Capital Structure and Cost of Capital Notes

Types of Capital & How to Raise Them

  • Long-term sources:

    • Bonds

    • Shares

    • Preference shares

    • Debentures

  • How to raise capital:

    • Initial Public Offer (IPO)

    • Private Issue

    • Right Issue

    • Private Placement

    • Share Options

  • Bonds:

    • Public Offer

    • Private Placements

    • Over-the-Counter (OTC)

  • Returns:

    • Shares: Dividends, growth in value, or capital gain.

    • Preference Shares: Dividends.

    • Debt Capital: Interest, bond coupons, or debenture interest.

Cost of Capital

  • From the investor's POV, returns on investments.

  • From a company's POV, cost of raising capital.

  • Analogous to interest paid to a bank (cost to borrower, income to bank).

Methods of Determining Returns as Cost of Capital

  • Dividend Valuation Model (for equity).

    • Calculate the present value of dividends.

    • Constant Dividends (Zero Growth):

      • Dividends become a perpetuity.

      • P = \frac{D}{r}, where P = Price, D = Dividends, r = Cost of equity.

      • If cost of equity is what we want to find, then:

      • r = \frac{D}{P}

      • Cost of equity becomes dividend yield.

    • Constant Dividend Growth Model

      • Dividend level is not constant, but the change in dividends is constant.

      • P = \frac{D1}{r - g}, where D1 = Expected dividend, r = Cost of equity, g = Growth rate in dividends.

      • r = \frac{D_1}{P} + g

      • Cost of equity = Expected dividend yield + Growth rate of dividends.

Capital Asset Pricing Model (CAPM)

  • Expected return on a security = Risk-free rate + Market risk premium

  • Market risk premium = Beta of a security * Market excess return

  • Market excess return = Market return - Risk-free rate

  • Formula:E(Ri) = Rf + \betai (Rm - R_f)

    • E(R_i) = Expected return on security

    • R_f = Risk-free rate

    • \beta_i = Beta of the security

    • R_m = Market return

  • Market return is the return on the stock market index (e.g., Ghana Stock Exchange).

  • Market Risk Premium: (Rm - Rf)

  • Beta: Sensitivity of security to the market; how the return/price of a company changes with general market conditions; also called the market risk factor

All-Equity Financed Firm

  • Accept a project when the return exceeds the cost of equity capital.

  • Reject otherwise.

Risk Adjustment for New Projects

  • Using one discount rate for all projects can increase risk and decrease value over time.

  • The risk level of new projects may differ from the current business.

  • Failing to account for the full risks in new projects leads to underpricing.

  • Evaluate projects with a cost of capital commensurate with the project risk.

  • MTN Example:

    • Started with voice services, now data.

    • Data services have different risks than voice services.

    • Data services should not be assessed as if they were voice business.

  • Adjust projects for their respective risks.

Gearing/Leverage and Beta

  • Gearing (British term) = Leverage (American term).

  • Leverage: How debt influences risk and return.

  • Cost of equity by CAPM: risk-free + beta * market risk.

  • Beta accounts for the level of leverage.

  • Using the existing firm's beta as a proxy may be inaccurate for new projects with different leverage.

Modigliani and Miller's Theory

  • Does it matter for the value of the firm (value of assets) whether or not the company has borrowed?

  • Firms are in homogeneous risk classes (grouped by common business risks).

  • Banks face similar risks, different from oil marketing companies.

  • Firm risk is two parts:

    • Risk of the line of business (operating/business risk).

    • Risk of the kind of financing used (financial risk).

  • Beta deals with business risk.

  • Borrowing adds financial risk, requiring additional compensation for shareholders.

Ungeared/Unlevered vs. Geared/Levered

  • All-equity financed = Ungeared/Unlevered (no borrowing).

  • Beta represents only business risk.

  • Cost of equity unlevered (Ku) and beta unlevered (\betau) are used.

  • Geared/Levered: Company has debt.

  • Beta with gearing (\betag). Cost of equity (Kg).

  • Leverage increases risk; \betag > \betau and Kg > Ku.

Cost of Equity Capital Determination

  • CAPM is used more often due to easier estimation compared to dividend models.

Adjusting Projects for Funding Structure

  • Leverage increases equity beta.

  • Required return on equity for geared firm (within CAPM):

  • Kg = Rf + \betag (Rm - R_f)

  • Unlevered beta adjusted by \betau [1 + (1-T)(\frac{Vd}{V_s})]

    • V_d = value of debt.

    • V_s = value of shares

    • T = tax

  • Tax adjustment due to interest payments being tax-deductible.

    • Borrowing cost = interest payment.

    • Borrowing benefit = tax savings.

Beta Adjustment

  • Going from unlevered beta (\betau) to geared beta (\betag): \betag = \betau *[1 + (1 - T)(\frac{D}{E})]
    *Where: D = Debt, E = Equity.

  • Going from beta geared (\betag) to beta ungeared (\betau): \betau = \frac{\betag}{[1 + (1 - T)(\frac{D}{E})]}

Theoretical Implications of Gearing

  • As gearing increases, beta begins to diverge from the unlevered beta.

  • Cost of capital has three parts:

    • Risk-free rate (minimum return any investor should earn).

    • Premium for the nature of the business.

    • Premium for borrowing (financial risk).

Illustration

  • Two firms: No Gear and High Gear.

  • Ungeared beta = 1.11.

  • Risk-free return = 10%.

  • Expected market return = 19%.

  • Corporate tax rate = 30%.

  • Asset value of both = 3,500,000.

  • High Gear has debt of 1,000,000.

  • Find required return for shareholders of both companies.
    *Decompose returns for High Gear to show premium for business risk and financial risk.

  • No Gear Firm:

    • Ke = Rf + \beta(Rm - Rf)

    • Ke = 10 + 1.11(19 - 10) = 19.99 \approx 20 *High Gear Firm: *Value of company = Assets + liability *The value of company with gearing is unlevered value + the PV of tax shield *Tax shield = 30% of 1,000,000. *Value of company = 3,500,000 + 300,000 = 3,800,000 *Value of shares = Value of geared company - value of debt = 3,800,000-1,000,000=2,800,000 *Cost of equity leverage = unlevered beta * (1+(1-T(Value of debt/value of equity)) Cost of equity beta leverage =1.11(1+((1-0.3)(1,000,000/2,800,000)))=1.2875
      *K      e = Rf + \betag(Rm - Rf) = 22.25

Risk Decomposition

  • Total cost of equity = Risk-free rate + Premium for business risk + Premium for borrowing.
    *Two-part formula
    *Risk free + beta unlevered = business risk premium
    *geared beta = financial risk

Linking the Beta

  • Underlying business/activity risk is unaffected by financing. *If we borrow, then the shareholders ask even more *Accounting equation *asset beta is = to beta of financing *Acquiring asset *Equal weight of averaging with financial methods *Portfolio better = beta of all individuals in a portfolio *Formula = Asset Beta = Beta of equity * weight of debt/ equity beta* debt of equity *Diversifying

    • borrowing better is = too market allowing us and obtain the beta. but we need to Adjust it for risk level.

Illustration 2

*ATLA- telcoms *wanting to invest into electronics.
Equitly better is =1.35the gearing debt is 40%, and it is a company.*tax rate30%. PLC - has 10%.
*what will be the beta is ATLA investment on the firms gearing.
*formula
*ATLA - going from 40% + 10%

  1. Going from electronics Gearing to electronics in An gear.
    *debt can only be zero formula
    *Asset Beta = is equal too and times and + is proportional and this is with total amount, and = Debt is to get total = same thing a has a light that *with tax amount value of the 3 = this formula get get what you want is equal to to calculate
    . The problem with value formula
    *Re calculate the formula with to beta beta formula

Financial Distress and Capital Structure

  • With taxation, companies should rely on debt financing due to the debt tax shield.

  • This model does not consider liquidation/bankruptcy costs (assumes perfect capital markets).
    *Assets in distress are sale: However a new decision in the capitols structure
    *PV is with is an an ( FD ), VALUE = GET that TAX.
    *Financial manage, should manage that in maximum range

  • In high level increases costs of premium if in not in zero balance we not, it is high we do use = it gets with, not zero the probability, if we expect cost, then gets zero

  • Market imperfection can then be I mean, exploited to raise the company's value as long as the tax benefits are greater than the probability of, of, you know, the expected cost of financial distress, then the company is okay to borrow. Once we reach a point where the tax benefits are just equal to this cost of borrowing, we would have reached the optimal. And a company should not borrow beyond that.