Fund.finance Lecture 8 Capital Structure

8/13/2019 Fund.finance Lecture 8 Capital Structure

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Capital

structure_Cost ofCapital

Lecture

Agendas

Capital structureWeighted Average Cost of Capital (WACC)Calculating WACCMeasuring Capital StructureCalculating Required Rates of ReturnFirm vesus Project

What’s the Big Idea?

• Earlier lectures on capital budgeting focusedon the appropriate size and timing of cash

flows.

• This lecture discusses the appropriate

discount rate when cash flows are risky.

Capital structure

Capital Structure - The firm’s mix of long termdebt financing and equity financing.

Cost of Capital - The return thefirm’s investors could expect to earnif they invested in the securities

having comparable degrees of risk.

Cost ofequity

Cost ofpreferred

Cost ofdebts (bank

loans)

Cost ofdebts

(bonds)

WACC (Weighted average cost of capital

Weighted Average Cost of Capital (WACC) –

Company cost of capital = Weighted average of debtand equity returns.

[ ] [ ]WACC = x (1 - Tc)r + x r DV debt

EV equity

• The Weighted Average Cost of Capital (WACC) isgiven by:

• It is because interest expense is tax-deductible thatwe multiply the last term by (1 – TC)

r WACC =

Equity + Debt

Equity × r Equity +

Equity + Debt

Debt × r Debt × (1 – T C )

r WACC = S + B

S× r S + S + B

B× r B × (1 – T C )

WACC (Cont.)

• Taxes are an important consideration in thecompany cost of capital because interestpayments are deducted from income before

tax is calculated.

WACC (Cont.)

Three Steps to Calculating Cost of Capital

1. Calculate the weight of eachfinancing sourse as a proportion of thefirm’s market value.

2. Determine the required rate ofreturn on each security (financingsource).

3. Calculate a weighted average ofthese required returns (WACC).

[ ] [ ]WACC = x (1 - Tc)r + x r DV debt

EV equity

WACC (Cont.)

Example - continuedStep 1

Firm Value = 4 + 2 + 6 = $12 milStep 2

Required returns are givenStep 3

[ ] ( ) ( )WACC = x(1-.35).06 + x.12 + x.18=.123 or 12.3%

Measuring Capital Structure

• In estimating WACC, do not use the Book

Value of securities.

• In estimating WACC, use the Market Value ofthe securities.

• Book Values often do not represent the truemarket value of a firm’s securities.

Measuring Capital Structure (Cont.)

Market Value of Bonds - PV of all couponsand par value discounted at the current

interest rate.

Market Value of Equity - Market price per

share multiplied by the number ofoutstanding shares.

If the long term bonds pay an8% coupon and mature in 12

years, what is their marketvalue assuming a 9% YTM?

Big Oil Book Value Balance Sheet (mil)Bank Debt 200$ 25.0%LT Bonds 200$ 25.0%Common Stock 100$ 12.5%

Retained Earnings 300$ 37.5%Total 800$ 100%

70.185$09.1

216....09.1

1609.1

161232 PV

Big Oil MARKET Value Balance Sheet (mil)Bank Debt (mil) 200.0$ 12.6%

LT Bonds 185.7$ 11.7%Total Debt 385.7$ 24.3%Common Stock 1,200.0$ 75.7%Total 1,585.7$ 100.0%

Cost of Capital

Cost of Capital - The returnthe firm’s investors could

expect to earn if theyinvested in the securities

having comparable degreesof risk.

Cost of equity

Cost ofpreferred stock

Cost of debts(bank loans)

Cost of debts(bonds)

The Cost of Equity

• From the firm’s perspective, using CAPM to estimate theexpected return that is the Cost of Equity Capital:

• To estimate a firm’s cost of equity capital, we need to knowthree things:

)( F M i F i R R β R R -

1. The risk-free rate, R F

F M R R - 2. The market risk premium,

M i i σ

R R Cov β 3. The company beta,

The Cost of Equity - Example

• Suppose the stock of Stansfield Enterprises, a publisher ofPowerPoint presentations, has a beta of 2.5. Assume a risk-free rate of 5-percent and a market risk premium of 10-percent.

• What is the appropriate discount rate for an expansion ofthis firm?

)( F M

i F R R

β R R -

% 10 5 . 2 % 5 R

% 30 R

Cost of equity (Cont.)

Dividend Discount Model Cost of EquityPerpetuity Growth Model =

solve for r e

P =Div

r - g01

r =Div

P + ge 1

Cost of preferred stocks

Expected Return on Preferred StockPrice of Preferred Stock =

solve for preferred

P =Div

preferred

r = DivP preferred

Cost of debts

Bonds r = YTMd

Bank loans: interest rate banks charge

The Firm versus the Project

• Any project’s cost of capital depends on theuse to which the capital is being put —not thesource, meaning that take risk into account

• Therefore, it depends on the r i sk o f thepro jec t and not the risk of the c o m p a n y .

Relationship Between Risk & ExpectedReturn

E x p e c t e

d r e t u r n

) ( β F M i F i R R R R -

F R 1.0

M R Security market line

CAPM - Theory of the relationship between risk and return whichstates that the expected risk premium on any security equals its

beta times the market risk premium.

Capital Budgeting & Project Risk (Cont.)

Project IRR

Project’s risk ( b)

1.3 2.00.6

r = 4% + 0.6 ×(14% – 4% ) = 10%10% reflects the opportunity cost of capital on an investment in

electrical generation, given the unique risk of the project.

24% Investments in harddrives or auto retailingshould have higherdiscount rates.

A firm that uses one discount rate for all projects may overtime increase the risk of the firm while decreasing its value.

j e c t I R R

Firm’s risk (beta)

b FIRM

Incorrectly rejected positive NPV projects

Incorrectly acceptednegative NPV projects

WACC )( F M FIRM F R R β R -

The SML can tell us why:

An all-equity firm should accept a project whose IRR exceedsthe cost of equity capital and reject projects whose IRRs fallshort of the cost of capital.

j e c t

Firm’s risk (beta)

Good project

Bad project

Estimating IP’s Cost of Capital (WACC)

• The industry average beta is 0.82; the risk free rateis 8% and the market risk premium is 8.4%.

• Thus the cost of equity capital is

r S = R F + b i × ( R M – R F )

= 3% + 0.82 ×8.4%= 9.89%

Estimating IP’s Cost of Capital (WACC)

• The yield on the company’s debt is 8% and the firm is in the37% marginal tax rate.

• The debt to value ratio is 32%

8.34% is International’s cost of capital. It should be used todiscount any project where one believes that the project’s risk isequal to the risk of the firm as a whole, and the project has the

same leverage as the firm as a whole

= 0.68 × 9.89% + 0.32 × 8% × (1 – 0.37)

= 8.34%

r WACC = S + BS × r S + S + BB × r B × (1 – T C )

Fund.finance Lecture 8 Capital Structure

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