CAPITAL STRUCTURE AND COST OF CAPITAL

Leverage/ Gearing is that portion of the fixed costs which represents a risk
to the firm. Operating leverage, a measure of operating risk, refers to the
fixed operating costs found in the firm’s income statement. Financial
leverage, a measure of financial risk, refers to financing a portion of the
firm’s assets, bearing fixed financing charges in hopes of increasing the
return to the common stockholders. The higher the financial leverage, the
higher the financial risk, and the higher the cost of capital.

Operating Leverage
Operating leverage is a measure of operating risk and arises from fixed
operating costs. A simple indication of operating leverage is the effect that a
change in sales has on earnings. The formula is: Operating leverage at a
given level of sales
percentage change in EBIT percentage change in sales

Financial Leverage
Financial leverage is a measure of financial risk and arises from fixed
financial costs. One way to measure financial leverage is to determine how
earnings per share are affected by a change in EBIT (or operating income).
Financial leverage at a given level of sales .

THE THEORY OF CAPITAL STRUCTURE

The theory of capital structure is closely related to the firm’s cost of capital.
Capital structure is the mix of the long-term sources of funds used by the
firm. The primary objective of capital structure decisions is to maximize the
market value of the firm through an appropriate mix of longterm sources of
funds. This mix, called the optimal capital structure, will minimize the
firm’s overall cost of capital. However, there are arguments about whether
an optimal capital structure actually exists.
The arguments center on whether a firm can, in reality, affect its valuation
and its cost of capital by varying the mixture of the funds used. There are
four different approaches to the theory of capital
structure:
1. Net operating income (NOI) approach

Financial management notes: Prepared by Mchele M. Makwani, University of Dodoma 1

2. Net income (NI) approach
3. Traditional approach
4. Modigliani–Miller (MM) approach

All four use the following simplifying assumptions:

i. No income taxes are included; they will be removed later.
ii. The company makes a 100 percent dividend payout.
iii No transaction costs are incurred.
iv. The company has constant earnings before interest and taxes (EBIT).
v. The company has a constant operating risk.

 Capital structure: is the proportion of firm’s capital which is equity or

debt.

 For most part, the firm can choose any capital structure that it wants.
If management so desired, the firm could issue some bonds and use
the proceeds to buy back some stock, thereby increasing debt to equity
ratio. Alternatively, it could issue stock and use the money to pay off
debt and therefore reducing debt to equity ratio.

 Capital structure decisions can have important implications for the

value of the firms and its cost of capital. The guiding principle is to
choose the course of action that will maximize the value of the firm
and our goal is to benefit the shareholders.

 To assist an appropriate level of borrowing for a firm given its equity

capital base it would be useful to know if it is possible to increase
shareholder’s wealth by changing the gearing (debt to equity ratio)
level.

Debt finance is cheaper and riskier for the company

 Financing a business through borrowing is cheaper than using equity.
That is, first, because lenders require a lower rate of return than
ordinary shareholders. Debt financing securities present a lower risk
than shares for the finance providers because they have prior claims
on annual income and in liquidation.

Financial management notes: Prepared by Mchele M. Makwani, University of Dodoma 2

  A profitable business effectively pays less for debt capital than equity
for another reason: the debt interest can be offset against pre tax
profits before the calculation of the corporation tax bill, thus reducing
the tax paid.

 Thirdly, issuing and transaction costs associated with raising and

servicing debt are generally less than for ordinary shares.

 Therefore, there are some valuable benefits from financing a firm with
debt. So why do firms tend to avoid very high gearing level? (i.e.
high debt to equity ratio) One reason is financial distress risk. This
could be induced by the requirement to pay interest regardless of the
cash flow of the business. If the firm hits a rough patch in its business
activities it may have trouble paying its bondholders, bankers and
other creditors their entitlement. Thus, as gearing increases, the risk of
financial failure grows.

Factors Affecting Capital Structure

Many financial managers believe, in practice, that the following factors
influence financial structure:
i. Growth rate of future sales
ii. Stability of future sales
iii. Competitive structures in the industry
iv. Asset makeup of the individual firm
v. Attitude of owners and management toward risk
vi. Control position of owners and management
vii. Lenders’ attitude toward the industry and a particular firm

EBIT–EPS ANALYSIS

The use of financial leverage has two effects on the earnings that go to the
firm’s common
stockholders: (1) an increased risk in earnings per share (EPS) due to the use
of fixed financial obligations, and (2) a change in the level of EPS at a given
EBIT associated with a specific capital structure.

Financial management notes: Prepared by Mchele M. Makwani, University of Dodoma 3

The first effect is measured by the degree of financial leverage previously
discussed. The second effect is analyzed by means of EBIT–EPS analysis.
This analysis is a practical tool that enables the financial manager to
evaluate alternative financing plans by investigating their effect on EPS over
a range of EBIT levels. Its primary objective is to determine the EBIT break-
even, or indifference, points among the various alternative financing plans.
The indifference points between any two methods of financing can be
determined by solving for EBIT in the following equality:

(EBIT -_ I)(1 -_ t) PD = (EBIT -_ I) (1 -_ t) _ PD

S1 S2
where t=tax rate
PD=preferred stock dividends
S1 and S2=number of shares of common stock outstanding after
financing for plan 1 and plan 2, respectively.

COST OF CAPITAL

Cost of capital is defined as the rate of return that is necessary to maintain

the market value of the firm (or price of the firm’s stock). Managers must
know the cost of capital, often called the minimum required rate of return in:

Importance of cost of capital

(1) Help to make capital budgeting decisions;
(2) Helps to establish the optimal capital structure; and
(3) Making decisions such as leasing, bond refunding, and working capital
management.
The cost of capital is computed as a weighted average of the various capital
components, which are items on the right-hand side of the balance sheet
such as debt, preferred stock, common stock, and retained earnings.

Computing individual cost components of capital

Each element of capital has a component cost that is identified by the

following:
ki= before-tax cost of debt

Financial management notes: Prepared by Mchele M. Makwani, University of Dodoma 4

kd= ki (1_t)=after-tax cost of debt, where t=tax rate
kp= cost of preferred stock
ke= cost of equity, or cost of issuing new common stock
ko= firm’s overall cost of capital, or a weighted average cost of capital

i. Cost of Debt

The before-tax cost of debt can be found by determining the internal rate of
return (or yield to maturity) on the bond cash flows. However, the following
shortcut formula may be used for approximating the yield to maturity on a
bond:

Kb= (I + ( F-P)/n *100%

(F +P)/2
where I=annual interest payments in dollars
F=par value, usually $1,000 per bond
P=value or net proceeds from the sale of a bond
n=term of the bond in years

Since the interest payments are tax-deductible, the cost of debt must be
stated on an after-tax basis. The
after-tax cost of debt is:

Kd= kb (1-t)

Where kb= market return

ii. Cost of Preferred Stock

The cost of preferred stock, kp, is found by dividing the annual preferred
stock dividend, dp, by the net proceeds from the sale of the preferred stock,
p, as follows:

Kp = Dp where Dp is the dividend paid ,p is the market price

p

Financial management notes: Prepared by Mchele M. Makwani, University of Dodoma 5

Since preferred stock dividends are not a tax-deductible expense, these
dividends are paid out after taxes. Consequently, no tax adjustment is
required.

EXAMPLE 10.2 Suppose that the Carter Company has preferred stock that
pays a $13 dividend per share and sells for $100 per share in the market. The
flotation (or underwriting) cost is 3 percent, or $3 per share. Then the cost of
preferred stock is:
Soln Kp = Dp = 13/97 =13.4%
p

iii.Cost of Equity Capital

The cost of common stock, ke, is generally viewed as the rate of return
investors require on a firm’s
common stock. Three techniques for measuring the cost of common stock
equity capital are available:
(1) the Gordon’s growth model; (2) the capital asset pricing model
(CAPM) approach; and (3) the bond plus approach.

The Gordon’s Growth Model. The model is given by

Ke = D1 + g
po

P0=value of common stock

D1=dividend to be received in 1 year
r=investor’s required rate of return
g=rate of growth (assumed to be constant over time)
Solving the model for r results in the formula for the cost of common
stock:

The CAPM Approach.

An alternative approach to measuring the cost of common stock is to use
the CAPM, which involves the following steps:

Financial management notes: Prepared by Mchele M. Makwani, University of Dodoma 6

1. Estimate the risk-free rate, rf, generally taken to be the United States
Treasury bill rate.
2. Estimate the stock’s beta coefficient, b, which is an index of systematic
(or nondiversifiable
market) risk.
3. Estimate the rate of return on the market portfolio such as the Standard &
Poor’s 500 Stock
Composite Index or Dow Jones 30 Industrials.
4. Estimate the required rate of return on the firm’s stock, using the CAPM
(or SML) equation:

ke = Rf + (Rm- Rf)b

Again, note that the symbol rj is changed to ke.

MEASURING THE OVERALL COST OF CAPITAL

The firm’s overall cost of capital is the weighted average of the individual
capital costs, with the weights being the proportions of each type of capital
used. Let ko be the overall cost of capital.

WACC
 It is the overall cost of capital. This is the weighted average of the
individual required rates of (costs).

 A calculation of a firm’s cost of capital; each category of capital is

proportionately weighted.

 All capital sources i.e. common stock, preferred stock, bonds and
notes (debt) and any other long term debt are included in a WACC
calculation. Therefore the capital structure (i.e. the proportion of
firm’s capital which is debt or equity) comprises of these elements.

Financial management notes: Prepared by Mchele M. Makwani, University of Dodoma 7

  Broadly speaking, a company’s assets are financed either y debt or
equity. WACC is the average costs of these sources of financing each
of which is weighted by its respective use.

Formula
WACC is calculated by multiplying the cost of each capital component by
its proportional weight (i.e. how much in terms of dollars or shilling for debt
or equity) and then summing:

WACC=( Kdwd + Kpwd + Kewe)

where wd =percentage of total capital supplied by debt

wp=percentage of total capital supplied by preferred stock
we=percentage of total capital supplied by external equity
wd=percentage of total capital supplied by retained earnings (or internal
equity)

REVIEW QUESTION ON COST OF CAPITAL

QUESTION ONE

The ABC company has 12% coupon rate bonds outstanding that yield 18%
to investors buying them now. The ABC company Marginal tax rate
including local taxes is 37%.

Required:

Determine ABC cost of debt

QUESTION TWO

The capital structure and specific cost of capital components of Azania

wheat processing company have been shown hereunder:

Capital Market Book Cost (%)

value(Tsh) value(Tsh)

Financial management notes: Prepared by Mchele M. Makwani, University of Dodoma 8

Long term debts 4,000,000 3,000,000 10

Preference shares 1,000,000 2,000,000 8

Ordinary shares 5,000,000 5,000,000 12

Required:

Calculate the weighted average cost [WACC] for the above company using

i) Market value

ii) Book value

QUESTION THREE

The sprounts N-steel company has two divisions: health foods and speciality
metals. Each division employs debt equal to 30% and preferred stock equal
to 10% of its total requirements, with equity capital used for the remainder.
The current borrowing rate is 15% and the company tax rate is 40%. At
present, preferred stock can be sold yielding 13%. Sprounts N-steel wishes
to establish a minimum return standard for each division based on the risk of
division. This standard then would serve as the transfer price of capital to the
division. The company has thought about using CAPM in this regard. It has
identified two samples of the companies with modal value betas of 0.90 for
health foods and 1.30 for speciallity metals. (Assume that the sample
companies had similar capital structure to that of sprounts N-steel). The risk
free rate is currently 12% and the expected return on the market portfolio is
17%. Using CAPM approach,

i) Compute CAPM

ii) What is WACC for these two divisions?

Financial management notes: Prepared by Mchele M. Makwani, University of Dodoma 9

Financial management notes: Prepared by Mchele M. Makwani, University of Dodoma 10