np) n(P−Np)
2 2
Requirement: Calculate the cost of
b. After tax preference share capital
3. Cost of Preference Share Capital – the annual Solution:
preference share dividend by the net proceeds from the Dp = (20,000 x 8%) x 100 = 160,000
sale of preference share. P = (20,000 x 100) + [(20,000 x 100) x
a. Cost of redeemable preference share capital 10%] = 2,200,000
Formula: Np = (20,000 x 100) – (20,000 x 2) =
D 1,960,000
Kp = Np x 100 (P−Np )
p Dp +
Where: Kp = (P+ Np)
n
x 100 =
Kp – Cost of preference share 2
(2,200,000 − 1,960,000)
160,000+
Dp – Fixed preference dividend 8
(2,200,000 + 1,960,000) x 100
Np – Net proceeds of an equity share 2
240,000
ILLUSTRATION: K =
160,000+
8 190,000
x 100 = 2,080,000 x 100
p 4,160,000
XYZ Ltd. issues 20,000, 8% preference 2
shares of Rs. 100 each. Cost of issue is Rs. 2 per = 9.13%
share. II. ABC Ltd. issues 20,000, 8% preference
Requirement: Calculate cost of preference share shares of Rs. 100 each at a premium of 5%
capital if these shares are issued redeemable after 8 years at par. The cost of
a. At par issue is Rs. 2 per share
Solution: Requirement: Calculate the cost of
Dp = (20,000 x 8%) x 100 = 160,000 preference share capital
Np = (20,000 x 100) – (20,000 x 2) = Solution:
1,960,000 Dp = (20,000 x 8%) x 100 = 160,000
Kp =
160,000
x 100 = 8.16% P = (20,000 x 100) = 2,000,000
1,960,000
Premium = (20,000 x 100) x 5% = 100,000
b. At a premium of 10%
Np = (20,000 x 100) + 100,000 – (20,000 x
Solution:
2) = 2,060,000
Dp = (20,000 x 8%) x 100 = 160,000 (P−Np )
Dp +
Premium = (20,000 x 100) x 10% = Kp = (P+ Np)
n
x 100 =
200,000 2
(2,000,000 − 2,060,000)
Np = (20,000 x 100) + 200,000 – (20,000 x 160,000+
8
x 100
2) = 2,160,000 (2,000,000 + 2,060,000)
2
160,000 60,000
Kp = 2,160,000 x 100 = 7.40% or 7.41% 160,000− 152,500
K =
p 4,060,000
8
x 100 = x 100
2,030,000
c. Of a debentures of 6% 2

Solution:
Dp = (20,000 x 8%) x 100 = 160,000
Debentures = (20,000 x 100) x 6% =
120,000
Np = (20,000 x 100) – 120,000 – (20,000 x
2) = 1,840,000
= 7.51%
4. Cost of Retained Earnings – the same as the cost of an
equivalent fully subscripted issue of additional shares,
which is measured by the cost of equity capital
 Retained Earnings – one of the sources of finance for Presentation:
investment proposal; it is different from other sources COST OF CAPITAL
like debt, equity and preference shares
Formula: COST OF CAPITAL – company's calculation of the minimum
Kr = Ke (1 – t)(1 – b) x 100 return that would be necessary in order to justify undertaking a
Where: capital budgeting project, such as building a new factory (Adam
Kr – Cost of retained earnings Hayes)
Ke – Cost of equity
t – Tax rate FACTORS AFFECTING THE COST OF CAPITAL
b – Brokerage cost 1. Fundamental Factors
ILLUSTRATION: a. Market opportunities
A firm’s Ke (return available to shareholders) is b. Capital provider preference
10%, the average tax rate of shareholders is 30% and c. Risk (business risk, financial risk)
it is expected that 2% is brokerage cost that d. Inflation
shareholders will have to pay while investing their 2. Economic
dividends in alternative securities. a. Interest rates
Requirement: What is the cost of retained 3. Other factors
earnings?
a. BSP monetary policy
Solution: b. Trade activity
Kr = Ke (1 – t)(1 – b) c. Foreign trade surpluses and deficits
Kr = 10% (1 – 50%)(1 – 2%) x 100 = 4.9% *bakit d. Exchange rate risk
0.50 yung tax rate
UNSYSTEMATIC RISK – can be eliminated by holding a
MEASUREMENT OF OVERALL COST OF CAPITAL diversified portfolio
- Also called as weighted average cost of capital and
composite cost of capital
SYSTEMATIC RISK – the only risk that investors require
- The expected average future cost of funds over the long compensation for bearing
run found by weighting the cost of each specific type of
capital by its proportion in the firms capital structure ACCOUNTING BALANCE SHEETS – reflect book values
Steps:
1. Assigning weights to specific costs FINANCE BALANCE SHEETS – reflect market values
2. Multiplying the cost of each of the sources by the
appropriate weights MARKET VALUE OF ASSETS
3. Dividing the total weighted cost by the total weights Formula:
Formula: MV of assets = MV of liabilities + MV of equity
Ko = KdWd + KpWp + KeWe + KrWr
Where: ESTIMATING COST OF CAPITAL
Ko – Overall cost of capital - If analysts at a firm could estimate the betas for each of
Kd – Cost of debt the firm’s individual projects, they could estimate the
Wd – Percentage of debt of total capital beta for the entire firm as a weighted average of the betas
Kp – Cost of preference share for the individual projects
Wp – Percentage of preference share to total capital - Analysts must use their knowledge of the finance
Ke – Cost of equity
balance sheet, along with the concept of market
We – Percentage of equity to total capital efficiency, to estimate the cost of capital for the firm
Kr – Cost of retained earnings
• Rather than performing calculations for the
Wr – Percentage of retained earnings
individual projects represented on the left-hand side
Weighted average cost of capital
of the finance balance sheet, analysts perform a
Formula:
∑ XW
similar set of calculations for the different types of
Kw = ∑W financing (debt and equity) on the right-hand side of
Where: the finance balance sheet
Kw – Weighted average cost of capital
X – Cost of specific sources of finance COST OF DEBT
W – Weight, proportion of specific sources of finance Formula:
Kd = Kd (1 – t)
Where:
Kd – after tax cost of debt
Kd – pretax cost of debt
 t – tax rate
ILLUSTRATION:
I. The before-tax cost of debt for a firm is 6% and the
marginal tax rate is 20%.
Requirement: What is the after-tax cost of debt for the
firm?
Solution:
Kd = Kd (1 – t)
Kd = 6% (1 – 20%) x 100 = 4.8%
II. Suppose that a company issues bonds with a before-
tax cost of 10%. Assuming company’s tax rate is 40%,
Requirement: the after-tax cost of debt is
Solution:
Kd = Kd (1 – t)
Kd = 10% (1 – 40%) x 100 = 6%
COST PREFERRED STOCK – the characteristics of
preferred stock allow us to use the perpetuity model to estimate
the cost of preferred equity
Formula:
D
Kp = P p x 100
p
Where:
Kp – Cost of preferred stock
Dp – Fixed preference dividend
Pp – Net proceeds of an equity share
ILLUSTRATION:
You can issue preferred stock for a net price of $42 and
the preferred stock pays a $5 dividend.
Requirement: cost of preferred stock
Solution:
D
Kp = P p x 100
p
5 rate is 5% and the expected market return is 13%
Kp = 42 x 100 = 11.90%
COST OF EQUITY: COMMON STOCK
1. Capital Asset Pricing Model (CAPM)
- There are some practical considerations that must be
considered when choosing the appropriate risk-free
rate, beta, and market- risk premium for the above
calculation
- The recommended risk-free rate to use is the risk-
free rate on a long-term Treasury security because
the equity claim is a long- term claim on the firm’s
cash flows
• A long-term risk-free rate better reflects long-
term inflation expectations and the cost of
getting investors to part with their money for a
long period of time than a short-term rate
- One can estimate the Beta for that stock using a
regression analysis
- Identifying the appropriate beta is much more
complicated if the common stock is not publicly
traded
• This problem may be overcome by identifying
a “comparable” company with publicly traded
stock that is in the same business and that has a
similar amount of debt
• When a good comparable company cannot be
identified, it is sometimes possible to use an
average of the betas for the public firms in the
same industry
- It is not possible to directly observe the market risk
premium since we don’t know what rate of return
investors expect for the market portfolio
- For this reason, financial analysts generally use a
measure of the average risk premium investors have
actually earned in the past as an indication of the risk
premium they might require today
• From 1926 through the end of 2015, actual
returns on the U.S. stock market exceeded
actual returns on long-term U.S. government
bonds by an average of 5.92% per year
• If a financial analyst believes that the market-
risk premium in the past is a reasonable
estimate of the risk premium today, then he or
she might use 5.92% (or a value close to it) as
the market risk premium for the future
- Most people use this to estimate the cost of equity if
the result is going to be used in the discount rate for
evaluating a project
Formula:
KS = KRF + β(KM – KRF)
Where:
KS – CAPM
KRF – risk-free rate
β – beta
KM – expected market return
ILLUSTRATION:
The estimated Beta of a stock is 1.2. The risk-free
Requirement: Cost of Equity
Solution:
KS = KRF + β(KM – KRF)
KS = 5% + 1.2(13% – 5%) = 14.6%
2. Constant-Growth Dividend Model
- Used to determine the intrinsic value of a stock
based on a future series of dividends that grow at a
constant rate
- Useful for a firm that pays dividends that will grow
at a constant rate, which is appropriate for an electric
utility but not for a fast growing high- tech firm
Formula:
D
KS = P 1 + g
0
D1
P0 = R−g
Where:
KS – constant-growth
D1 – dividends
g – growth rate
P0 – market price
ILLUSTRATION:
The market price of a share of common stock is
$60. The dividend just paid is $3, and the expected
growth rate is 10%
 Requirement: Cost of Equity Requirement: What is the firm's weighted average
Solution: cost of capital?
D
KS = P 1 + g Solution:
0
3(110 %)
Kd = 6.75% x (1 – 38%) = 4.185%
KS = + 10% = 15.5% (7% x 100)
60 Kp = = 13.208%
53
3. Multistage-Growth Dividend Model (Supernormal-
Ks = 2.8% + 1.34(11.2% - 2.8%) = 14.056%
growth dividend model)
Total debt = 80,000 x 1,000 = 80,000,000
- The complexity of this approach lies in choosing the
Total common stock = 2,500,000 x 42 =
correct number of stages of forecasted growth as
105,000,000
well as how long each stage will last
Total preference stock = 750,000 x 53 = 39,750,000
- Because of the algebraic complexity in solving for
Total capital = 80,000,000 + 105,000,000 +
the required rate of return, the value is generally
39,750,000 = 224,750,000
solved for using a trial and error method, after
Wd = 80,000,000/224,750,000 = 35.60%
forecasting the different stages of dividend growth
Wp = 39,750,000/224,750,000 = 17.70%
a. Cost of new common stock – must adjust the
Ws = 105,000,000/224,750,000 = 46.72%
Dividend Growth Model equation for floatation
WACC = (4.185% x 35.60%) + (13.208% x
costs of the new common shares
17.70%) + (14.056 x 46.72%) = 10.4%
Formula:
D1
II. The total value of a firm is $4,000,000 and it has
Kn = P +g $300,000 debt. The cost of debt is 6% and the cost of
0 +F
Where: equity is 10%
Kn – cost of new common stock Requirement: What is the weighted-average cost of
D1 – dividends capital (WACC)?
g – growth rate Solution:
P0 – market price Wd = 300,000/4,000,000 = 7.5%
F – floatation Ws = 3,700,000/4,000,000 = 92.5%
ILLUSTRATION: WACC = (6% x 7.5%) + (10% x 92.5%) = 9.7%
The market price of a share of common stock
is $60. The dividend just paid is $3, and the LIMITATIONS OF WACC AS A DISCOUNT RATE FOR
expected growth rate is 10% EVALUATING PROJECTS
Requirement: Cost of Equity - Financial theory tells us that the rate that should be used
Solution: to discount these incremental cash flows is the rate that
D1
Kn = P +F +g reflects their systematic risk
0 - This means that the WACC is going to be the appropriate
3(1+10%)
Kn = 60−(60 x 12%) + 10% = 16.25% discount rate for evaluating a project only when the
project has cash flows with systematic risks that are
WEIGHTED-AVERAGE COST OF CAPITAL exactly the same as those for the firm as a whole
Formula: - When a single rate, such as the WACC, is used to
WACC = KsWs + KpWp + KdWd discount cash flows for projects with varying levels of
Where: risk, the discount rate will be too low in some cases and
WACC – Overall cost of capital too high in others
Kd – Cost of debt • When the discount rate is too low, the firm runs the
Wd – Percentage of debt of total capital risk of accepting a negative NPV project – estimated
Kp – Cost of preference share NPV will be positive even though the true NPV is
Wp – Percentage of preference share to total capital negative
Ks – Cost of equity • When the discount rate is too high, the firm runs the
Ws – Percentage of equity to total capital risk of rejecting a positive NPV project – estimated
ILLUSTRATION: NPV will be negative even though the true NPV is
I. Phillips Equipment has 80,000 bonds outstanding that positive
are selling at par. Bonds with similar characteristics • The key point is that it is only really correct to use a
are yielding 6.75 percent. The company also has firm’s WACC to discount the cash flows for a project
750,000 shares, 7%, P100 par value preferred stock, if the following conditions hold
and 2.5 million shares of common stock outstanding. Condition 1: A firm’s WACC should be used to evaluate the
The preferred stock sells for $53 a share. The common cash flows for a new project only if the level of systematic
stock has a beta of 1.34 and sells for $42 a share. The risk for that project is the same as that of the portfolio of
U.S. Treasury bill is yielding 2.8 percent and the return projects that currently comprise the firm
on the market is 11.2 percent. The corporate tax rate is Condition 2: A firm’s WACC should be used to evaluate a
38 percent project only if that project uses the same financing mix – the
 same proportions of debt, preferred shares, and common
shares – used to finance the firm as a whole
ALTERNATIVES TO WACC
- If the discount rate for a project cannot be estimated
directly, a financial analyst might try to find a public firm
that is in a business that is similar to the project
• This public company would be what financial
analysts call a pure-play comparable because it is
exactly like the project
• This approach is generally not feasible due to the
difficulty of finding a public firm that is only in the
business represented by the project
- Financial managers sometimes classify projects into
categories based on their systematic risks
• They then specify a discount rate that is to be used
to discount the cash flows for all projects within
each category
Reading Material:
CAPITAL STRUCTURE POLICY
- Financing decisions typically are tied to investment
spending and are based on the company’s ability to
support debt given the nature of its business model,
assets, and operating cash flows
- A company’s stage in the life cycle, its cash flow
characteristics, and its ability to support debt largely
dictate its capital structure, because capital not sourced
through borrowing must come from equity (including
retained earnings)
- Generally speaking, as companies mature and move
from start-up through growth to maturity, their business
risk declines as operating cash flows turn positive with
increasing predictability, allowing for greater use of
leverage on more attractive terms
- Modigliani and Miller’s work, with its simplifying
assumptions, provides a starting point for thinking about
the strategic use of debt and shows us that managers
cannot change firm value simply by changing the firm’s
capital structure
• Firm value is independent of capital structure
decisions
- Given the tax-deductibility of interest, adding leverage
increases firm value up to a point but also increases the
risk of default for capital providers who demand higher
returns in compensation
- To maximize firm value, management should target the
optimal capital structure that minimizes the company’s
weighted average cost of capital
- Managers may provide investors with information
(“signaling”) through their choice of financing method
EXAMPLE: Commitments to fixed payments may
signal management’s confidence in the company’s
prospects
- Managers’ capital structure decisions affect various
stakeholder groups differently
• In seeking to maximize shareholder wealth or their
own, managers may create conflicts of interest in
which one or more groups are favored at the expense
of others, such as a debt-equity conflict
OPTIMAL CAPITAL STRUCTURE – a trade-off between
the benefits of higher leverage, which include the tax-
deductibility of interest and the lower cost of debt relative to
equity, and the costs of higher leverage, which include higher
risk for all capital providers and the potential costs of financial
distress
Presentation:
CAPITAL STRUCTURE POLICY
CAPITAL STRUCTURE AND FIRM VALUE
- A firm’s capital structure is the mix of financial securities
used to finance its activities
- The mix will always include common stock and will
often include debt and preferred stock
- The firm may have several classes of common stock, for
example with different voting rights and possibly
different claims on the cash flows available to
stockholders
- The debt of a firm can be long-term or short-term,
secured or unsecured, convertible or not convertible into
common stock, and so on
- Preferred stock can be cumulative or noncumulative and
convertible or not convertible into common stock
- The fraction of the total financing that is represented by
debt is a measure of the financial leverage in the firm’s
capital structure
- A higher fraction of debt indicates a higher degree of
financial leverage
- The amount of financial leverage in a firm’s capital
structure is important because it affects the value of the
firm
OPTIMAL CAPITAL STRUCTURE
- Managers at a firm choose a capital structure so that the
mix of securities making up the capital structure
minimizes the cost of financing the firm’s activities
- The capital structure that minimizes the cost of financing
the firm’s projects is also the capital structure that
maximizes the total value of those projects and,
therefore, the overall value of the firm
THE MODIGLIANI AND MILLER PROPOSITIONS
- M&M analysis tells us exactly where we should look if
we want to understand how capital structure affects firm
value and the cost of equity
- If financial policy matters, it must be because of:
a. Taxes
b. Information or transaction costs
 c. Capital structure choices that affect a firm’s real
investment policy
1. Proposition 1
• States that the capital structure decisions a firm
makes will have no effect on the value of the firm
if:
a. There are no taxes
b. There are no information or transaction costs
c. The real investment policy of the firm is not
affected by its capital structure decisions
•
The real investment policy of the firm includes the
criteria that the firm uses in deciding which real
assets (projects) to invest in
• The market value of the debt plus the market value
of the equity must equal the value of the cash
flows produced by the firm’s assets, referred to as
firm value or enterprise value
Formula:
Assets = Debt + Equity
• The combined value of the equity and debt claims
(represented by the present value of free cash
flows the firm’s assets are expected to produce in
the future) does not change when you change the
capital structure of the firm if no one other than
the stockholders and the debt holders are
receiving cash flows
• Financial restructuring – where a combination
of financial transactions occur that change the
capital structure of the firm without affecting its
real assets
2. Proposition 2
• The required return on a firm’s common stock is
directly related to the debt-to-equity ratio
Formula:
V𝐷𝑒𝑏𝑡
Kcs = Kassets + ( ) (Kassets – Kdebt)
V without debt, and how much would debt
• Two sources of risk in cash flows to stockholders:
a. Business risk – associated with the
characteristics of the firm’s business
activities
b. Financial risk
o Associated with the capital structure of
the firm, which reflects the effect that the
firm’s financing decisions have on the
riskiness of the cash flows that the
stockholders will receive
o Associated with required payments to
firm’s lenders
ILLUSTRATION:
After its restructuring, Millennium Motors will
be financed with 20% debt and 80% common equity.
The return on assets is 10% and the return on debt is
5%.
Requirement: What is the cost of equity for the
firm?
Solution:
V
Kcs = Kassets + ( 𝐷𝑒𝑏𝑡 ) (Kassets – Kdebt)
V
20%
Kcs = 10% + (80%) (10% – 5%) = 11.25%
BENEFITS OF DEBT
1. Interest tax shield benefit
- The most important benefit of including debt in a
firm’s capital structure stems from the fact that
firms can deduct interest payments for tax
purposes but cannot deduct dividend payments
- This makes it less costly to distribute cash to
security holders through interest payments than
through dividends
- The total dollar amount of interest paid each year,
and therefore the amount that will be deducted
from the firm’s taxable income
• This will result in a reduction in taxes where
t is the firm’s marginal tax rate that applies to
the interest expense deduction
Formula:
CF D x kdebt x t
VTax savings debt = PVA = ( i ) = ( )
i
ILLUSTRATION:
You are considering borrowing $1,000,000
at an interest rate of 6% for your pizza business.
Your pizza business generates pre-tax cash
flows of $300,000 each year and pays taxes at a
rate of 25%. The cost of equity is 10%
Requirement: What is the value of your firm
increase its value What is WACC before and
after restructuring?
Solution:
VFirm = (
300,000 x (1−25%
) = 2,250,000
10%
Value of tax shield = 1,000,000 x 25% =
250,000
- The perpetuity model assumes that:
a. The firm will continue to be in business
forever
b. The firm will be able to realize the tax savings
in the years in which the interest payments
are made (the firm’s EBIT will always be at
least as great as the interest expense)
 c. The firm’s tax rate will remain constant
- With taxes, the cost of equity can be written as:
Formula:
V
Kcs = Kassets + ( 𝐷𝑒𝑏𝑡 ) (Kassets – Kdebt)(1 – t)
𝑉
𝑐𝑠
2. Other benefits
- Underwriting spreads and out-of-pocket costs are
more than three times as large for stock sales as
they are for bond sales
- Debt provides managers with incentives to focus
on maximizing the cash flows that the firm
produces since interest and principal payments
must be made when they are due
- Because managers must make these interest and
principal payments or face the prospect of
bankruptcy, not making the payments can destroy
a manager’s career
- Debt can be used to limit the ability of bad
managers to waste the stockholder’s money on
things such as fancy jet aircraft, plush offices, and
other negative-NPV projects that benefit the
managers personally
COSTS OF DEBT: AGENCY COSTS
COST OF DEBT
- Financial managers limit the amount of debt in their
firms’ capital structures in part because there are costs
that can become quite substantial at high levels of debt
- At low levels of debt, the benefits are greater than the
costs, and adding additional debt increases the overall
value of the firm
• At some point, the costs begin to exceed the
benefits, and adding more debt financing destroys
firm value
• Financial managers want to add debt just to the point
at which the value of the firm is maximized
COST OF DEBT: BANKRUPTCY COSTS
- Also referred to as costs of financial distress
- Costs associated with financial difficulties that a firm
might get into because it uses too much debt financing
- The term bankruptcy cost is used rather loosely in capital
structure discussions to refer to costs incurred when a
firm gets into financial distress
Direct bankruptcy costs – out-of-pocket costs that a firm
incurs as a result of financial distress
• They include things such as fees paid to lawyers,
accountants, and consultants
Indirect bankruptcy costs – costs associated with changes
in the behavior of people who deal with a firm in financial
distress
• Some of the firm’s potential customers will decide to
purchase a competitor’s products because of:
1. Concerns the firm will not be able to honor its
warranties
2. Parts or services will not be available in the future
TRADE-OFF THEORY OF CAPITAL STRUCTURE
- The benefits and costs of debt combine to affect firm
value
- For low levels of debt, adding more debt to a firm’s
capital structure increases firm value because the
additional (marginal) benefits are greater than the
additional (marginal) costs
- The point at which the value of the firm is maximized,
the costs of adding more debt begin to outweigh the
benefits, and the value of the firm decreases as more debt
is added
- The difference between the upward-sloping line and the
curved line reflects the costs associated with debt
- Managers choose a specific target capital structure based
on the trade-offs between the benefits and the costs of
debt
- Managers will increase debt to the point at which the
costs and benefits of adding an additional dollar of debt
are exactly equal because this is the capital structure that
maximizes firm value
- Result from conflicts of interest between principals and
agents where one party, the principal, delegates its
decision-making authority to another party, the agent
- The agent is expected to act in the interest of the
principal, but agents sometimes have interests that
conflict with those of the principal
- Stockholder-manager agency costs occur to the extent
that if the incentives of the managers are not perfectly
identical to those of the stockholders, managers will
make some decisions that benefit themselves at the
expense of the stockholders
- Using debt financing provides managers with incentives
to focus on maximizing the cash flows that the firm
produces and limits the ability of bad managers to waste
the stockholders’ money on negative NPV projects
- These benefits amount to reductions in the agency costs
associated with the principal/agent relationship between
stockholders and managers
- While the use of debt financing can reduce agency costs,
it can also increase these costs by altering the behavior
of managers who have a high proportion of their wealth
riding on the success of the firm, through their
stockholdings, future income, and reputations
- The use of debt increases the volatility of a firm’s
earnings and the probability that the firm will get into
financial difficulty
- Increased risk causes managers to make more
conservative decisions
- Stockholder-Lender Agency Costs – occur when
investors lend money to a firm and delegate authority to
the stockholders to decide how that money will be used
- Lenders expect that the stockholders, through the
managers they appoint, will invest the money in a way
that enables the firm to make all of the interest and
principal payments that have been promised
 • However, stockholders may have incentives to use
the money in ways that are not in the best interests
of the lenders
- Lenders know that stockholders have incentives to
distribute some or all of the funds that they borrow as
dividends and so they protect themselves against this sort
of behavior by including provisions in the lending
agreements that limit the ability of stockholders to pay
dividends and conduct other behaviors
• These protections are not, however, foolproof
1. Asset substitution problem – where once a loan
has been made to a firm, the stockholders have an
incentive to substitute less risky assets for more
risky assets such as negative-NPV projects
2. Underinvestment problem – occurs in a financially
distressed firm when the value that is created by
investing in a positive-NPV project is likely to go to
the lenders instead of the stockholders, the firm
therefore forgoes financing and undertaking the
project
PECKING ORDER THEORY
- Recognizes that different types of capital have different
costs
- This leads to a pecking order in the financing choices that
managers make
- Managers choose the least expensive capital first then
move to increasingly costly capital when the lower-cost
sources of capital are no longer available
• Managers view internally generated funds, or cash
on hand, as the cheapest source of capital
• Debt is more costly to obtain than internally
generated funds but is still relatively inexpensive
• Raising money by selling stock is the most
expensive
EMPIRICAL EVIDENCE
- When researchers compare the capital structures in
different industries, they find evidence that supports the
trade-off theory
- Some researchers argue that, on average, debt levels
appear to be lower than the trade-off theory suggests they
should be
- Firm value is estimated as the market value of equity plus
the book value of debt
- Industries with a great many tangible assets, such as the
building construction, air transportation, and printing,
publishing, and related industries, tend to have larger
debt-to-firm value ratios
- More general evidence also indicates that the more
profitable a firm is, the less debt it tends to have, which
is exactly opposite what the trade-off theory suggests we
should see
- This evidence is consistent with the pecking order theory
- The pecking order theory is also supported by the fact
that, in an average year, public firms actually repurchase
more shares than they sell
• Both the trade-off theory and the pecking order
theory offer some insights into how managers
choose the capital structures for their firms but
neither is able to explain all of the capital structure
choices that we observe
PRACTICAL CONSIDERATIONS
- In choosing a capital structure, managers don’t think
only in terms of a trade-off or a pecking order but are
also concerned with how their financing decisions will
influence the practical issues that they must deal with
when managing a business
- Financial flexibility – important consideration in many
capital structure decisions
- Managers must ensure that they retain sufficient
financial resources in the firm to take advantage of
unexpected opportunities as well as unforeseen problems
• They try to manage their firms’ capital structures in
a way that limits the risk to a reasonable level
- Managers think about leverage and the effect that interest
expense has on the reported dollar value of net income
- Managers consider control implications when choosing
between equity and debt financing of the firm
KNOWLEDGE CHECKS:
1. The bootstrapping period usually lasts for _____ years – 1
to 2 years
2. The process by which many entrepreneurs raise seed
money and obtain other resources necessary to start their
businesses is often called – bootstrapping
3. To complete an IPO, a firm will need the services of _____,
who are experts in bringing new securities to market –
investment bankers
4. Advantages of going public include all except – the cost of
going public is less compare to debt financing
5. Are the following statements true or false?
Shelf registration allows firms to register an
False
inventory of securities for an unlimited time
The securities can be taken off the shelf at any
time within 2 years of such registration and sold True
to the public
Shelf registration reduces flotation and other
True
expenses associated with registration
There is a large penalty if the authorized
False
securities are not issued
A shelf registration can cover multiple
True
securities
6. Trajax, Inc., a high-technology firm in Portland, raised a
total of $90 million in an IPO. The company received $27
of the $30 per share offering price. The firm’s legal fees,
SEC registration fees, and other out-of-pocket costs were
$450,000. The firm’s stock price increased 17 percent on
the first day of trading.
Requirements: What was the total cost to the firm of
issuing the securities
a. Underwriting Cost
Solution:
Underwriter’s spread = 30 – 27 = 3
 No. of shares outstanding = 90,000,000/30 = Solution:
3,000,000 0.80
Cost of equity = 42.40 + 6% = 7.89%
Underwriting cost = 3,000,000 x 3 = 9,000,000
15. XYZ Corporation has paid annual dividends of P1.30,
b. Out-of-pocket expenses
P1.40, P1.50, and P2.00 per share over the last four years,
Answer: 450,000
respectively. The stock is currently selling for P50 per
c. Underpricing
share.
Solution:
Requirement: What is the firm’s cost of equity?
Stock price at end of first day = 30 x 1.17 = 35.10
Solution:
First-day underpricing = 35.10 – 30 = 5.10
Growth rate:
Total underpricing = 3,000,000 x 5.10 =
1.30 (1.40 – 1.30)/1.30 0.0769
15,300,000
1.40 (1.50 – 1.40)/1.40 0.0714
d. Total cost to the firm of selling the IPO 1.50 (2.00 – 1.50)/1.50 0.3333
Solution: 0.4816
Total cost to the firm of selling the IPO = 0.4816/3 16.1%
9,000,000 + 450,000 + 15,300,000 = 24,750,000 2.00 x (2.00 x 16.1%)
Cost of equity = + 16.1% = 20.74%
7. Berron Comics, Inc., has borrowed $100 million and is 50
required to pay its lenders $8 million in interest this year. 16. DEF Corporation has 1,200 bonds outstanding that are
Requirement: If Berron is in the 35% marginal tax selling for P990 each. The company also has 2,500
bracket, then what is the after-tax cost of debt (in dollars as preference shares at a market price of P28 per share and
well as in annual interest) to Berron ordinary shares priced at P37 per share with 28, shares
Solution: outstanding.
Kd = Kd (1 – t) Requirement: What is the weight of the preference shares
Kd = 8,000,000 (1 – 35%) = 5,200,000 as it relates to the firm’s weighted average cost of capital?
8. A company has preferred stock that has an annual dividend Solution:
of $3. Bonds 1,200 x 990 1,188,000
Requirement: If the current share price is $25, what is the Preference 2,500 x 28 70,000
cost of preferred stock? Ordinary 28,000 x 37 1,036,000
Solution: Total 2,294,000
70,000
3
Cost of preferred stock = 25 x 100 = 12% Preference shares WACC = 2,294,000 = 3.05%
9. What information is needed to use the CAPM to estimate 17. Reflects the uncertainty associated with the underlying
kcs or kps? – risk-free rate, market risk premium, beta assets of the firm – Business risk
for the stock 18. The value of a firm is maximized when the – weighted
10. Turquoise Electronics, Inc. paid a dividend of $1.87 last average cots of capital is minimized
year. If the firm's growth in dividends is expected to be 19. Cerberus Security Company produces a cash flow of $200
10% next year and then zero thereafter, per year and is expected to continue doing so in the infinite
Requirement: What is its cost of equity capital if the price future. The cost of equity capital for Cerberus is 20 percent,
of its common shares is currently $25.71? and the firm is financed entirely with equity. Management
Solution: would like to repurchase $100 in shares by borrowing $100
1.87 𝑥 1.10 at a 10 percent rate (assume that the debt will also be
Cost of equity = 25.71 = 8%
outstanding into the infinite future)
11. TeleNyckel, Inc. has a beta of 1.4. If the risk-free rate of Requirement: Using Modigliani and Miller’s Proposition
return is 9% and the market risk premium is 5%, 1:
Requirement: What is the firm's after-tax cost of equity a. What is the value of the firm today?
capital if the firm's marginal tax rate is 30%? Solution:
Solution: 200
Value of the firm today = 20% = 1,000
KS = KRF + β(KM – KRF)
KS = 9% + 1.4(5%)= 16% b. What will be the value of the claims on the firm’s
12. A group of individuals got together and purchased all of the assets after the stock repurchase?
outstanding shares of common stock of D’Bright Solution:
Corporation. What is the return that these individuals Value of the claims = 1,000 – 100 = 900
require on this investment called? – Cost of Equity c. What will be the rate of return on common stock
13. Michelle Restobar borrowed money at a rate of 16%. This required by investors after the share repurchase?
interest rate is referred to as the – Cost of debt Solution:
200−(100x10%)
14. ABC Corporation is expected to pay an annual dividend of Rate on return of common stock = =
900
P.80 a share next year. The market price of the stock is 21.11%
P42.40 and the growth rate is 6%. 20. Bankruptcy and agency cost both act as limits on the
Requirement: What is the firm’s cost of equity? amount of debt in the capital structure – True
21. These are out-of-pocket costs that a firm incurs as a result
of financial distress. They are considered transactions costs
and occur when a firm must navigate the bankruptcy
process – Bankruptcy costs
22. Melba's Toast has a capital structure with 30% debt and
70% equity. Its pretax cost of debt is 6%, and its cost of
equity is 10%. The firm's marginal corporate income tax
rate is 35%.
Requirement: What is the appropriate WACC?
Solution:
WACC = (30% x 6%) x (1-35%) + 70% x 10% = 8.17%
LEARNING TASKS: (Module 3)
Learning Task 6
1. Management of Stanley, Inc., is planning to raise
P10,000,000 in new equity through a private placement
Requirement: If the sale price is P500 per share, the
number of shares that the company have to issue would be
Solution:
No. of shares = 10,000,000/500 = 20,000
2. _____ is defined as the offering of new securities for sale
at an offer price below the intrinsic value of the security-
Underpricing
3. The initial “seed” money usually comes from the _____ or
other _____. Other cash may come from _____, the sale of
_____ loans from _____ and friends, and _____ secured
from credit cards – entrepreneur, founders, personal
savings, assets, family members, loans
4. Dean Foods Co. needs to borrow $23,000,000 for a factory
equipment upgrade. Management decides to sell 10-year
bonds. They determine that the 3-month Treasury bill
yields 4.32%, the firm’s credit rating is AA, and the yield
on 10-year Treasury bonds is 1.06% higher than for 3-
month bills. Right now, AA bond rates are 1.35% above the
10-year Treasury bond rate.
Requirement: The borrowing cost for this transaction is
Solution:
Borrowing cost = 4.32% + 1.06% + 1.35% = 6.73%
5. The components of the cost associated with an IPO are
underwriting spread, _____ expenses, and _____ - out-of-
pocket, underpricing
6. A _____ is a sale of debt or equity, open to all investors, by
a registered public company that has previously sold stock
to the public – general cash offering
7. Negotiated sales allow the investment bankers to form a
closer relationship with the issuer and develop a better
understanding of the firm – True
8. _____ are individuals or groups of people that help new
businesses to get started and provide much of their early
financing – Venture capitalists
9. The two ways a security issue can be underwritten are
_____ basis and _____ basis – firm-commitment, best-
effort basis
10. Management of the Emerald Corporation, designer and
marketer of athletic apparel, is planning an expansion into
foreign markets and needs to raise $10,000,000 to finance
this move. Management anticipates raising the money
through a general cash offering for $13 a share.
Requirement: If the underwriters charge a 5% spread, the
number of shares that the company have to sell to achieve
its goal is
Solution:
Underwriter’s spread = 13 – (13 x 5%) = 12.35
No. of shares outstanding = 10,000,000/12.35 =
809,717
11. _____ refers to the securing of initial funding by
entrepreneurs to start a new business – Bootstrapping
Learning Task 7
1. France Co. has a capital structure, based on current market
values, that consists of 50% debt, 10% preferred stock, and
40% common stock. If the returns required by investors are
8%, 10%, and 15% for the debt, preferred equity, and
common stock, respectively
Requirement: Assuming that the firm’s marginal tax rate
is 30%, France’s after-tax WACC is
Solution:
Debt after tax = (50% x 8%) x (1 – 30%) = 2.8%
WACC = 2.8% + (10% x 10%) + (40% x 15%) = 9.8%
2. Whitewall Tire Co. just paid an annual dividend of $1.60
on its common shares. If Whitewall is expected to increase
its annual dividend by 2% per year into the foreseeable
future and the current price of Whitewall’s common shares
is $11.66,
Requirement: The cost of common stock for Whitewall is
Solution:
1.60
Cost of preferred stock = [11.66 + 2%] x 100 = 16%
3. Eve Autos has preferred shares outstanding that pay annual
dividends of $12, and the current price of the shares is $80.
Requirement: The after-tax cost of new preferred shares
for Eve if the flotation (issuance) costs for preferred shares
are 5% will be
Solution:
D1
Kn = P +g
0 +F
12
Kn = 80−(80 x 5%) = 15.8%
4. Milton Corp. issued bonds 10 years ago with a coupon rate
of 10 percent at a price of $1,000. The current price of the
bonds is $980. The before-tax cost of the debt to the firm is
still 10 percent – False
5. KneeMan Markup Company has total debt obligations with
book and market values equal to $30,000,000 and
$28,000,000, respectively. It also has total equity with book
and market values equal to $20,000,000 and $70,000,000,
respectively.
Requirement: If you were going to buy all of the assets of
KneeMan Markup today, the amount that I am willing to
pay is
Solution:
Amount = 70,000,000 + 28,000,000 = 98,000,000
6. Gems Ltd. has issued bonds that never require the principal 6. Andi’s T-shirts, Inc. has debt claims of $400 (market value)
amount to be repaid to investors. Correspondingly, Gems and equity claims of $600 (market value). If the after-tax
must make interest payments into the infinite future. If the cost of debt financing is 11% and the cost of equity is 17%,
bondholders receive annual payments of $75 and the Requirement: Then Andi’s weighted average cost of
current price of the bonds is $882.35, capital must be
Requirement: The after-tax cost of this debt for Gems if Solution:
the firm is subject to a 40% marginal tax rate is Total cost = 400 + 600 = 1,000
Solution: Cost of debt = 400/1,000 = 40%
75
After-tax = [882.35 x (1 – 40%)] x 100 = 5.1% Cost of equity = 600/1,000 = 60%
WACC = (40% x 11%) + (60% x 17%) = 14.6%
7. The current cost of preferred equity can be found by taking
7. Metro Water Guns, Inc. is expected to pay a dividend of
the ratio of the annual dividend on the preferred stock to
$2.10 one year from today. If the firm’s growth in dividends
the current price of preferred shares – True
is expected to remain at a flat 3% forever,
8. The WACC is often used as an estimate of the cost of
Requirement: The cost of equity capital for Metro Water
financing a new project given the firm’s current mix of –
Guns if the price of its common shares is currently $17.50
debt, equity
would be
9. Long-term debt typically describes debt that will mature in
Solution: 15%
two years or more – True D
10. The market risk premium for the future is always perfectly Kn = 1 + g
P0 +F
known, and it is 6.51 percent – False 2.10
Kn = [17.50 + 3%] x 100 = 15%
11. Lloyd Luxury Liners has preferred shares outstanding that
8. The finance balance sheet is – the same as the accounting
pay an annual dividend equal to $15 per year. If the current
balance sheet, but it is based on market values
price of Lloyd preferred shares is $107.14,
9. Jacque Ewing Drilling, Inc. has a beta of 1.3. If the risk-
Requirement: the after-tax cost of preferred stock for
free rate of return is 8% and the expected rate of return on
Lloyd is
the market is 12%,
Solution:
D Requirement: The firm’s after-tax cost of equity capital
Kn = 1 + g assuming the firm’s marginal tax rate is 40% would be
P0 +F
15
Kn = 107.14 x 100 = 14% Solution:
KS = KRF + β(KM – KRF)
12. Sheena Wok C3o. is expected to pay a dividend of $1.10
KS = 8% + 1.3(12% - 8%) = 13.2%
one year from today on its common shares. That dividend
10. Which of the following need to be excluded from the
is expected to increase by 5% every year thereafter.
calculation of a firm’s amount of permanent debt? –
Requirement: If the price of Sheena Wok's common stock
revolving lines of credit
is $13.75, the cost of its common equity capital is
11. Maloney’s Inc. has found that its cost of common equity
Solution: 13%
D1 capital is 17% and its cost of debt capital is 6%. The firm
Kn = P +g is financed with $3,000,000 of common shares (market
0 +F
1.10
Kn = [13.75 + 5%] x 100 = 13% value) and $2,000,000 of debt.
Requirement: What is the after-tax weighted average cost
of capital for Maloney’s, if it is subject to a 40% marginal
QUIZZES: (Module 3)
tax rate?
Quiz 5
Solution:
1. Which statement is/are true? – PIPE transactions refer to
Total = 3,000,000 + 2,000,000 = 5,000,000
transactions in which a public company sells
Cost of equity = 3,000,000/5,000,000 = 60%
unregistered stock to a hedge fund or some other
Cost of debt = 2,000,000/5,000,000 = 40%
institutional investor, The biggest drawback of private
WACC = (60% x 17%) + [(40% x 6%) x (1 – 40%)] =
placements involves restrictions on the resale of the
11.64%
securities
12. A typical venture capital fund may generate annual returns
2. Bootstrapping is the process by which – many
of – 15% to 25% on the money that it invests, compared
entrepreneurs raise seed money and obtain other
with an average annual return for the S&P 500 of
resources necessary to start their businesses
almost 12%
3. Disadvantages of going public include all except –
13. The market value of a firm’s asset is $3,500,000,000. If the
managers’ tendency to focus on long-term profits
market value of the firm’s liabilities is $2,000,000,000
4. To reduce risk in any particular investment, venture
Requirement: The market value of the stockholder’s
capitalists _____ – adopt syndications
investment is
5. If a company’s weighted average cost of capital is less than
Solution:
the required return on equity, then the firm – has debt in
Market value = 3,500,000,000 – 2,000,000,000 =
its capital structure
1,500,000,000
14. The recommended model to estimate the cost of common 8. A firm plans to issue $1 million worth of debt at an YTM
equity for a firm is – the capital asset pricing method of 9%. The debt is trading at par. The firm’s marginal
(CAPM) corporate tax rate is 35%.
15. Which statement is/are true? – In the firm-commitment Requirement: What is the present value of the tax savings
underwriting, which is more typical, the investment if the debt never matures?
banker guarantees the issuer a fixed amount of money Solution:
from the stock sale PV of tax savings = 1,000,000 x 35% = 350,000
16. Basic services provided by investment bankers bringing 9. A firm’s capital structure is the mix of financial securities
securities to market include – origination, underwriting, used to finance its activities and can include _____, _____,
distribution and _____ – debt, preferred stock, common stock
10. The _____ theory of capital structure postulates that
Quiz 6 managers set a specific target for the capital structure of a
1. The underinvestment problem occurs in a financially firm in which they try to achieve the mix of debt and equity
distressed firm when – the value of investing in a positive that will minimize the cost of financing the firm's projects
NPV project is likely to go to debt holders instead of and thereby maximize its value – trade-off
equity holders 11. The asset substitution problem occurs when – managers
2. The _____ theory says that, instead of trying to achieve a substitute more risky assets for less risky ones to the
specific target capital structure, firms use the cheapest from detriment of bondholders
of capital available at any given time, until it is used up – 12. The _____ capital structure for a firm is the combination of
pecking order debt and equity financing, which minimizes the overall cost
3. Which statement is/are true? – without debt in the capital of financing the firm’s real activities (projects) – optimal
structure, there are no asset substitution or
underinvestment problems
4. The use of debt financing – limits the ability of managers
to waste stockholders’ money
5. In order to calculate the present value of debt tax savings,
the _____ is used as the discount rate – required rate of
return on debt
6. Financial risk – refers to the effect that a firm’s financing
decisions have on the riskiness of the cash flows that the
stockholders will receive
7. Suppose that Banana Computers has $1,000 in revenue this
year, along with COGS of $400 and SG&A of $100. The
required rate of return on its equity is 14%, and the risk-
free rate is 5%. Assume that the COGS only include the
marginal costs of selling a computer. Banana is considering
adding $700 worth of debt with a coupon rate of 5% and an
YTM of 7.9% to its capital structure
Requirement:
a. Suppose, revenues fall by $300, what is the percent
change in net income with and without the debt?
Assume that the total variable production costs remain
the same.
Solution:
Net income w/o debt = 700 – 400 – 100 = 200
Net income % change w/o debt = [100 - (200/500)]
x 100 = 60%
Net income w debt = 700 – 400 – 100 – (700 x 5%)
= 165
Net income % change w debt = [100 - (165/465)]
x 100 = 64.5%
b. The net income of Banana without debt is
Solution:
Net income w/o debt = 1,000 – 400 – 100 = 500
c. The net income of Banana with debt is
Solution:
Net income w debt = 1,000 – 400 – 100 – (700 x
5%) = 465