COST OF CAPITAL
AND CAPITAL STRUCTURE Lesson 6
Corporate Finance Castellanza,
13th October, 2010
COST OF CAPITAL
AND CAPITAL STRUCTURE Lesson 6
Corporate Finance Castellanza,
13th October, 2010
Cost of capital Def: is the expected rate of return that the market requires in order to attract funds to a particular investment. (cost of capital/rate of return)
Characteristics:
it is it is market driven
it is forward-looking
it is usually measured in nominal terms (including expected inflation)
Capital refers to the components of a capital structure: debt and equity
Cost of equity (Ke) indirect way (CAPM)
opportunity cost: the cost of foregoing the next best alternative investment at a specific level of risk
rf = free risk return
P = premium
Ke = rf+ P
i = interest rate
t = tax rate of the company (interests are tax-deductible expenses)
Kd = f. interest rate
bankruptcy risk
tax benefits Cost of debt (Kd) Kd = i( 1-t )
Weighted average cost of capital (WACC) To be used when the objective is to value the entire capital structure of a company.
E = equity, D = net financial debt or Net Financial Position
Ke > WACC > Kd WACC = [Ke E/(E+D)] + [Kd D/(E+D)]
Capital structure Def: the capital structure of a firm is broadly made up of its amounts of equity and debt
Components:
equity (shareholder’s equity, corporate reserves, earnings)
debt (ST and LT debts, corporate bonds, commercial papers …)
quasi-equity (convertible bonds, mezzanine financing)
Capital structure (cont’d) Debt versus Equity
Residual claims
Lowest priority on cash flows
No tax deductible
Infinite life
Management control Fixed claims
High priority on cash flows
Tax deductible
Fixed Maturity
No management control _____________________________________________ Debt
Hybrids
(Quasi-equity)
Equity
Capital structure – costs and benefits of debt (cont’d) Benefits of debt
Tax benefits
when you borrow money, you are allowed to deduct interest expenses from your income to arrive a taxable income. This reduces your taxes. When you use equity you are not allowed to deduct payments to equity (such as dividends) to arrive at taxable income
Adds discipline to management
if you are manager of a firm with no debt, and you generate high income and cash flows each year, you tend to become complacent. The complacency can lead to inefficiency and investing in poor projects
Costs of debt
Bankruptcy costs
Agency costs
Loss of future flexibility
The financing mix question In deciding to raise financing for a business, is there an optimal mix of debt and equity? What is the trade-off
that let us determine
the optimal mix? If yes
If: taxes = 0 and extraord. rev.-exp. = 0 Maximization of shareholders’ return (ROE) ROE = [ROI + (D/E) * (ROI – i)] ROI = EBIT CI ROE = Net profit E i = Interests expenses Net Debt Leverage = D E D = Net Debt or Net Financial Position E = Equity i = interest rate paid on Net Debt CI = Capital invested = D + E
Relationship between ROE and ROI (cont’d) Considering taxes:
ROE = [ROI + (D/E) * (ROI – i)] * (1-t)
t = tax rate (taxes/EBT)
Considering extraordinary revenues/expenses:
ROE = [ROI + (D/E) * (ROI – i)] * (1-t) * (1-s)
s = (net extraordinary rev.-exp./earnings before net extraordinary rev.-exp.)
Relationship between ROE and ROI : Example
Relationship between ROE and ROI : Example ROE = [ ROI + ( D / E ) * ( ROI – i) ] * (1 – t) ROE = [11,2% + (12.000/10.300) * (11,2% – 5,0%)] * (1-31,6%) ROE = [11,2% + (1,17) * (6,2%)] * (68,4%) ROE = [11,2% + 7,2%] * (68,4%) ROE = 18,4% * 68,4% = 12,6%
* Relationship between ROE and ROI Decrease ROI Increase
cost of debt Decrease
ROE Decrease
self-financing Increase
of debt
* Leverage Leverage = D / E
D = total financial debt or Net Financial Position
E = equity
Using leverage it is possible to increase debt in order to increase return on equity
D/E = 1 neutral situation
D/E > 1 situation to monitor
D/E < 1 situation to exploit
Modigliani – Miller theory Hp: in an environment where there are no taxes, bankruptcy risk or agency costs (no separation between stockholders and managers), capital structure is irrelevant.
the value of a firm (V) is independent of its debt ratio (D/E). The cost of capital of the firm will not change with leverage.
Va D/E V
Modigliani – Miller theory (cont’d) The effect of taxes Vi =Vu + Vats Vi = value of levered firm
Vu = value of unlevered firm
Vats = actual value of tax shields Va D/E V Vi
Trade-off theory The effect of bankruptcy costs Vl = Vu+Vats-Vabc Vabc = actual value of bankruptcy costs
Vats = actual value of tax shields Vu D/E V Vi Value of levered firms
without bankruptcy costs Value of
levered firms Value of
unlevered firms Vats Vabc Vl
Picking order theory Self-financing
Debt
Increase of equity Financing sources Internal External Profitability Net Debt Level
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