CHAPTER THREE

AG
COST OF CPITAL AND
CAPITAL STRUCTURE
Suggested Reading(s)
Eugene F. Brigham & Michael C. Ehrhardt (2020) Financial
Management: Theory and Practice, 16th ed (Chapter 9, 15)
Brigham, E. F., & Houston, J. F. (2019). Fundamentals of financial
management. 15th ed. Cengage Learning (Chapter 10, 14)
 Introduction
 Capital: Investor-supplied funds such as long- and short-
term loans from individuals and institutions, preferred
stock, common stock, and retained earnings.
 Capital Structure: The mix of debt, preferred stock, and
common equity that is used to finance the firm’s assets.
 Capital structure is different from financial structure. 2

AG 2
 Cont’d…
 Financial structure consists of all liabilities and equity
capital.
– Thus, it is the manner how an organization’s assets are
financed.
 Capital structure is the sum of all long-term sources of
3

capital.
– Thus, it is a part of the financial structure.
Financial Structure = Current Liabilities + Debt + Fixed
Preference + Common stock
Capital Structure = Debt + Fixed Preference + Common
stock
AG 3
 Sources of capital

 Ordinary shares (common stock)

 Hybrid securities
– Preference shares (preferred stock)
 Loan capital
– Bank loans
– Corporate bonds

AG 4
 Ordinary shares (common stock) and Preference Shares

Ordinary Shares Preference Shares

Dividends are only paid if  Fixed dividend
profits are made and only  Payment before ordinary shareholders
after other claimants have in a liquidation situation;
been paid e.g. lenders and  No voting rights: Holders of preferred
preference shareholders stock typically are not entitled to vote
A high rate of return is at all.
required/high risk for the  They are hybrid securities with some
investors property of debt and some property of
Provide voting rights - the equity;
appointment of new directors  Cumulative Vs Non-Cumulative
Preference Shares:
Preemptive right  In cumulative PS, all past suspended
No tax benefit, unlike payments must be made in full before
borrowing common stockholders can receive
anything at all.
AG 5
 Loan capital
 Financial instruments that pay a certain rate of interest
until the maturity date of the loan and then return the
principal;
 Bank loans or corporate bonds;
 Interest on debt is allowed against tax;

AG 6
 Optimal capital structure
 Optimal Capital Structure is the capital structure that
Maximizes a stock’s intrinsic value &
Minimizes the weighted average cost of capital
(WACC)
 What factors influence a company’s composite WACC?
7
Market conditions.
The firm’s capital structure and dividend policy.
The firm’s investment policy.
Firms with riskier projects generally have a higher
WACC.

AG 7
 The Cost of Capital

Expected Return Flotation Costs –

cost of issuing
securities to the
general public
Accounting
Risk premium Legal
Risk-
free Printing (prospectus)
rate Time value of money
____________________________________________________ Underwriting
Treasury Corporate Preference Hybrid Ordinary
Risk (investment banker)
Bonds Bonds Shares Securities Shares
Filing Fees (for the
regulator)
AG 8
 The cost of debt

 Required rate of return for creditors

 e.g. Suppose that a company issues bonds with a before tax cost of

10%.
 Since interest payments are tax deductible, the true cost of the

debt is the After Tax cost

ATkd = kd(1 – T)
Where: ATkd=After tax cost of debt; Kd= Before tax cost of debt; T= is tax rate

 If the company’s tax rate is 40%, the after tax cost of debt

AT kd = 10%(1-.4) = 6%
AG 9
 The cost of preferred shareCost Preferred Stock
Cost to raise a birr of preferred stock.
Example: You can issue
preferred stock with a market
price of ETB 45, and flotation
Where: costs of ETB 3 per share and if the
preferred stock pays a ETB 5
Dp = preferred stock dividend
dividend,
Pp = Market price per share
The cost 5.00
of preferred stock:
11.9%
F = flotation costs per share 42.00
Flotation costs reduce the amount of

money you get when you sell preferred

stock
AG 10
 Equity Financing Compute Cost of Common Equity
 The required rate of return on investment of the common
shareholders of the company.
 Two Types of Common Equity Financing
– Retained Earnings (internal common equity)
– Issuing new shares of common stock (external common equity)
 Cost of Common Equity (Retained Earnings)
• Management should retain earnings only if they earn as much as
stockholder’s next best investment opportunity of the same risk.
• Cost of Common Equity = opportunity cost of common stockholders’
funds.
• Two methods to determine
Dividend Growth Model
Capital Asset Pricing Model (Chapter 2).
AG 11
 Compute Cost of Common Equity
Equity Financing

D1
kS = + g
P0

Ks = cost of internal common equity

D1 = the next dividend to be paid
Po = the current market price of the stock
g = the projected rate of growth of the
company

AG 12
 Compute Cost of Common Equity
Equity Financing
Example:

The market price of a share of common stock is ETB60. The prior

dividend (D0) is ETB 3, and the expected growth rate (g) is 10%.

If you are given D0, you must calculate D1

D1 = D0 (1 + g)
D1 = 3.00 (1.10) = 3.30

3.30 + .10 =.155 15.5

kS =
60 = %
AG 13
 Compute Cost of Common Equity
Equity Financing
Cost of New Common Stock

– Must adjust the Dividend Growth Model equation for

flotation (F) costs of the new common shares.

Ks = cost of sale of new common stock

D1 is the next dividend to be paid
Po is the current market price of shares
outstanding
F is the flotation cost

AG G is the rate of growth 14

 Equity Financing
Example:

If additional shares are issued, floatation costs will be 12% of price

per share. D0 = ETB 3.00 and estimated growth is 10%, Price is
ETB 60 as before. Flotation cost = ETB 60 x .12 = ETB 7.20.

(Po – F = 60.00 – 7.20 = ETB 52.80)

(D1 = 3.00 x 1.10 =

3.30)
3.30
ks = 52.80 + .10 = .1625 = 16.25%

AG 15
 Weighted Average Cost of Capital

 ABC Corporation estimates the following costs for each

component in its capital structure:

Source of Capital Cost

Bonds (after tax) kdt = 6.0%

Preferred Stock kp = 11.9%
Common Stock
Retained Earnings ks = 15.5%
New Shares kn = 16.25%

Tax rate is 40%

AG 16
 Weighted Average Cost of Capital
• If using retained earnings (Internal Equity) to finance the equity portion:

WACC = (WTd x AT kd ) + (WTp x kp ) + (WTs

x ks)
WACC = weighted average cost of capital
WT = the weight, or percentage of each element of capital
(% of debt, preferred and common stock to total assets)
ATkd = after tax cost of debt
Kp = Cost of preferred stock
Ks = Cost of equity (Internal – retained earnings)

AG 17
 Weighted Average Cost of Capital
• If using retained earnings (Internal Equity) to finance the equity portion:

WACC = (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

• Assume that ABC’s desired capital Structure is 40% debt,

10% preferred and 30% Internal equity, 20% External
WACC
equity, and . =
Cost of Debt .40 x 6.0% =2.40%
+ Cost of Preferred .10 x 11.9% =1.19%
+New share .20 x16.25% =3.25%
+ Cost of Int. Equity .30 x 15.5% =4.65%
1.00 = 11.49%
AG 18
 Business and Financial risk
 Business risk arises from the nature of the firm’s
business environment and the particular
characteristics of the industry in which it operates
and it is a variable which lies largely outside
management’s control.
 It is possible to measure a firm’s business risk by the 19

degree of variability of its EBIT.

 This type of risk is a function of the firm’s regulatory
environment, labor relations, competitive position, etc.

AG 19
 Cont’d..
 Financial risk represents the risk that arises from a firm’s
level of gearing and is a variable which can be directly
controlled by management.
 This type of risk is a direct result of management decisions
regarding the relative amounts of debt and equity in
the capital structure. 20

 The more debt a firm introduces into its capital structure,

the greater the level of financial risk and the greater the
return the equity shareholders require to compensate for
the additional financial risk.
 It creates the variability of the firm’s EPS.

AG 20
 Capital Structure Theories
 MM theory
 Zero taxes
 Corporate Taxes
 Personal Taxes
 Trade-off theory 21

 Pecking order theory

 Signalling theory
 Windows of opportunity

AG 21
 MM Theory
 Modern capital structure theory began in 1958, when
Professors Franco Modigliani and Merton Miller (MM)
published the most influential finance article ever
written.
 M&M, Nobel Prize winners in financial economics, have had
a profound influence on capital structure theory since their 22

seminal paper on capital structure in 1958.

F. Modigliani M. Miller

AG 22
 Modigliani & Miller I ( MM1) : No taxes
 M&M originally argued, very controversially, against the
traditional model of capital structure and proposed that the
value of a firm is independent of its cost of capital and its
capital structure.
 MM’s study was based on some strong assumptions:
1. There are no brokerage costs.
2. There are no taxes.
23

3. There are no bankruptcy costs.

4. Investors can borrow at the same rate as corporations.
5. All investors have the same information as management
about the firm’s future investment opportunities.
6. EBIT is not affected by the use of debt.

AG 23
 MM1…
 Modigliani and Miller imagined two hypothetical portfolios.
– The first portfolio contains all the equity of an unlevered
firm, so the portfolio’s value is VU, the value of an
unlevered firm.
 Because the firm has no growth (it does not need to
invest in any new net assets) and pays no taxes, the 24

firm can payout all of its EBIT in the form of

dividends.
 Therefore, Cash flow from owning this first portfolio is
equal to EBIT

AG 24
 MM1…
 The second portfolio contains all of the levered firm’s stock (SL)
and debt (D), so the portfolio’s value is VL.
 If the interest rate is rd, then the levered firm pays out interest
in the amount rdD.
 Because the firm is not growing and pays no taxes, it can pay
out dividends in the amount EBIT − rdD. 25

 If you owned all of the firm’s debt and equity:

 The cash flow would be equal to the sum of interest &
dividends:
rdD + (EBIT − rdD) = EBIT.
– Thus, the cash flow of each portfolio is equal to EBIT.
AG 25
 MM1…

Modigliani-Miller (MM) Theory: Zero Taxes

Firm U Firm L
EBIT ETB 4,000 ETB 4,000
Interest 0 1,000
NI ETB 4,000 EB 3,000

CF to shareholder ETB 4,000 ETB 3,000

CF to debtholder 0 ETB 1,000
Total CF ETB 4,000 ETB 4,000

Notice that the total CF are identical for both firms.

AG 26
 MM1…
 MM concluded that two portfolios producing the same cash
flows must have the same value:
VL = SL + D = VU
 MM proved that a firm’s value is unaffected by its capital structure.
 As leverage increases, more weight is given to low-cost debt but
equity becomes riskier, which drives up rs.
 Under MM’s assumptions, rs increases by exactly enough to keep 27

the WACC constant.

 If MM’s assumptions are correct, then it doesn’t matter how a firm
finances its operations and so capital structure decisions are
irrelevant.
Further reading: Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of
investment. The American economic review, 48(3), 261-297.

AG 27
 Modigliani and Miller II (MM II): The Effect of Corporate Taxes
 In 1963, MM relaxed the assumption that there are no corporate taxes.
 The Tax Code allows corporations to deduct interest payments as an
expense, but dividend payments to stockholders are not deductible.
 The differential treatment encourages corporations to use debt in their
capital structures.
 The tax deductibility of the interest payments shields the firm’s pre-tax
income. 28

 The value of a levered firm is value of an identical unlevered firm plus value
of any “side effects.”
VL = VU + Value of side effects
= VU + PV of tax shield

AG 28
 MM II…
 Present value of the tax shield is equal to the corporate tax rate, T,
multiplied by the amount of debt, D:
VL = VU + TD
 With a tax rate of 40%, every birr of debt adds about 40 cents of
value to the firm, and this leads to the conclusion that the optimal
capital structure is virtually 100% debt.
29
 MM also argued that rs, increases as leverage increases but it
doesn’t increase quite as fast as it would if there were no taxes.
 As a result, under MM with corporate taxes, the WACC falls as
debt is added.
Further reading: Modigliani, F., & Miller, M. H. (1963). Corporate income
taxes and the cost of capital: a correction. The American economic
review, 53(3), 433-443.
AG 29
 Miller: The Effect of Personal Taxes
 Miller (1977) later brought-in the effects of personal taxes.
 The income from bonds is interest, which is taxed as
personal income at rates (Td) going up to 35%, while
income from stocks comes partly from dividends and partly
from capital gains.
 Long-term capital gains are taxed at 15%, and this tax is 30

deferred until the stock is sold and the gain realized.

– If stock is held until the owner dies, no capital gains tax
whatsoever must be paid.
– So, on average, returns on stocks are taxed at lower
effective rates (Ts) than returns on debt.
AG 30
 Personal Taxes..
 Because of the tax, Miller argued that investors are willing to
accept relatively low before-tax returns on stock relative to the
before-tax returns on bonds.
 Thus, Miller pointed out,
– The deductibility of interest favors the use of debt financing, but
– The more favorable tax treatment of income from stock lowers
the required rate of return on stock and thus favors the use of
equity financing. 31

 Most observers believe that there is still a tax advantage to debt if

reasonable values of tax rates are assumed.
– Thus, it appears that the presence of personal taxes reduces
but does not completely eliminate the advantage of debt
financing.
Miller, M. H. (1977). Debt and taxes. the Journal of Finance, 32(2), 261-275.

AG 31
 Trade-off Theory
 MM theory ignores bankruptcy costs, which increases as more
leverage is used.
 However, bankruptcy can be quite costly.
 Firms in bankruptcy have very high legal and accounting expenses,
and they also have a hard time retaining customers, suppliers, and
employees.
 Bankruptcy often forces a firm to liquidate or sell assets for less 32

than they would be worth if the firm were to continue operating.

 Therefore, bankruptcy costs discourage firms from pushing their use
of debt to excessive levels.
 Bankruptcy-related costs have two components:
– The probability of financial distress and
– The costs that would be incurred if financial distress does occur.

AG 32
 Trade-off …
 Thus, firms should trade-off the benefits of debt financing (favorable
corporate tax treatment) against higher interest rates and bankruptcy
costs.
– At low leverage levels, tax benefits outweigh bankruptcy costs.
– At high levels, bankruptcy costs outweigh tax benefits.
 The trade-off theory states that the Value of a levered firm is equal to the
value of an unlevered firm plus the value of any side effects, which
include the tax shield and the expected costs due to financial distress. 33

VL = VU + PV tax shied – Financial distress costs

 An optimal capital structure exists that balances these costs and

benefits.
Further reading: Graham, J. R., and C. R. Harvey, 2001, The theory and
practice of corporate finance: Evidence from the field, Journal of Financial
Economics, 60, 187-243.
AG 33
 Signaling Theory
 MM assumed that investors have the same information about a
firm’s prospects as its managers, called symmetric information.
 However, managers have better information than outside
investors, called asymmetric information.
– This has an important effect on the optimal capital structure.
 Managers use issues of debt and equity to signal 34

information about a firm’s future prospects to less

informed owners and investors.
 By issuing debt, the company would be signaling to investors and
current shareholders that the future outlook of the company is
bright.
– Issuing debt would be interpreted as a positive signal about
the company’s future.
AG 34
 Signaling…
 In contrast, the decision to issue equity would generally be
interpreted by shareholders and investors as a negative signal.
– It indicates that the company’s future prospects are not so good and its
equity is currently overvalued.
 This theory argues that shareholders and investors understand
these issues that managers have more information about a
firm’s prospects and use financing policy to signal this 35

information to shareholders and investors.

 The key implication for capital structure management is that, if
possible, firms should retain some degree of reserve borrowing
capacity which would allow them to take full advantage of
wealth enhancing investment opportunities when they arise.

AG 35
 Pecking Order Theory
 Myers (1984) argues that the management of firms follow a
distinct order in their preferences of sources of finance for
investment and therefore do not seek to maintain an optimal or
target capital structure.
 Firms use internally generated funds first (1):
– No flotation costs
– No negative signals
 If more funds are needed, firms then issue debt (2) 36

– Lower flotation costs than equity

– No negative signals
 If more funds are still needed, firms then issue equity (3)
 Thus, a firm’s capital structure at any point in time is simply a reflection
of its past pecking order preferences for long-term financing.
Further reading: Myers, Stewart C., and Nicolas S. Majluf, 1984, “Corporate financing and
investment decisions when firms have information that investors do not have”, Journal of
Financial Economics 13,187-221.
AG 36
 Pecking Order…
 Donaldson followed by Myers suggests that management
follows a preference ordering when it comes to financing.
1.Internal financing is preferred: it avoids the outside
scrutiny of suppliers of capital, there are no flotation
costs associated with the use of retained earnings
2.Straight debt: less intrusion (imposition) into 37

management by suppliers of capital, flotation costs are

less than with other types of external financing,
asymmetric information and financial signaling
considerations come into play.

AG 37
 Pecking Order…
3. Preferred stock, which has some of the features of debt.
4. This is followed by the various hybrid securities, like
convertible bonds.
5. Finally, the least desirable security to issue is straight
equity.
 Not only are investors the most intrusive (disturbing), but 38

flotation costs are higher than with the other methods of

financing and there is likely to be an adverse signaling effect.

AG 38
 Optimal capital structure
 Optimal capital structure is one that minimizes the
firm’s cost of capital and maximizes firm value.
 Empirical evidences show that companies tend to
operate within a target or optimal capital structure range.
– If companies have to move outside the optimal range by taking on
more debt than they would prefer because of business 39

circumstances (e.g. financing a substantial expansion program)

they will revert to their considered optimal or target structure
range as soon as is feasible.

AG 39
 Cont’d…
 The basic approach to determine the optimal capital
structure is to consider a trial capital structure, based
on the market values of the debt and equity, and then
estimate the wealth of the shareholders under this capital
structure.
– This approach is repeated until an optimal capital 40

structure is identified.
 The objective is to find the amount of debt
financing that maximizes the value of operations.

AG 40
 Cont’d…
 The basic steps in analysis of each potential capital
structure:
– Estimate the interest rate the firm will pay.
– Estimate the cost of equity.
– Estimate the weighted average cost of capital.
41

– Estimate the value of operations, i.e., the present

value of free cash flows discounted by the WACC.

AG 41
Optimal
Capital
Percent of firm financed with debt (wd)
Structure Wd 0% 10% 20% 30% 40% 50% 60%
s Ws 100% 90% 80% 70% 60% 50% 40%
rd 7.7% 7.8% 8% 8.5% 9.9% 12% 16%
b 1.09 1.16 1.25 1.37 1.52 1.74 2.07
rs 12.82% 13.26% 13.8% 14.5% 15.43% 16.73% 18.69%
rd(1-T) 4.62% 4.68% 4.8% 5.1% 5.94% 7.2% 9.6%
WACC 12.82% 12.4% 12% 11.68% 11.63% 11.97% 13.24% 42

Vop 233.98 241.96 250 256.87 257.86 250.68 226.65

Debt 0 24.2 50 77.06 103.14 125.34 135.99
Equity 233.98 217.76 200 179.81 154.72 125.34 90.66
#shares 12.72 11.34 10 8.69 7.44 6.25 5.13
Stock price 18.4 19.2 20 20.69 20.79 20.07 17.66
NI 30 28.87 27.6 26.07 23.87 20.98 16.95
EPS 2.36 2.54 2.76 3 3.21 3.36 3.3
AG 42
 Observed Practices
 The greater the marginal tax rate, the greater the
benefit from the interest deductibility and, hence, the more
likely a firm is to use debt in its capital structure.
 The greater the business risk of a firm, the greater the
present value of financial distress and, therefore, the less
likely the firm is to use debt in its capital structure. 43

 The greater extent that the value of the firm depends on

intangible assets, the less likely it is to use debt in its
capital structure.
 Within an industry there may not be a homogeneous group
of firms and they might have different types of business risk.

AG 43
 Cont’d…
 Firms prefer using internally generated capital to
externally raised funds.
 Firms try to avoid sudden changes in dividends.
 When internally generated funds are greater than
needed for investment opportunities, firms pay off debt
or invest in marketable securities. 44

 When internally generated funds are less than needed

for investment opportunities, firms use existing cash
balances or sell off marketable securities.
 If firms need to raise capital externally, they issue the
safest security first; for example, debt is issued before
preferred stock, which is issued before common equity.
AG 44
 Windows of Opportunity
 Managers try to “time the market” when issuing securities.
 They issue equity when the market is “high” and after big
stock price run ups.
 They issue debt when the stock market is “low” and when
interest rates are “low.”
 They issue short-term debt when the term structure is
upward sloping and long-term debt when it is relatively
flat.

Baker, Malcolm and Jeffrey Wurgler, 2002, “Market timing and

capital structure”, Journal of Finance 57, 1-32.
AG 45
 Determinants of capital structure
Several factors affect the capital structure of the firm. The most common ones are
described below:
1. Sales stability. A firm whose sales are relatively stable can safely take on more debt
and incur higher fixed charges than a company with unstable sales.
2. Asset structure. General-purpose assets that can be used by many businesses make
good collateral, whereas special-purpose assets (and intabgibles)do not.
3. Taxes. Interest is a deductible expense, and deductions are most valuable to firms
with high tax rates. Therefore, the higher a firm’s tax rate, the greater the advantage
of debt.
4. Financial flexibility. Refers to maintaining adequate reserve borrowing capacity. If a
firm has adequate reserve borrowing capacity, it opt for debt financing than equity
financing.
5. Managerial conservatism or aggressiveness.

AG 46
 Lease
What is lease?
Lease is an agreement whereby the lessor conveys to the lessee in
return for a series of payments for the right to use an asset for an
agreed period.
– Lessor - who owns the property, and
– Lessee - who obtains the right to use the property. 47

 The agreement establishes that the lessee has the right to use
an asset and in return must make periodic payments to the
lessor.
 The lessor is either the asset’s manufacturer or an independent
leasing company.
AG 47
 Cont’d…

AG 48
 Why leasing?
 Leasing is an important activity for many entities. It is a
means of gaining access to assets, of obtaining finance
and of reducing an entity’s exposure to the risks of asset
ownership.
– May be lower interest rate
– Way to avoid risk of technological change
– Way to avoid transactions costs associated with buying and selling
– Way to avoid restrictions (covenants) of debt financing
– Maintenance costs may be included

AG 49
 Types of lease arrangements
 Leasing takes several different forms:
– Operating leases;
– Financial, or capital leases;
– Sale-and-leaseback arrangements;
– Combination leases; and 50

– Synthetic Leases

AG 50
 Types…
Operating Leases
 It does not transfer substantially all the risks and rewards
incident to ownership.
 Rental payments of the lease contract are not sufficient for
the lessor to recover the full cost of the asset.
 It requires the lessor to maintain and service the leased 51

asset.
 It often contains a cancellation clause that gives the lessee
the right to cancel the lease and return the asset before
the expiration of the basic lease agreement.

AG 51
 Types…
Financial or Capital Leases
 Transfer all the risks and rewards of the leased property to
the lessee.
 Financial leases differ from operating leases;
– Do not provide for maintenance service
– Are not cancellable 52

– Are fully amortized (i.e., the lessor receives rental

payments equal to the full price of the leased equipment
plus a return on invested capital)

AG 52
 Operating vs Finance lease

AG 53
 Cont’d…
Sale-and-Leaseback
 A firm sells the property to another firm and
simultaneously agrees to lease the property back for a
stated period under specific terms.
 They are almost the same as financial leases.
– The major difference is that the leased asset is not new, 54

and
– The lessor buys it from the user-lessee instead of a
manufacturer or a distributor.
– It is a special type of financial lease.

AG 54
 Cont’d…
Combination Leases
 Leases do not fit exactly into the operating lease or
financial lease category but combine some features of
each.
 Example;
– Cancellation clauses are normally associated with 55

operating leases, but many of today’s financial leases

also contain cancellation clauses.

AG 55
 Cont’d…
Synthetic Leases
A corporation that wanted to acquire an asset—generally
real estate, with a very long life with debt would first
establish a special purpose entity, or SPE.
The SPE would then obtain financing, typically 97% debt
provided by a financial institution and 3% equity provided by 56

a party other than the corporation itself.

The SPE would then use the funds to acquire the property,
and the corporation would lease the asset from the SPE
Because of the relatively short term nature of the lease, it
was deemed to be an operating lease and hence did not
have to be capitalized and shown on the balance sheet.
AG 56
 Evaluation of the Leases-Lessee
 Leases are evaluated by both the lessee and the lessor.
– The lessee must determine whether leasing an asset is
less costly than buying it.
– The lessor must decide whether the lease payments
provide a satisfactory return on the capital invested in
57
the leased asset.

AG 57
 Cont’d…
Evaluation by the Lessee
 The lease decision is typically a financing decision.
– Once the firm has decided to acquire the asset, the next
question is how to finance it.
 A lease is comparable to a loan in the sense that the firm
58
is required to make a specified series of payments, and a
failure to meet these payments could result in bankruptcy.
 The most appropriate comparison is lease financing
versus debt financing.

AG 58
 Example 1

Assume that Ab Company needs a 4-years asset that costs

ETB 100 million, and the company must choose between
leasing and buying the asset. Tax rate is 40%. If the asset is
purchased, bank would lend Ab Company birr 100 million at 59

10% on a 4-years, simple interest loan. The firm would have

to pay the bank birr 10 million in interest at the end of each
year and birr 100 million of principal at the end of Year 4.

AG 59
 Cont’d…
 Assume that Ab Company could depreciate the asset over 4
years for tax purposes by the straight-line method if it is
purchased, resulting in tax depreciation of birr 25 million and tax
savings of
– T(Depreciation) = 0.4(25) = ETB 10 million in each year; and
60

– The asset’s value at the end of 4 years will be 0.

 Alternatively, Ab Company could lease the asset for 4 years for a
payment of ETB 30 million at the end of each year.
– Tax saving from lease =0.4 (30)=ETB 12 Million in each year

AG 60
 Cont’d…
 The analysis for the lease-versus-borrow decision consists
of
– Estimating the cash flows associated with borrowing and
buying the asset;
– Estimating the cash flows associated with leasing the
61
asset; and
– Comparing the two financing methods to determine
which has the lower present value costs.
– Assume the appropriate discount rate is 6%

AG 61
 Cont’d…
Lease-versus-Buy Decision (Millions of ETB)
Year
Cost of Owning 0 1 2 3 4
Equipment cost (100.00)
Loan amount 100.00
Interest expense (10.00) (10.00) (10.00) (10.00)
Tax savings from 4.00 4.00 4.00 4.00 62

interest .4(10)
Principal repayment (100.00)
Tax savings from 10.00 10.00 10.00 10.00
depreciation
Net cash flow 4.00 4.00 4.00 (96.00)
PV ownership CF @ 6%
(65.35)
AG PVIFA 6%,3 3.465 2.673*4 = 10.692 62
 Cont’d…
Lease analysis-Lessor (Millions of ETB)
Year
0 1 2 3 4
Cost of Leasing
Lease Payment (30.00) (30.00) (30.00) (30.00)
Tax savings from 12.00 12.00 12.00 12.00
lease .4(30)
Net cash flow 0 (18.00) (18.00) (18.00) (18.00)
PV of leasing CF @ 6% (62.37)
PVIFA 6%,4 =3.465 (From financial
table)

Cost of Leasing 62.37

Net advantage to leasing (NAL)
AG NAL = Cost of ownership − cost of leasing= 65.35-62.37 = 2.98
63
 Cont’d…
 The financing method produces the smaller PV of costs is
the one that should be selected.
 The PV cost of owning exceeds the PV cost of leasing, so
the NAL is positive.
– Therefore, Ab company should lease the asset.
64

AG 64
 Evaluation of the Leases-Lessor
 Lease terms on large leases are generally negotiated, so the
lessee should know what return the lessor is earning. The lessor’s
analysis involves;
1) Determining the net cash outlay, which is usually the invoice price
of the leased equipment less any lease payments made in
advance;
2) Determining the periodic cash inflows, which consist of the lease
payments minus both income taxes and any maintenance expense
the lessor must bear;
3) Estimating the after-tax residual value of the property when the
lease expires; and
4) Determining whether the rate of return on the lease exceeds the
lessor’s opportunity cost of capital or, equivalently, whether the
NPV of the lease exceeds zero
AG 65
 Evaluation of the Leases-Lessor
Lease Evaluation-Lessor (Millions of ETB)

Year
0 1 2 3 4
Equipment cost (100)
Lease receipt 30.00 30.00 30.00 30.00
Tax on lease receipt (12.00) (12.00) (12.00) (12.00)
Depreciation tax saving 10 10 10 10
Net cash flow (100) 28.00 28.00 28.00 28.00
PV of leasing CF @ 6% 97.02
PVIFA 6%,4 =3.465
NPV
NPV = Cost of equipment − PV of net cash flows = 97.02-100= -2.98
AG 66
 67

Chapter End

AG 67