Chapter 5

Capital Structure and Cost of Capital

5.0 Introduction

This chapter is going to focus on capital structure and cost of capital. It is

the duty of the finance manager to come up with a proper and robust capital

structure which allow the company to achieve its objectives. By the same

token, the finance manager must also ensure that the company can secure

capital at the lowest cost in order for it to attain the overall goal. With this in

mind, this chapter focuses on the importance of cost of capital, types of

capital, determination of cost of equity, cost of equity using Capital Asset

Pricing Model (CAPM), cost of debt, cost of preference shares, and

determination of Weighted-Average Cost of Capital (WACC).

5.1 Cost of Capital Defined

Within the existing finance literature, cost of capital has been defined in

three different ways:

a) It is the cut-off rate which separates viable from non-viable investment

opportunities

b) It is the minimum return that a firm requires from an investment so as to

increase the value of the firm in the market place.

b) It is the minimum return that finances would require on a capital project

implying that a firm must not invest on a project that will result in return

which is below the cost of capital.

NB. Cost of capital is the rate of return that a firm must earn on its project

investments to maintain its market value. It represents the investors`

opportunity cost of taking on the risk of putting money into a company. The

firm must not invest on a project that will result in a return which is below

the cost of capital. Only those firms that are able to offer the prospect of a

return in excess of a cost of funds will be able to attract funds required to

grow and those unable to do so will normally wither to extinction. Cost of

capital can also be defined as the rate of return that a firm must earn on its

capital projects in order to maintain its attractiveness.

5.2 Importance of cost of capital

It is important to correctly compute an organization’s weighted average cost

of capital since the weighted average cost of capital affects a number of

important decisions that will be made by the organization’s management.

5.2.1 Weighted average cost of capital and security valuation

Security analysts employ the weighted average cost of capital when valuing

financial securities. In the valuation of financial securities the weighted

average cost of capital is used as a discount rate, which is applied to future

cash flows to be generated by the financial instrument being valued. In this

case the weighted average cost of capital will be used as a hurdle rate. If the
weighted average cost of capital is wrongly calculated then the intrinsic

value of the financial instrument as calculated will be wrong.

5.2.2 Weighted average cost of capital and the investment decision

Organizations also use the weighted average cost of capital when evaluating

capital projects. The weighted average cost of capital is used as a hurdle rate

when evaluating project cash flows using the net present value to discount

cash flows. Comparison with the internal rate of return of the company can

also be done to make useful capital budgeting decision. If the weighted

average cost of capital is wrongly calculated then capital projects will either

be wrongly accepted or rejected.

5.2.3 Weighted average cost of capital and economic value added

(EVA)

In financial management economic value added (EVA) is the determination

of value created for the shareholders of the company. The approach used is

as follows:

EVA = NPAT – (NOA * WACC)

Where NPAT = Net profit after taxes

NOA = Net operating assets

WACC = Weighted average cost of capital

Shareholders will receive a positive value added when the return from the

equity employed in the business operations is greater than the cost of

capital.

Schmalenbach, first introduced this concept, but the EVA as used today has

been developed by Stern Stewart and Company.

It can be noted that if the computation of weighted average cost of capital

were wrongly carried out then the value added would be wrong. Any

decisions that are eventually made on the basis of the economic value added

as calculated will be misleading.

5.2.4 Weighted average cost of capital and the individual investor

Weighted average cost of capital serves as a useful reality check for

investors. The average investor may not bother to calculate weighted average

cost of capital because it is a complicated measure that requires much

detailed information but it helps investors to know the meaning of weighted

average cost of capital when they encounter it in brokerage analysts`

reports. Therefore cost of capital is useful in evaluation of performance of

the organization as the organization cannot be said to be performing when it

is not giving high returns to equity holders.

5.2.5 Weighted average cost of capital and the dividend policy

Weighted average cost of capital is useful in deciding how much of the

company’s earnings should be channeled towards dividends.

5.2.6 Weighted average cost of capital and the capital structure

Weighted average cost of capital is also useful in capital a structure decision

that is it is used in planning on the composition of debt or equity a company

should have.

NB. It is important therefore to realize that in most cases the capital projects

that the firm invests in are financed by capital from different sources

5.3 Types of capital

5.3.1 Equity capital

Is referred to as ordinary share capital or common stock. It is supplied by

the enterprise or owners when starting up a business. It’s a risky capital

because they do not automatically get a dividend as dividends are declared

after all costs have been met. However, it has a higher return which is a

high cost to the firm.

5.3.2 Debt capital

Is borrowed capital from debentures, loan notes and warrants. It is secured

and therefore the risk is low as well as returns implying that it’s a low cost

to the firm. The major advantage of using it is that it is tax deductible.

5.3.3 Preferred Equity

This is hybrid capital; it has both common stock and debt properties.

Holders receive fixed dividends and are paid before ordinary shareholders. It

is a low-risk form of capital and can also be cumulative in nature.

The above-mentioned components of capital have different risk levels and

profiles as well as costs. It is from this perspective that the cost of different

sources of capital used within the firm should be evaluated and understood

before the overall cost of capital can be computed.

Cost of equity Cost of pref share Cost of debt

ke capital (kp) kd

Weighted average cost of capital

(WACC)

WACC is the rate which is then used as a discounting rate to determine

long-term capital projects’ attractiveness (capital budgeting) as it also

represents the investor's required rate of return (WACC=RRR) on a

particular capital project.

5.4 Computation of the cost of capital

It is a two-step process:

a) Computation of costs of specific sources of capital that is the cost of

equity, debt and preferred equity.

b) Computation of WACC

Where WACC = We ke +We kd(1-t) +Wp kp

Where ke is the cost of equity

kd is the cost of debt before tax

kp is the preferred share capital

We is the weight of equity

Wd is the weight of debt

Wp is the weight of preferred equity

NB. On equity, debt and preferred share capital we take the market value of

each.

How to calculate the weights?

We = E Wd= D Wp =P
E + P+ D E + P+ D E + P+ D

5.5 Determination of cost of equity

This is the return that equity investors require in their investment in the

firm and in order to determine what equity investors require. We basically

use two approaches:

a) The Gordon constant growth model (Dividend growth model)

b) The Capital Asset Model (CAPM)

Determination of cost of equity depends on the assumption made regarding

the dividends to be paid by the equity being looked at.

5.5.1 Cost of equity with a constant dividend

If the rate of ordinary dividend is assumed to be fixed, cost of equity (ke) is

obtained as follows:

(ke) = Ordinary dividend payable * 100

Market price ex-dividend

Worked Example: A $1.00 share is quoted at $2.32 and is about to receive

a $0.20 dividend. Calculate the cost of equity.

ke = $0.20 * 100
$2.32 -$0.20

= 9.43%

5.5.2 Cost of equity with constant growth dividends (The Gordon

Model.)

The model uses expected dividends at the end of twelve months and the

annual growth rate of dividends as well as the price of shares in question

excluding (exc div) dividends. Thus the cost of equity is obtained as follows:

ke = D1 + g
Po (ex div)

Where D1 =dividend per share expected after one financial year

Po=current market price of share excluding dividends

g =constant annual growth rate of dividends into the foreseeable future or forever

Do =current dividend

Dividend expected on a financial year is computed as

D1=Do (1 +g) therefore the above formula can be shown as ke= Do(1 + g) +g

Po
Worked Example:
A and C Pvt Ltd has shares with a market price of $20 per share. It is about
to pay a $4 dividend per share which dividend is expected to grow at an
annual rate of 5% per year into the future. Determine the cost of equity for
this company

Ke = D1 +g
Po (ex div)

=4(1.05) + 0.05
20-4
=0.3125
=31.25%

Therefore, for equity investors to be adequately compensated for their funds,

they require 31.25 cents for every dollar invested in the firm.

5.5.3 Cost of new equity

If a company has a new capital project it wants to implement and decides to

raise the required funding through the issue of new ordinary shares, it

naturally incurs floatation costs (costs of issuing shares). Sometimes the

new issue may be deliberately underpriced in order to make it more

attractive and under such circumstances, the cost of new equity is then

estimated as follows:

ken = D1 +g
net proceeds from sale of new shares (Np)

where D1 is the expected dividend per share

Np is the net proceeds from the sale of each share

g is the constant annual growth rate of dividends

Worked Example:
T Ltd wishes to raise new equity finance to expand its existing operations.
The new issue will have an intrinsic value of $50 per share and the expected
dividend at the end of the first year is $10 per share. Dividends are expected
to grow at an annual rate of 12% into the future. If $2 per share
underpricing is necessary to make the issue attractive and flotation costs is
5% of the fair value of each year. Determine the cost of new equity finances
for T Ltd

D1 =$10 g=0.12 N =50-2-2.5=45.5 Par value=50 Growth rate =12 % Discount

=$2/share Floatation = 0.05 x 50 =2.5

ke = 10 + 0.12
45.5
=33.98%.
= 34%

NB: If the new issue of ordinary shares is not underpriced, the cost of new
equity becomes:
D1 +g where f represents floatation costs rate
(1-f) Po

=10 + 0.12
(1-0.05)50
=33.05%

NB. Tax adjustment: No tax adjustment is necessary as ordinary dividends

are paid out of after-tax cash flows.

Follow up question
F Ltd. uses a constant growth model. Its expected dividend at the end of the
coming year is $4.00. Its current market price is $50.00 and the expected
growth rate of dividends is 5%. If a $3.00 underpricing is necessary because
of the competitive nature of the market and an underwriting fee of $2,50 per
share is required, what is the cost of new ordinary shares?
 5.6 Limitations to computation of cost of equity

5.6.1 The computational assumption is that the dividend valuation

model is valid. This may not be the case.

5.6.2 The computational assumption is that dividends are payable at

annual intervals. In practice, this is not usually the case as there

are interim dividends.

5.6.3 Accurate knowledge of the shareholder’s expected required rate

of return is also assumed. If what the shareholder requires, for

some reason changes, and this is unknown to the organization,

then the valuation becomes wrong. This problem is usually

brought about by growth in dividends.

5.7 Cost of equity using Capital asset pricing model (CAPM)

Due to the weaknesses of the Gordon model in estimating costs of equity,

that is not all companies regularly declare or payout dividends and

difficulties in estimating the dividend growth with accuracy, the CAPM

becomes handy in estimating the cost of equity. The model describes the

relationship between the required rate of return (cost of equity) and non-

diversifiable risk of a firm as measured by a beta coefficient (b) in the

following manner:

.
ke = Rf + b (rm – rf)
where Rf is the risk rate of return (return paid by government securities)
rm is the market rate of return on average rate of return
b (beta) measures the sensitivity of a company’s market operations to changes in the
market conditions. It is a measure of risk for the firm. The higher the beta, the
higher the return
Worked Example:
Suppose the risk-free rate is 6% and the return in the market is 11%. Estimate
the cost of equity for a company with beta coefficient of 1.2.

Solution
ke =Rf + b (Rm-Rf)
=0.06 + 1.2(0.11-0.06)
=0.12
NB. For new capital projects, the Beta for similar companies in the same line
of business may be used as estimates.

Follow up question
X Ltd in the beverage industry has an equity beta coefficient of 1.3. The
average company in the industry is generating an annual return of 20% but
government long-term debt securities are giving a return of 12% per year.
Calculate the cost of equity for X Ltd.

Advantage of the CAPM approach: While the constant growth model does
not look at risk and uses the market price to reflect the expected risk-return
preferences of investors the CAPM directly considers the firm’s risk as
reflected by beta.

Disadvantage of the CAPM approach: It is not easy to adjust for

floatation costs when using CAPM, as is the case with the Gordon model

5.8 Determination of cost of debt

Cost of debt: Investors who subscribe to debentures anticipate future

interest payments. This means that the present value of a debenture is

equal to the investor’s future expected receipts discounted at the investor's

required rate of return. Debt can be redeemable or perpetual. Can also be

issued at par, at a premium or at a discount.

5.8.1 Component cost of irredeemable debentures

These debentures give a return to the investor in the form of a constant

interest payment, which is paid in perpetuity. Debentures are usually

denominated in units of $1 000 or $100 nominal value and companies are

entitled to tax relief on the interest payable on debenture capital.

Cost of debt (kd) = Interest charge

Market value of debt (exc interest)
Where kd = before tax cost of debt

However, when there is tax the cost of debt becomes:

ki =interest charge(1-t)
Market value of debt (exc interest)

Where t = marginal tax rate of corporation tax payable

Worked Example:
A Ltd. has in issue 6% debentures quoted at $980 cum interest. Calculate the
cost of debt, assuming a tax rate of 35%.

ki = $60 (1 – 0.35) * 100

$980 - $60

= $39 * 100
$920

= 4.24%

Assumption: Interest is payable annually

5.8.2 Component cost of redeemable long- term debt

The cost of debt is the return that the firm’s long-term creditors require on

borrowing. Since interest on debt is tax-deductible/tax allowable, the

starting point is to establish the before-tax cost of debt (kd) and then provide

the tax adjustment. The tax adjustment is necessary because the effect of

tax-deductibility of interest on debt is to reduce or lower the cost(ki) through

a tax saving created (tax shield). One way of doing it is to approximate the

cost of debt using the yield to maturity. This approach relies on the use of

the approximate yield to maturity on similar risk bonds. This approximate

YTM will then be used as the before-tax cost of debt (kd).

YTM=I +Fd-wd
n

Fd +2wd
3
This YTM will then be the before tax cost of debt for redeemable debt.
Where I is the annual interest paid on the debt security in dollars
Wd is the market value of debt
Fd is the face value of debt
N is the number of years remaining to maturity.

The YTM can also be approximated as follows when flotation costs are
involved.
For a bond with a $1 000 par value the approximate YTM (kd) is obtained by
the following equation:
kd =I + 1/n(P-NP)
1/2(P + NP)

Where P= proceeds at par

I=interest
n = number of years in which debt is to be redeemed
NP =net proceeds from sale of bonds
After tax cost of debt (ki): Since interest on debt is tax deductible /tax
allowable, a tax adjustment is required because the real cost of debt should
be lower. Once the cost of debt before tax has been obtained, the next thing
is to calculate the firm’s cost of debt (ki) since it is the required real cost of
debt and this is obtained as follows:

ki = kd (1 – t)

Where kd = before tax cost of debt

t = tax rate

Worked Example:
A company issues $100 000 10% redeemable debentures at a 5% discount.
The floatation costs are $3 000 and the debentures are redeemable after 5
years, compute the before tax and after tax cost of debt if the tax rate is 50%

Solution
kd =I + 1/n(P-NP)
1/2 (P +NP)
I =10 000 n=5 P=100 000 NP=95 000-3 000=92 000
kd =10 000 +1/5(100 000-92 000)
1/2 (100 000 + 92 000)
=11 600
96 000
=12.08%

ki =kd(1-t)
12.08(1-0.5)
=6.04%

Follow up questions:
a) A company issues new 15% debentures of $1 000 face value to be
redeemed after 10 years. The debenture is expected to be sold at 5%
discount. It will also involve floatation costs of 5%. The company’s tax rate is
50%. What would the cost of debt be?

b) Mamoyo Holdings has debentures outstanding with 5 years left before

maturity. The debentures are currently selling for $90 (the face value is
$100). The debentures are to be redeemed at 5% premium. The interest is
paid annually at a rate of 12%. The firm tax rate is 50%. Calculate the after-
tax cost of debt.

5.9 Effect of tax deductibility on interest on the cost of debt

Worked Example:
Suppose we have got 2 companies A and B with identical operating profits of
$100 000 annually on which they pay corporate tax of 30%. However, B Ltd
has an issue of $50 000 debentures on which it is paying 25% interest per
annum. Determine the effect of interest

Benefits of using debt deductibility on the after-tax cost of debt

Item A Ltd B Ltd Cost/Benefit
Operating income 100 000 100 000
Interest ---------- (12 500) 12 500
Income b4 100 000 87 500
taxation
Tax @30% 30 000 26 250 3 750
Earnings 70 000 61 250 8 750
available for
distribution

Ki=8 750 x 100 =17.5%

50 000
or
Ki=kd (1-T) =0.25(1-0.03) = 17.5%

5. 10 Cost of preference shares

Preference shares are another source of capital used by the firm to finance
their long-term capital projects. As with debentures, the cost of preference
shares is calculated on the assumption that the market value of the share is
equal to all expected future receipts (dividends) discounted at the investor’s
required rate of return.

a) Cost of irredeemable preference shares

Cost of preference shares (kps) = Preference dividend payable = Dp

Market value of share ex div Po (exc div)
If floatation costs are incurred these have to be incorporated in the
calculation of the cost of preference shares.

Kpn = Dp or kpn = kp
Np (1-f) where kp is the pref dividend rate(%) f is
floatation cost rate

Where kp = before tax cost of preference shares

Dp = annual preference dividend payable
Np = Net proceeds from sale of preference shares.

Worked Example:
D Ltd. is considering issuing 10% preference shares that are expected to sell
for $87 per share par value. Floatation costs are expected to be $5.00 per
share. Calculate kpn.

Dp = 10/100 x $87 = $8.70

Np = $87 - $5 = $82

Kpn = $8.70 x 100

$82.00

= 10.61%

Follow up question
X Ltd is considering issuing 15% pref shares that are anticipated to sell at
$120/share. If floatation costs of 10% per share will be incurred, calculate
the cost of this new issue of pref share capital

Tax adjustment
No tax adjustment to before tax cost of preference shares is necessary since
preferred share dividends are paid out from the firm’s after-tax cash flows.

b) Cost of redeemable preference shares

The method is identical to that used for redeemable debentures ignoring
corporate tax. However, remember to substitute interest (I) with (D) since
preference shares earn dividends

5.11 Determination of weighted average cost of capital (WACC)

Having completed the cost components of various sources of capital, ie

equity,pref shares and debt, the next thing is to determine the average cost

of financing being used in the firm which is referred to as WACC. Closely

defined,WACC is the cost of capital as a whole ie the rrr of the overall firm.

More specifically, it is the average cost of the company’s finance weighed

according to the proportion of each source of capital contribution to the total

pool of funding. The funds are used partly in existing operations and partly

to finance new projects. In practice, there is usually no separation between

funds from different sources and their application to specific capital

projects. Thus, the need to determine the average cost of financing which is

the rate of return that financial managers use to evaluate all possible

investments opportunities so as to determine which one to invest in for

purposes of value creation. To accomplish this, the different proportions of

various sources of capital in the firm’s capital structure is then used as

weights as follows;

WACC = (wi * ki) + (wp * kp) + (we * ke)

Where
Wi = proportion of long-term debt in the capital structure,
Ki = after tax component cost of debt,
Wp = proportion of preference shares in the capital structure,
Kp = component cost of preference shares,
We = proportion of ordinary shares in the capital structure,
Ke = component cost of ordinary shares.
 Wi + wp + we = 1.0.

For computational convenience one can convert the weights to decimal form

and leave component costs in percentage terms.

Weights can be calculated as book value or market value:

i)Book value weights

Accounting book values are used to measure the proportion of each type of

capital in the financial structure when calculating the weighted average cost

of capital.

The advantage of this approach is that the accounting information is readily

available. The disadvantage is that book values do not usually indicate the

approximate value that could be realized on the sale of the assets.

ii) Market value weights

The market values of each type of capital in the firm’s capital structure are

used to establish the weights to use when calculating the weighted average

cost of capital.

The advantage of using market values is that the market values closely

approximate actual dollar amounts to be realized should assets be sold. The

problem, however, is the fact that market values are generally not readily

available.

Example
The accounts of Z Ltd reveals the following capital structure as at 31/12/2019
 $
$2 ordinary shares 4 000 000
Retained earnings 2 500 000
15% 100 debenture stock 2 000 000
8 500 000
Additional information
Ordinary shares for the company are currently valued at $3 after dividends have been paid.
Debenture stock is selling for $95 per stock. The cost of equity has been estimated at 28%
and the applicable corporate tax is 30%.

Required:
a) Determine both the book and market value weights for these capital components
b) Calculate the after-tax cost of debt for Z ltd
c)Compute the WACC for Z Ltd and comment on the viability of a potential capital project
with an expected annual return of 26% using market values.

a) Book value weights

We =4 000 000 + 2 500 000 = 6 500 000 = 76.4%
8 500 000
Wi = 2 000 000 = 23.6%
8 500 000

Market values
Ordinary equity (2m shares x3) 6 000 000
Debentures (2m/100) x $95 1 900 000
7 900 000

NB: Retained earnings amount is ignored because it's reflected in the market value

We = 6 000 000 = 75.9%

7 900 000

Wi = 1 900 000 =24.1%

7 900 000

b)ki=kd(1-t)=0.15(1-0.3) =10.5%

c)WACC= Weke + Wiki=(0.759 x 0.28) + (0.241 x 0.105)=0.237825=23.8%

Comment: Therefore the potential project is a viable investment as it has the potential to add
value to the firm ie(26- 23.8) = 2.2 cents per every $1 of investment

Practice question
Dee Ltd has the following cost situation
Debt:2 000 bonds were issued 5 years ago at a coupon rate of 15% p.a. They had a 15 year
term and $1 000 face value. They are now selling to yield 10% (kd) but interest is paid semi-
annually.
Preferred stock:4 000 shares of pref shares are outstanding each of which we pay an annual
dividend of 15% on face value of $50.The are now selling to yield 13% p.a
Equity:Dee Ltd has 200 000 ordinary shares outstanding currently selling at $15/share. The
estimated cost of equity is 20% p.a whilst corporate tax is 30%
Required
a) Determine both the book value and market values
b) The business cost components
c)Calculate Dee Ltd’s WACC using market values
d)Compute the capital gearing of this company assuming that the preferred stock is
cumulative in nature and comment given that the industry’s average gearing is 30%

Po =I(PVIFA r,n) + M(PVIF r,n)

=75(PVIFA 5%,20) + 1000(PVIF5%,20)
= 75(12.4622) + 1000(0.37689)
=$1 312

Preferred stock =Dp =50 x 0.15 =$57.69

Kp 0.13
Market based structure
Ordinary share capital 15(200 000) 3 000 000
Pref shares 57.69(4000) 230 760
Debt $1312(2000) 2 624 000
5 854 760
Kd=10% kp=13 % ke=20%
We =3 000 000 Wp= 230 760 Wi= 2 624 000
5854 760 5 854 760 5 854 000
= 0.51 = 0.04 = 0.45
After tax cost of debt
Ki=kd(1-t) =10(1-0.03) = 7%
WACC =Weke +Wpkp +Wiki
=(0.51 x20% ) +(0.04 x13%) + (0.45 x7%)
=13.7%

Breaking point
This is the level of total new financing at which the cost of the financing component increases
creating an upward shift in the weighted marginal cost of capital. The breaking point is
obtained by using the following equation:

Breaking point = Amount of financing available from a given financing source

Capital structure weight stated in decimal form

Once the breaking points are established, the different weighted average cost of capital at
given levels of financing can be calculated. From this, the marginal increments, which define
the weighted marginal cost of capital, can be deduced. It is also necessary to have knowledge
of the investment opportunities schedule. This can then be used in conjunction with the
weighted marginal cost of capital to indicate the various investments that will be acceptable.

EXAMPLE.
Nice Time Ltd is a leading company with an optimal capital structure made up of 30% debt,
20% preference shares and 50% equity. The cost of debt is 20%, cost of preference shares is
18% and cost of equity is 24%. The company can borrow up to $2.4 million in debentures
and $3 million in preference shares without a change in the cost of debt and preference shares
respectively. The expected retained earnings for the firm are $5 million after which the cost
of equity would increase because of floatation costs. If additional debt finance over $2.4
million is required the cost will increase by 15%, additional preference shares over $3 million
will increase the cost of preference shares to 24% and a new issue of ordinary shares will
increase the cost of equity to 28%.
a)What is the breaking point for each source of financing?

Solution
Breaking point (Equity) = $5 000 000
0.50
= $10 000 000
Breaking point (Debt) = $2 400 000
0.30
= $8 000 000
Breaking point (Preference shares) = $3 000 000
0.20
= $15 000 000

5.12 Capital Structure

Most financing decisions in practice revolve around the choice of debt and equity. Thus,
bringing to the concept of capital structure. It is either the firm is using equity or prior charge
capital because it has to be serviced prior/before equity. This capital is in most cases
represented by cum pref shares and long-term liability. Capital structure therefore defines the
different components of capital that build up the total financing of a company. Alternatively,
it reflects the particular mixture of debt and equity capital that the firm employs. Capital
structure unavoidably brings to light the concept of capital gearing which shows the
proportion of prior charge capital in total financing ie how much debt are we using to finance
our operations. It is either the firm is highly geared where the proportion of debt in total
financing will be relatively high. The firm will be using more debt to finance its operations
on shareholders’ funds.

The major advantage of high gearing arises from the tax savings created by debt capital as
interest on debt is tax allowable. Thus, it creates a tax shield for the company hence reducing
the impact of taxation on corporate profits as well as reducing the cost of debt. On the other
hand, the major disadvantage arises from the fact that heavy reliance on debt financing means
high interest obligations on payments which reduces the earnings available to shareholders.
High borrowings may also lead to inability to meet interest obligations especially during
years of poor trading thus the possibility of choking the firm. In addition, shareholders are
thus exposed to a 2nd category or tier of risk and the inherent business risk of the trading
activity as a result, rational shareholders may seek additional compensation for this extra
exposure hence pushing the cost of capital upwards for the firm. Low or no gearing may not
necessarily be in the equity best interest because the company may be failing to exploit the
benefits of borrowing provided that the return generated from borrowed funds is greater than
the cost of the funds, capital gearing can be increased.

In light of the above, the levels of capital gearing in the firm has multiple effects as it also
affects even the dividend policy of the company. Capital gearing is thus obtained as follows:

CG=Long term borrowing or prior charge capital

 Long term borrowing + equity prior charge capital + equity

NB: Whenever possible, market values should be used in preference of book values for
determining capital gearing ratio. This is because market value reflects better what the market
is prepared to offer for the company assets now than the book values(historical). However,
when equity is valued using book values, it must include any reserves or retained earnings as
this is part of shareholders’ funds not distributed
Book value equity = ordinary share capital +reserves
When market values are used, reserves must be excluded since they are already reflected in
the current market price, thus market value equity = current market price per share x number
of ordinary shares

Example
The following is an extract from T Ltd as at 31 Dec 2013
$1 ordinary shares 250 000
Retained earnings 350 000
10% pref shares of $1 each 250 000
15% 100 unsecured loan stock 150 000
1 000 000
Additional information
Ordinary shares are currently trading at $5 each. Loan stock is quoted at $90 per $100
nominal value on the market and preference shares are selling for $0.75 each.
Determine the capital gearing ratio for the firm using market values

Market values
Ordinary shares 5(250 000) 1 250 000
Pref shares 0.75(250 000) 187 500
Loan stock (150 000/100) x 90 135 000
1 572 500

Capital gearing = PCC = 135 000 +187 500 = 0.21

PCC + equity 1 572 500

NB: For every $ used in the firm,0.21 is representing PCC.Any decision which a firm takes
has some uncertainty about it and uncertainty is about not knowing what will happen in
future. There is uncertainty in almost every investment decision manager make because no
one knows precisely what changes will occur in such factors like tax, laws, consumer
demand, inflation, interest rate, government policy and the economy at large.

Practice problems on weighted average cost of capital

Problem 1
Assuming the corporate tax rate of 55%, compute the after tax cost of capital in the following
situations:
a)A perpetual 12% debenture of $1 000, sold at the premium of 10% with no flotation costs.
b)A fifteen – year 10% debenture of $2 000, redeemable at par, with 3.75% floatation costs.
c)A ten – year 11% Preference share of $100, redeemable at a premium of 5%, with 5%
floatation costs.
d)An equity share selling at $50 and paying a dividend of $6 per share, which is expected to
be continued indefinitely.
e)The same equity share (in iv above), if dividends are expected to grow at the rate of (a) 5%,
(b) –5%.
f)An equity share, selling at $120 per share, of a company that engages only in equity
financing. The earnings per share amounts to $20 of which 50% is paid in dividends. The
shareholders expect the company to earn a constant after – tax rate of 10% on its investment
of retained earnings.

Problem 2
From the following information supplied, determine the appropriate weighted average cost of
capital, relevant for evaluating long – term investment projects of the company:

Cost of equity 12%

After – tax cost of long – term debt 7%
After – tax cost of short – term loans 4%

Source of capital Book value Market value

$ $
Equity 500 000 750 000
Long – term debt 400 000 375 000
Short – term debt 100 000 100 000
1 000 000 1 225 000

Problem 3
An electricity equipment manufacturing company wishes to determine the weighted average
cost of capital for evaluating capital projects. You have been supplied with the following
information to calculate the value of the weighted average cost of capital:

Balance sheet at 31 March 2006

Assets $
Sundry assets 3 900 000

Liabilities and equity

Equity shares 1 200 000
Preference shares 450 000
Retained earnings 450 000
Debentures 900 000
Current liabilities 900 000
3 900 000

Anticipated external financing information:

20 year, 8% debentures of $2 500 face value, redeemable at 5% premium sold at par, 2%

floatation costs.
10% preference shares: sale price $100 per share, 2% floatation costs.
Equity shares: sale price $115 per share floatation costs would be $5 per share.

The corporate tax rate is 55% and expected equity dividend growth is 5% per year. The
expected dividend at the end of the current financial year is $11 per share. Assume that the
company is satisfied with its present capital structure and intends to maintain it.
Problem 4
Zamndela Investments is interested in measuring its cost of specific types of capital as well as
its overall capital cost. The finance department of the company indicates that the following
costs would be associated with the sale of debentures, preference shares and equity shares.
The corporate tax rate is 55%.

Debentures: The company can sell 15 – year 10% debentures of the face value of $1 000 for
$970. In addition, an underwriting fee of 1.5% of the face value would be incurred in this
process.

Preference shares: 12% preference shares having a face value of $100 can be sold at a
premium of 10%. An underwriting fee of $2 per share is to be paid to the underwriters.
Equity shares: The Company’s equity shares are currently selling for $125 per share. The
firm expects to pay $15 per share at the end of the coming year. Its dividend payments over
the past 6 years per share are given below:

Year Dividend ($)

1 10.60
2 11.24
3 11.91
4 12.62
5 13.38
6 14.19

It is expected that the new equity shares can be sold at $123 per share. The company must
also pay $3 per share as underwriting fee.

Market and book values for each type of capital are as follows:

Book value ($) Market value ($)

Long – term debt 1 800 000 1 930 000
Preference shares 450 000 520 000
Equity shares 6 000 000
Retained earnings 1 500 000 1 000 000
9 750 000 12 450 000

Required
a) Calculate the specific cost of each source of financing.
b) Determine the weighted average cost of capital using book value weights and market value
weights.

Problem 5
A company has the following specific cost of capital along with the indicated book and
market value weights.

Type of capital Cost Book value Market value

weights weights
% % %
 Long – term debt 5 30 25
Preference shares 10 20 17
Equity shares 12 40 46
Retained earnings 12 10 12
100 100

Calculate the weighted average cost of capital using book value and market value weights.
Which of them do you consider better and why?
.
5.12 Chapter summary

This chapter has focused on capital structure and cost of capital. It has

been observed that it is the duty of the finance manager to come up with a

proper and robust capital structure which allow the company to achieve its

objectives. By the same token, the finance manager must also ensure that

the company can secure capital at the lowest cost in order for it to attain its

overall goal. With this in mind, this chapter has presented the information

related to the importance of cost of capital, types of capital, determination of

cost of equity, cost of equity using Capital Asset Pricing Model (CAPM), cost

of debt, cost of preference shares, and determination of Weighted-Average

Cost of Capital (WACC).

SELF ASSESSMENT QUESTIONS

1. "In making capital structure decision, finance manager faces the problem
of striking compromise among conflicting but equally important principles of
control, cost, risk and flexibility". Comment upon this statement.
2. Spell out the financial considerations that should be taken into account
while reaching a capital structure decision.
3. Should the finance managers take into consideration environmental
factors while making capital structure decisions?
4. What sort of capital structure would you propose for a company if its
primary objectives were?
(a) To maximise the possible income for common stockholders?
(b) To assure control with a minimum investment?
(c) To minimise fluctuations in earnings per share on common stock?
5. If management agrees that the chances are about 8 out of 20 that
earnings will remain above the break-even point, should they agree to resort
to debt financing? What might deter them from doing so?
6. How would the capital structure of a trading concern different from that
of a manufacturer of trucks? What are the reasons for any differences that
might exist?
7. What differences in typical structures within the industry might you
expect to find if the industry was characterised by greater price competition?
8. What is traditional approach to the concept of capital structure?
9. Explain the position of M-M approach on the issue of an optimal capital
structure, admitting to the existence of the corporate income tax.
10. Evaluate the merits and demerits of each of the capital structure model.