Capital Structure and Cost of Capital — Class 3 Notes

Capital and the Balance Sheet

Capital refers to the resources a business needs to acquire land, buildings, equipment, supplies, and to pay employees; i.e., the money required to operate the business.
When firms obtain resources, they must determine the capital structure: how much debt vs. equity they use to finance those resources.
Debt = borrowing money; Equity = raising money from investors.
The capital structure represents the right-hand side of the balance sheet: Liabilities and Equity.
Left-hand side shows Assets (what the firm owns). Right-hand side shows Liabilities and Equity (how those assets were financed).
Basic economic process: obtain capital → make investments → generate positive returns.
Returns earned must be in excess of the cost of capital used to acquire the assets; this excess is the hurdle rate for projects.
Projects must yield returns greater than their cost of capital; otherwise they should not be undertaken.
Ongoing: businesses continuously go through the cycle of capital acquisition, investment, and return generation.
The hurdle rate is the internal minimum acceptable rate of return for projects, reflecting the cost of capital and risk.

The Cost of Capital and the Hurdle Rate

Cost of capital is a function of three components:
- Cost of debt capital (r_D)
- Cost of equity capital (r_E)
- Capital structure (relative weights of debt and equity)
Key metric: Weighted Average Cost of Capital (WACC).
Formula:
$\text{WACC} = \frac{D}{V} rD + \frac{E}{V} rE, \quad V = D + E$
Example from the transcript:
- Debt cost: $r_D = 0.08$ (8%)
- Equity cost: $r_E = 0.16$ (16%)
- Capital structure: 50% debt, 50% equity, so $D/V = 0.5, E/V = 0.5$
- Calculations: $\text{WACC} = 0.5\times 0.08 + 0.5\times 0.16 = 0.12 \Rightarrow 12\%.$
- Contributions to WACC: debt contributes $0.5 \times 0.08 = 4\%$ ; equity contributes $0.5 \times 0.16 = 8\%$ ; total 12\%.
The cost of capital (WACC) is used to evaluate investment opportunities and to determine the hurdle rate for projects.
A separate note: the cost of capital exercise is mentioned as a more complicated example later in class (class 03).

Risk and Return

Risk-Return principle: riskier investments require higher expected returns.
For debt: riskier borrowers pay higher interest; for example, a high-credit-risk borrower may pay more than a low-risk borrower.
For equity: higher risk demands a higher return from investors; the cost of equity capital is higher than the cost of debt because equity is riskier (owners have a residual claim).
Residual claim concept: in a liquidation, debt holders are paid first; equity holders are paid last.
This priority makes debt less risky for lenders and explains tax and control differences between debt and equity.
If two investments offer the same expected return, the riskier investment will have a lower current stock price due to the higher required return (discount rate).
When expected future cash flows are discounted at a higher rate, their present value is lower, reducing the price investors are willing to pay.
Equity holders' expected return is the cost of equity capital (analogous to interest for debt).
Net takeaway: higher risk equals higher required return; lower risk demands lower return.

Raising Capital: Internal Funds, Debt, and Equity; and the Pecking Order

Three traditional ways to raise capital:
1) Internal funds retained earnings (earned capital): profits kept in the business for reinvestment.
2) Borrowing from creditors (long-term notes payable, mortgages): creates long-term liabilities.
3) Issuing new equity (selling stock): raising funds from new or existing shareholders; introduces contributed capital.
Preferred phrasing: best to be profitable and use profits first; borrowing is acceptable; issuing new equity is the last resort.
The order of preference is described by the Pecking Order Hypothesis:
- 1) Internal funds (retained earnings)
- 2) Debt financing
- 3) Equity (new stock) financing
Mezzanine financing: issuing preferred stock as a debt-equity hybrid; discussed as a way to balance debt and equity features.
When issuing stock, ownership is diluted for existing shareholders because new shares increase total shares outstanding.
Common vs. preferred stock: common stockholders have residual claims and voting rights; preferred stockholders have priority in dividends and liquidation but typically no voting rights.
Three main methods of raising capital, summarized:
- Earned capital (retained earnings): internal profits reinvested
- Debt financing: long-term notes, mortgages; creates liabilities
- Equity financing: issuing new stock; creates contributed capital
Mezzanine financing / preferred stock (hybrid): features of both debt and equity without full dilution or voting rights。

Mezzanine Financing: Preferred Stock

Preferred stock as a debt-equity hybrid: combines features of both debt and equity.
Features of preferred stock:
- Dividend preference: preferred dividends are paid before common stock dividends.
- Liquidation preference: in bankruptcy, preferred shareholders are paid before common shareholders.
- Nonvoting (usually): does not provide voting rights to holders.
- Dividend characteristics: often fixed and may be cumulative (unpaid dividends accrue and must be paid later).
- Call feature (issuer option): issuer may buy back preferred shares at a specified price, terminating the preferred status.
- Conversion feature (holder option): holder may convert preferred shares to common shares (e.g., 3-for-1) if common stock performs well.
Benefits of mezzanine/preferred stock:
- Does not increase voting control problems for existing owners (no or limited voting rights).
- Less investment flexibility reduction than pure debt (no mandatory quarterly payments like debt).
- Does not dilute existing common shareholders as equity issuance does.
Trade-offs:
- Still has some priority over common equity (dividends and liquidation), but typically avoids some downsides of pure debt.
- Issuer can call the stock (risking higher cost if called) or convert to common if beneficial to holder.
In sum: preferred stock offers a balance between debt and equity, often treated as a debt-equity hybrid and used as a strategic financing option.

Common Stock, Dilution, and Investor Rights

Common stock basics:
- Primary ownership unit in a corporation.
- Common stockholders have a residual claim after liabilities are paid.
- They have voting rights, elect the board of directors, and are entitled to a proportionate share of distributions (dividends).
- They may sell their ownership stake in the company.
Effects of issuing new common stock:
- Dilution of existing stockholders: ownership percentage decreases when new shares are issued.
- Example (illustrative): If you own 6 of 18 shares (33%) pre-issuance and 6 additional shares are issued, total shares become 24 and your ownership becomes 6/24 = 25%.
- This dilution reduces each existing shareholder’s percentage ownership, but if the company benefits from the new capital, overall value may still rise.
Equity vs debt finance: each has costs and benefits; general points include:
- Equity increases cost of capital due to dilution and dividend expectations; debt generally cheaper due to tax deductibility and no ownership dilution.
- Debt provides tax shields from interest expense; dividends are not tax-deductible and can be taxed as income (double taxation concerns).
- Debt can lead to loss of financial flexibility due to covenants and mandatory payments; equity reduces control risk as new owners gain voting rights.

Debt vs Equity: Costs, Taxes, Control, and Risk

Debt advantages:
- Lower cost of capital (on average) due to tax deductibility of interest (tax shield).
- No dilution of current owners’ control or voting rights.
Debt disadvantages:
- Mandatory payments (principal and interest); increased default risk if cash flows falter.
- Debt covenants can constrain investment opportunities and strategic options.
Equity advantages:
- Dilution-free funding for debt; no mandatory payments.
- Provides capital without obligatory debt service; may improve liquidity and balance sheet flexibility in some contexts.
Equity disadvantages:
- Higher cost of capital due to higher risk and residual claim.
- Dilution of ownership and potential loss of control; dividends are not guaranteed and may be missed without legal consequences beyond signaling and investor relations.
Tax considerations:
- Interest on debt is generally tax-deductible, creating a tax shield.
- Dividend payments to equity holders are not tax-deductible and can be taxed twice (corporate level and shareholder level).
Risk of default and control considerations:
- Debt increases default risk due to mandatory payments; equity does not have mandatory distributions (though dividends can be cut).
- Debt covenants can limit management flexibility.
Summary: from a cost-of-capital and control perspective, debt is often preferred for cheaper funding and no ownership dilution, but increases default risk and reduces flexibility; equity reduces financial risk of default but is more expensive and dilutes ownership.

Dividends, Stock Options, and Retained Earnings

Retained earnings (earned capital) and stock options:
- Stock options give employees the right to buy stock at a predetermined price; vesting period is common (e.g., 2–3 years).
- The fair value of stock options on grant date is recognized as compensation expense over the vesting period on the income statement.
- CEO compensation increasingly incorporates stock options as a major component.
Cash dividends:
- Traditional method of rewarding shareholders; typically paid quarterly, though not all companies pay dividends.
- Dividends are a direct cash payout to shareholders and are a signaling mechanism of profitability and confidence.
Growth vs. mature firms:
- Growth companies may retain earnings and reinvest rather than pay dividends.
- Mature companies with excess capital may pay dividends to redistribute profits to shareholders.
Trends in shareholder payouts:
- There is a trend toward stock repurchases (buybacks) over cash dividends in many firms.
- Signaling effect: increases in dividend payouts tend to raise stock price; decreases tend to lower stock price.
Signaling implications of dividends:
- Dividend announcements can convey information about insiders’ view of the firm’s prospects, sometimes beyond what is publicly known (insider signaling).
Stock repurchases vs dividends: signaling and value implications:
- Repurchases can increase share price and are often viewed as signaling that the manager believes the stock is undervalued.
- Both dividends and repurchases return value to shareholders; divestiture of cash vs increase in share price yields equivalent overall value under certain conditions.
Tax considerations again (dividends vs capital gains):
- Dividends are generally taxed as ordinary income.
- Gains from selling shares (capital gains) may be taxed at capital gains rates, often favorable relative to ordinary income.
Role of stock options in signaling and value:
- Managers holding stock options may be incentivized to support higher stock prices via buybacks to raise option value.

Stock Repurchases, Treasury Stock, and Signaling

Stock repurchase is when a company buys its own stock on the open market; this is called treasury stock when held by the company.
Reasons for repurchases:
- Reduce the number of shares outstanding to increase earnings per share (EPS) and ostensibly the stock price; this is antidilutive in effect.
- Signal to the market that the stock is undervalued by the management’s assessment of intrinsic value.
- Offset dilution from employee stock options and other equity-based compensation.
Effects on ownership and signaling:
- Reducing shares outstanding can increase the stock price per share and the value of remaining shares.
- If the market perceives the stock as undervalued, buybacks can lift the stock price and signal confidence from management.
Stock dividends and stock splits (related payout mechanisms):
- Stock dividends involve issuing additional shares to shareholders on a pro rata basis; does not change ownership percentage for each investor (not antidilutive in percentage terms).
- Stock splits are similar in effect to large stock dividends, expanding the number of shares outstanding while reducing the price per share to keep trading in a reasonable range.
Practical signaling value of buybacks and stock issuance:
- Issuing new shares when price is high can signal overvaluation of the stock price leading to a price decline.
- Repurchasing shares when price is low suggests the stock is undervalued and tends to push the price back toward intrinsic value.
Tax considerations for stock payouts:
- Stock repurchases can be more tax-efficient for investors who realize capital gains rather than receiving cash dividends (capital gains tax vs dividend tax).
Treasury stock and employee options:
- Repurchases can offset potential dilution from employee stock options, preserving the value of existing holders’ ownership.

Stock Dividends and Stock Splits: Details and Signaling

Stock dividends:
- Additional shares are issued to shareholders on a pro rata basis; ownership percentage for each investor remains the same
- No direct cash payout; no immediate change in net ownership percentage, though the total number of shares outstanding increases.
Stock splits:
- Similar to larger stock dividends in substance; used to lower the trading price per share to fit a preferred trading range or psychological comfort.
- May have signaling value if the company believes its stock is overvalued or undervalued relative to intrinsic value.
Why companies perform these actions:
- Psychological effects on shareholders (feeling of higher ownership or more shares).
- Maintain a stock price within a target trading range and ensure liquidity.

Signaling and Insider Information

Dividends and buybacks can convey information about management’s view of the firm’s prospects.
Insider signaling: executives use payout decisions to communicate privately held information to the market, which may or may not be publicly known.
The signaling effect interacts with market expectations and can influence stock price movements beyond fundamental factors.

Practical Takeaways and Case Considerations

When evaluating capital structure decisions, consider:
- Cost of capital (WACC) and hurdle rate for proposed investments.
- Tax consequences of debt vs. equity financing.
- Effects on control and voting rights with different funding options.
- Potential for default risk and the impact of covenants on strategic flexibility.
- The signaling value of dividends, buybacks, issuances, and other payout policies.
- The dilution impact on existing shareholders when new equity is issued.
- The role of mezzanine financing as a hybrid option.
The financing decision influences managerial actions and equity holders’ expectations, including how earnings targets are treated and what lenders/investors demand in terms of returns.

Summary Points for Quick Review

Capital structure determines how a firm finances its assets through debt and equity; it is the right-hand side of the balance sheet.
The cost of capital (WACC) integrates the costs of debt and equity and their relative weights; a project must earn more than this cost (hurdle rate).
Risk and return are directly linked: higher risk requires higher expected return; this affects pricing of securities and investment decisions.
Mezzanine financing (preferred stock) blends debt-like features (creditor priority) with equity-like features (non-voting; potential conversion).
Issuing new equity dilutes existing ownership; debt does not dilute but introduces default risk and covenants.
Dividends deliver cash to shareholders; stock buybacks/repurchases reduce shares outstanding (antidilution), can signal undervaluation and raise stock price; stock dividends and stock splits affect share counts without changing ownership percentages.
Tax considerations favor debt (interest tax shield) over dividends; control considerations favor debt financing to avoid diluting ownership.
Stock options are a key form of manager compensation and affect the cost of capital and payout signaling.

Key Formulas and Concepts

Balance sheet identity:
$\text{Assets} = \text{Liabilities} + \text{Equity}$
WACC (Weighted Average Cost of Capital):
$\text{WACC} = \frac{D}{V} rD + \frac{E}{V} rE, \quad V = D + E$
Example numbers for WACC:
- $rD = 0.08, rE = 0.16, D/V = E/V = 0.5$
- $\text{WACC} = 0.5(0.08) + 0.5(0.16) = 0.12 = 12\%$
Ownership dilution example (pre- and post-issuance):
- Pre-issuance: 6 of 18 shares = $\frac{6}{18} = \frac{1}{3} = 33\%$
- Post-issuance: 6 of 24 shares = $\frac{6}{24} = \frac{1}{4} = 25\%$
Key terms:
- Dilution: decrease in ownership percentage due to new shares
- Antidilutive: actions (like buybacks) that offset potential dilution
- Treasury stock: shares repurchased by the company and held as its own stock
- Dividend vs Buyback equivalence: can deliver similar value to shareholders via cash vs increased remaining stake value
- Call feature: issuer can call back preferred shares; Conversion feature: holder can convert to common shares
- Liquidation preference and dividend preference: order of payments in distress or liquidation
- Vesting: stock options typically vest over several years; compensation expense recognized over vesting period