Financial Management Lecture 9 NUML Capital Structure

1. Capital Structure

2. Capital Structure
Coverage –
•Capital Structure
concept
•Capital Structure
planning
•Concept of Value of a
Firm
•Significance of Cost of
Capital (WACC)
•Capital Structure
theories –
 Net Income
 Net Operating
Income
 Modigliani-Miller
 Traditional Approach

3. Capital Structure
A capital structure is a mix of a company's long-term debt, specific short-
term debt, common equity and preferred equity.
The capital structure is how a firm finances its overall operations and
growth by using different sources of funds.
• Concerned with the effect of capital market decisions on
security prices.
• Assume: (1) investment and asset management decisions are
held constant and (2) consider only debt-versus-equity
financing

4. Capital Structure
Capital structure can be defined as the mix of owned capital (equity,
reserves & surplus) and borrowed capital (debentures, loans from
banks, financial institutions)
Maximization of shareholders’ wealth is prime objective of a
financial manager. The same may be achieved if an optimal capital
structure is designed for the company.
Planning a capital structure is a highly psychological, complex and
qualitative process.
It involves balancing the shareholders’ expectations (risk & returns)
and capital requirements of the firm.

5. Planning the Capital Structure
Important Considerations –
 Return: ability to generate maximum returns to the shareholders, i.e.
maximize EPS and market price per share.
 Cost: minimizes the cost of capital (WACC). Debt is cheaper than equity
due to tax shield on interest & no benefit on dividends.
 Risk: insolvency risk associated with high debt component.
 Control: avoid dilution of management control, hence debt preferred to
new equity shares.
 Flexible: altering capital structure without much costs & delays, to raise
funds whenever required.
 Capacity: ability to generate profits to pay interest and principal.

6. Value of a Firm – directly co-related with the
maximization of shareholders’ wealth.
Value of a firm depends upon earnings of a firm and its cost of capital
(i.e. WACC).
Earnings are a function of investment decisions, operating efficiencies,
& WACC is a function of its capital structure.
Value of firm is derived by capitalizing the earnings by its cost of capital
(WACC). Value of Firm = Earnings / WACC
Thus, value of a firm varies due to changes in the earnings of a
company or its cost of capital, or both.
Capital structure cannot affect the total earnings of a firm (EBIT), but it
can affect the residual shareholders’ earnings.

7. Weighted Average Cost of Capital
WACC, or Weighted Average Cost of Capital, is a financial metric
used to measure the cost of capital to a firm. A
It is most usually used to provide a discount rate for a financed
project, because the cost of financing the capital is a fairly logical
price tag to put on the investment. WACC is used to determine
the discount rate used in a DCF valuation model.
Weighted average cost of capital (WACC) is a calculation of a
firm's average cost of capital in which each category of capital is
proportionately weighted.
The common required rate of return that just satisfy all capital providers.

8. Weighted Average Cost of Capital
• Using a weighted average cost of capital allows the firm to calculate
the exact cost of financing any project.
• The formula for how to calculate WACC may seem complicated but
in reality is fairly simple:
• (Percentage of finance that is equity x Cost of Equity) + (Percentage
of finance that is debt x Cost of Debt) x (1 - Tax Rate)

9. Weighted Average Cost of Capital
• Re = cost of equity
• Rd = cost of debt
• Rp= cost of debt( preferred stock)
• E = market value of the firm's equity
• D = market value of the firm's debt
• V = E + D = total market value of the firm’s financing (equity and debt)
• E/V = percentage of financing that is equity
• D/V = percentage of financing that is debt
• P/V= percentage of financing that is preferred stock
• Tc = corporate tax rate
WACC= (E/V) * RE + (D/V) * RD *(1 -TC)
WACC =(E/V)* RE + (P/V)* RP+(D/V)* RD * (1- TC)

10. Re = cost of equity
• The most difficult Question :What is the firm’s overall cost of equity?
• There is no way of directly observing the return that the firm’s equity
investors require on their investment. Instead, we must somehow estimate it.
There are two approaches to calculate Cost of Equity
1. The Dividend Growth Model Approach
2. The SML Approach
Using the SML, we can write the expected return on the company’s equity,
E(RE)
The required rate of return on investment of the common
shareholder of the company.

11. Example Re = Cost of Equity
Suppose stock in Alpha Air Freight has a beta of 1.2. The market risk
premium is 8 percent, and the risk-free rate is 6 percent. Alpha’s last
dividend was $2 per share, and the dividend is expected to grow at 8
percent indefinitely. The stock currently sells for $30. What is Alpha’s cost
of equity capital?
Sol:
Step 1: SML.
the expected return on the common stock of Alpha Air Freight is:

12. Example Re = Cost of Equity
• This suggests that 15.6 percent is Alpha’s cost of equity. We next use the
dividend growth model. The projected dividend is
D1=
so the expected return using this approach is:
Our two estimates are reasonably close, so we might just average
them to find that Alpha’s cost of equity is approximately 15.4 percent.

13. Rd = cost of debt
• The cost of debt is the return that the firm’s creditors demand on new
borrowing.
• Cost of debt can normally be observed either directly or indirectly,
because the cost of debt is simply the interest rate the firm must pay
on new borrowing, and we can observe interest rates in the financial
markets.
• For example, if the firm already has bonds outstanding, then the yield
to maturity on those bonds is the market-required rate on the firm’s
debt.

14. Rd = cost of debt
• Two costs are included in calculation of Total cost of debt of a Firm
1. Cost of Preferred stock: As preferred stock has a fixed dividend paid
every period forever, making it a perpetuity.
Where D is the fixed dividend and P0 is the current price per share of the preferred
stock
2. Cost of Debt is the required rate of return on investments of the
lenders of the company.

15. Cost of Debt: Cost of Preferred stock
On May 30, 2008, Alabama Power Co. had two issues of ordinary preferred
stock with a $25 par value that traded on the NYSE. One issue paid $1.30
annually per share and sold for $21.05 per share. The other paid $1.46 per
share annually and sold for $24.35 per share. What is Alabama Power’s
cost of preferred stock?
Calculate that the cost of preferred stock is:

16. Cost of Debt: Cost of Preferred stock
• Solution:

17. The Capital Structure Weights
• Symbol E (for equity) to stand for the market value of the firm’s equity.
• Calculate as by taking the number of shares outstanding and
multiplying it by the price per share.
• Symbol D (for debt) to stand for the market value of the firm’s debt.
• For long-term debt, we calculate this by multiplying the market price of
a single bond by the number of bonds outstanding.
• Symbol V (for value) to stand for the combined market value of the
debt and equity.
( To t a l F i n a n c i n g ) V = D + E

18. Finding the WACC Titan Mining Corporation has 8 million shares of
common stock outstanding, .5 million shares of 6 percent preferred
stock outstanding, and 100,000 9 percent semiannual bonds
outstanding, par value $1,000 each. The common stock currently
sells for $32 per share and has a beta of 1.15, the preferred stock
currently sells for $67 per share, and the bonds have 15 years to
maturity and sell for 91 percent of par. The market risk premium is
10 percent, T-bills are yielding 5 percent, and Titan Mining’s tax rate
is 35 percent.
a. What is the firm’s market value capital structure?
b. If Titan Mining is evaluating a new investment project that has the
same risk as the firm’s typical project, what rate should the firm use
to discount the project’s cash flows?

19. Sol:
a.
MVD = 100,000($1,000)(0.91) = $91M; MVE = 8M($32) = $256M
MVP = 500,000($67) = $33.5M; V = $91M + 256M + 33.5M = $380.5M
D/V = 91/380.5 = .2392;
P/V = 33.5/380.5 = .0880;
E/V = 256/380.5 = .6728
b. For projects equally as risky as the firm itself, the WACC should be used as the discount rate.
RE = .05 + 1.15(.10) = 16.50%
P0 = $910 = $45(PVIFAR%,30) + $1,000(PVIFR%,30);
R = 5.092%, YTM = 10.18%
RD = (1 – .35)(.1018) = 6.6191%
RP = $6/$67 = 8.96%
WACC= Re*E/V+ Rp*P/V+[Rd*(1-Tc)*D/V]
WACC = .1650(.6728) + .0896(.0880) + .06619(.2392) = 13.47%