Chapter 18 Capital Structure and the Cost of Capital © 2011 John Wiley and Sons

2 Chapter Outcomes n Explain how capital structure affects a firm’s capital budgeting discount rate. n Explain how a firm can determine its cost of debt financing and cost of equity financing. n Explain how a firm can estimate its cost of capital. n Describe how a firm’s growth potential, dividend policy, and capital structure are related.

3 Chapter Outcomes, continued n Explain how EBIT/eps analysis can assist management in choosing a capital structure. n Describe how a firm’s business risk and operating leverage may affect its capital structure. n Describe how a firm’s degree of financial leverage and degree of combined leverage can be computed and explain how to interpret their values. n Describe the factors that affect a firm’s capital structure.

4 What is Capital Structure? n Capital structure is the mix of debt and equity n An optimal debt/equity mix will minimize the firm’s cost of capital n A lower cost of capital means a higher firm value

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6 Required Rate of Return and the Cost of Capital n Project cost = $1000 n Financed by: n $600 debt at 9% interest (pre-tax) n $400 equity with a 15% return requirement

7 Minimum Required Returns n Annual pre-tax cash flow = $600 (0.09) + $400 (0.15) = $114 n Minimum pre-tax return = 114/$1000 = 11.4% or: = $600/$1000 (9%) + $400/$1000(15%) =11.4%

8 Three Names, Same Concept n Required rate of return—investor n Cost of capital (or weighted average cost of capital)—firm n Discount rate—NPV calculation

9 Why a Weighted Average? n In most cases, the weighted average cost of capital should be used in project evaluation, NOT project- specific financing costs n This month: accept project with IRR of 9% and is debt-financed at 8% n Later this year: reject project with IRR of 12% that was to be equity financed at 15% n This is not a value-maximizing strategy!

10 Computing Capital Costs n After-tax cash flows require the use of after-tax financing costs n Incremental cash flows require incremental, or marginal, financing costs

11 Cost of Capital n Cost of debt n Cost of preferred stock n Cost of common equity –Retained earnings –New common stock

12 Cost of Debt n Yield to maturity (YTM) of new debt n Sources: –current interest rates for rated bonds –investment bank advice –current YTM on firm’s outstanding bonds –long-term bank financing rate

13 Cost of debt calculation n Interest is tax-deductible to the firm n k d = YTM ( 1 - T) n Example: 40 percent marginal tax rate New debt can be issued with a 10 percent YTM k d = 10% (1 -.4) = 6%

14 Cost of Preferred Stock n Recall: Price of preferred stock = D p / r p  r p = D p / P ps taking flotation costs into account, cost of preferred stock = k p = D p / (P ps - F ps )

15 Cost of Preferred Stock Example n Dividend = $5 per share n Price of preferred stock = $55 n Flotation cost = $3 per share n k p = D p / (P ps - F ps ) n k p = $5 / ($55 - $3) = 9.62%

16 Cost of Common Equity n Two sources of common equity: –Retained earnings –New common stock

17 Cost of Retained Earnings n Is cost of retained earnings = zero? n No, because of opportunity cost to shareholders n Two methods to find cost of retained earnings –security market line approach –constant dividend growth model

18 Cost of Retained Earnings: Security Market Line Approach n Recall: E (R i ) = RFR +  i ( R MKT - RFR) n This represents the opportunity cost to shareholders of the firm’s use of retained earnings to finance projects so: k RE = E (R i ) = RFR +  i ( R MKT - RFR)

19 Cost of Retained Earnings: Constant Dividend Growth Model n Recall: Price of common stock = D 1 / (r cs - g) n Since shareholder required return = opportunity cost if firm uses retained earnings as a financing source, n k RE = r cs = (D 1 / P) + g

20 Cost of New Common Stock n Adapt the constant dividend growth model to reflect flotation costs since when new shares are sold, the firm receives (Price - flotation costs) per share. n k n = [D 1 / (P - F cs )] + g

21 Weighted Average Cost of Capital WACC = w d k d + w p k p + w e k e where w d + w p + w e = 1.0 n Weights should reflect management’s belief of a target capital structure which minimizes financing costs n Measuring whether the firm is moving toward the target capital structure: –book value weights (balance sheet) –market value weights (market prices)

22 WACC and Project Analysis n WACC represents the discount rate to be used in capital budget project analysis –Use the project’s WACC, not necessarily the firm’s WACC, because of risk differences –Higher risk projects will have higher WACC

23 Difficulty of Making Capital Structure Decisions n Interrelationships –Firm’s growth rate –Profitability –Dividend policy

LTD Divided by Total Assets, various firms

25 Planning Growth Rates n Internal Growth Rate –How quickly assets can grow without raising external funds IGR = (RR x ROA)/(1 – RR x ROA) n Sustainable Growth Rate –How quickly assets can grow if debt/equity ratio remains constant SGR = (RR x ROE)/(1 – RR x ROE)

26 Effects of Unexpectedly Higher (or Lower) Growth n Dividend policy n Profitability n Capital Structure

27 EBIT/eps analysis n Examine how different capital structures affect earnings and risk n EBIT - interest Net income (ignore taxes) eps = Net income / # of shares

28 Current and Proposed Capital Structures CURRENT PROPOSED Total assets $100 million $100 million Debt 0 million50 million Equity 100 million50 million Common stock price $25 $25 Number of shares 4,000,000 2,000,000 Interest rate 10% 10%

29 CURRENT—No Debt, 4 Million Shares (Millions Omitted) EBIT 50% EBIT 50% BELOW ABOVE EXPECTED EXPECTED EXPECTED EBIT $6.00$12.00 $18.00 – Int NI $6.00$12.00 $18.00 eps $ 1.50 $ 3.00 $ 4.50

30 PROPOSED—50% Debt (10% Coupon), 2 Million Shares (Millions Omitted) EBIT 50% EBIT 50% BELOW ABOVE EXPECTED EXPECTED EXPECTED EBIT $6.00$12.00 $18.00 – Int NI $1.00$ 7.00 $13.00 eps $ 0.50 $ 3.50 $ 6.50

31 EBIT/eps analysis Current versus Proposed Proposed Current eps EBIT

32 Indifference Level n Occurs where the lines cross; at that level of EBIT both capital structures have the same eps n Occurs where EBIT = interest cost (%) x total assets or, in other words, where EBIT/TA = interest cost (%)

33 Indifference Level EBIT/TA = interest cost (%) If EBIT/TA > interest cost, higher leverage is helpful (higher eps) If EBIT/TA < interest cost, higher leverage is harmful (lower eps)

34 Comments on EBIT/eps analysis n Positives –Indicates EBIT values when one capital structure may be preferred over another –Analysis of expected EBIT can focus on the likelihood of actual EBIT exceeding the indifference point n Drawbacks –Does not capture risk –Value-maximizing eps is probably less than maximum eps (Figure 18.8)

35 Risk and the Income Statement Sales Operating–Variable costs Leverage–Fixed costs EBIT –Interest expense FinancialEarnings before taxes Leverage–Taxes Net Income eps = Net Income Number of Shares

36 Business Risk n Unit volume variability n Price-variable cost margin n Fixed cost n Degree of operating leverage (DOL) = % change in EBIT/% change in sales = Sales – variable costs Sales – variable costs – fixed costs

37 Degree of Financial Leverage DFL = percent change in eps percent change in EBIT =EBIT / (EBIT - Interest)

38 Degree of Combined Leverage DCL = percent change in eps percent change in sales =DOL x DFL

39 Leverage Example THIS 10% SALES YEAR INCREASE Net sales $700,000$770,000 Less: variable costs (60% of sales) 420, ,000 Less: fixed costs 200, ,000 EBIT 80, ,000 Less: interest 20,000 20,000 EBT 60,000 88,000 Less: taxes 18,000 26,400 Net income $42,000$ 61,600

40 Leverage Calculations Percent change in sales +10.0% Percent change in EBIT +35.0% Percent change in net income +46.7% DOL = 35% / 10% = 3.50 DFL = 46.7% / 35% = 1.33 DCL = 46.7% / 10% = 4.67 DCL = DOL x DFL = 3.50 x 1.33 = 4.67

41 Insights from Theory and Practice n Taxes and Non-debt tax shields n Bankruptcy costs n Static tradeoff hypothesis Benefits of tax-deductible interest payments versus higher risk of bankruptcy n Agency costs –Cross-border differences in shareholder protection help explain global financing patterns

42 Insights from Theory and Practice n Type of Assets (tangible versus intangible) n Pecking order theory Prefer to use internal financing, then debt, then equity to finance growth n Market timing theory Current capital structure is the cumulative result of past financing decisions and attempts to issue securities when prices are high n Pecking order and Market timing: is there an optimal capital structure?

43 Flavors of Debt and Equity n Debt: –convertible or straight –maturity: can be extended/shortened –interest: fixed or variable n Equity: –preferred stock –common stock –different classes of common stock

44 Guidelines for Financing Strategy n Business risk n Taxes and non-debt tax shields n Mix of tangible and intangible assets n Financial flexibility n Control of the firm n Profitability n Financial market conditions n Management’s attitude toward debt and risk

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