FINANCE

12. Capital Structure and Cost of Capital

Professor André Farber

Solvay Business School

Université Libre de Bruxelles
Fall 2004
 Risk and return and capital budgeting

• Objectives for this session:

– Beta of a portfolio
– Beta and leverage
– Weighted average cost of capital
– Modigliani Miller 1958

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 Beta of a portfolio

• Consider the following portfolio

Stock Value Beta
A nA  PA A
B nB  PB B
• The value of the portfolio is:
V = n A  PA + nA  P B
• The fractions invested in each stock are:
Xi = ( ni Pi) / V for i = A,B

• The beta of the portfolio is the weighted average of the betas of the
individual stocks
 P = XA  A + X B  B

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 Example

• Stock $  X
• ATT 3,000 0.76 0.60
• Genetech 2,000 1.40 0.40
• V 5,000

 P = 0.60 * 0.76 + 0.40 * 1.40 = 1.02

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 Application 1: cost of capital for a division

• Firm = collection of assets

• Example: A company has two divisions
• Value($ mio) 
• Electrical 100 0.50
• Chemical 500 0.90
• V 600
• firm = (100/600) * (0.50) + (500/600) * 0.90 = 0.83

• Assume: rf = 5% rM - rf = 6%
• Expected return on stocks: r = 5% + 6%  0.83 = 9.98 %
• An adequate hurdle rate for capital budgeting decisions ? No
• The firm should use required rate of returns based on project risks:
• Electricity : 5 + 6  0.50 = 8% Chemical : 5 + 6  0.90 = 10.4%
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 Application 2: leverage and beta

• Consider an investor who borrows at the risk free rate to invest in the
market portfolio
• Assets $  X
• Market portfolio 2,000 1 2
• Risk-free rate -1,000 0 -1
• V 1,000

 P = 2  1 + (-1)  0 = 2

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 Expected Return
Expected Return

P
20% P

14% M
14% M

8%
8%

Sigma 1 2 Beta

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 Cost of capital with debt

• Up to now, the analysis has proceeded based on the assumption that

investment decisions are independent of financing decisions.
• Does
• the value of a company change
• the cost of capital change
• if leverage changes ?

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 An example

• CAPM holds – Risk-free rate = 5%, Market risk premium = 6%

• Consider an all-equity firm:
• Market value V 100
• Beta 1
• Cost of capital 11% (=5% + 6% * 1)
• Now consider borrowing 10 to buy back shares.
• Why such a move?
• Debt is cheaper than equity
• Replacing equity with debt should reduce the average cost of
financing
• What will be the final impact
• On the value of the company? (Equity + Debt)?
• On the weighted average cost of capital (WACC)?

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 Weighted Average Cost of Capital

• An average of:
• The cost of equity requity
• The cost of debt rdebt
• Weighted by their relative market values (E/V and D/V)

E D
rwacc  requity   rdebt 
V V

• Note: V = E + D

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 Modigliani Miller (1958)

• Assume perfect capital markets: not taxes, no transaction costs

• Proposition I:
• The market value of any firm is independent of its capital structure:
V = E+D = VU

• Proposition II:
• The weighted average cost of capital is independent of its capital
structure
rwacc = rA
• rA is the cost of capital of an all equity firm

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 Using MM 58

• Value of company: V = 100

• Initial Final
• Equity 100 80
• Debt 0 20
• Total 100 100 MM I

• WACC = rA 11% 11% MM II

• Cost of debt - 5% (assuming risk-free debt)

• D/V 0 0.20
• Cost of equity 11% 12.50% (to obtain rwacc = 11%)
• E/V 100% 80%

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 Why is rwacc unchanged?

• Consider someone owning a portfolio of all firm’s securities (debt and

equity) with Xequity = E/V (80% in example ) and Xdebt = D/V (20%)

• Expected return on portfolio = requity * Xequity + rdebt * Xdebt

• This is equal to the WACC (see definition):
rportoflio = rwacc
• But she/he would, in fact, own a fraction of the company. The expected
return would be equal to the expected return of the unlevered (all equity)
firm
rportoflio = rA
• The weighted average cost of capital is thus equal to the cost of capital of
an all equity firm
rwacc = rA

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 What are MM I and MM II related?

• Assumption: perpetuities (to simplify the presentation)

• For a levered companies, earnings before interest and taxes will be split
between interest payments and dividends payments
EBIT = Int + Div
• Market value of equity: present value of future dividends discounted at the
cost of equity
E = Div / requity
• Market value of debt: present value of future interest discounted at the cost
of debt
D = Int / rdebt

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 Relationship between the value of company and
WACC
• From the definition of the WACC:
rwacc * V = requity * E + rdebt * D
• As requity * E = Div and rdebt * D = Int
rwacc * V = EBIT

V = EBIT / rwacc
Market value of EBIT is If value of company
levered firm independent of varies with leverage, so
leverage does WACC in
opposite direction

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 MM II: another presentation

• The equality rwacc = rA can be written as:

D
requity  rA  (rA  rdebt ) 
E

• Expected return on equity is an increasing function of leverage:

requity
12.5%
Additional cost due to leverage
11%
rA rwacc

5%
rdebt
D/E
0.25
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 Why does requity increases with leverage?

• Because leverage increases the risk of equity.

• To see this, back to the portfolio with both debt and equity.

• Beta of portfolio: portfolio = equity * Xequity + debt * Xdebt

• But also: portfolio = Asset
• So:
E D
 Asset   Equity    Debt 
ED ED

• or
D
 Equity   Asset  (  Asset   Debt ) 
E

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 Back to example

• Assume debt is riskless:

D V
 Equity   Asset (1  )   Asset
E E

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