CAPITAL STRUCTURE AND THE COST OF CAPITAL

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Lecture 10
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CAPITAL STRUCTURE AND THECOST OF CAPITAL
How do we determine r k the discount rate
or the opportunity cost of capital Discount
Rate If you are looking at an investment/project
its logical that the return from that investment
should at least exceed the cost of the money
(capital) raised to finance the investment
/project.
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CAPITAL STRUCTURE AND THECOST OF CAPITAL

• ie If someone gives you 100 costing 10 then
  you will only
• invest in projects that offer a return greater
  than or equal
• to 10.
• eg If a project has a cost of 100 and gives
  you a single
• return at the end of the period of 111 would you
  invest
• in it if you had to borrow the 100 at 10?
• since IRR of 11 gt cost of 10
  ..............invest
• or NPV ive
  ..........invest
• ie the discount rate/required rate of return
  is at a minimum
• equal to the cost of servicing the finance each
  year.

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THE WEIGHTED AVERAGE COST OF CAPITAL (WACC)

• COMPANY
• When raising finance
• DEBT EQUITY
• eg. eg.
• 1. Overdraft 4. Preference Shares
• 2. Mortgage 5. Ordinary Shares
• 3. Debentures

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WACC Without Tax

• Each source of funds will have a separate cost
• A Simple example....... ( No Tax)
• If you finance an investment using
• 60 debt at a annual cost of 10 per annum
• 40 equity at an annual cost of 12 annum.....
• the W.A.C.C (0.6 10) (0.4 12)
  10.8

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WACC Without Tax

• ie W.A.C.C (no tax)
• where
• Ke the cost of equity E value of equity
• Kd the cost of debt D value of the debt
• V value of all capital raised

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WACC With Tax

• TAXATION
• When conducting NPV analysis the " Net Cashflows
• after tax " are estimated, therefore it stands to
  reason that
• the W.A.C.C should be estimated on an after tax
  basis as
• well.
• Equity payouts (dividends) are not tax deductible
  but
• debt payouts (interest payments) are.

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WACC With Tax

• An investment requires an outlay of 1m. You are
  going to issue bonds raising 0.2m giving the
  bondholders a return of 12p.a.. You will borrow
  from the bank 0.4m with an annual interest
  charge of 10. You will sell both ordinary and
  preference shares to investors raising 0.2m from
  both sources offering the investors 18p.a. and
  15p.a. respectively. On average what has this
  1m costed you if the tax rate is 40?
• 10.44 after tax

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RISK AND THE W.A.C.C

• In the previous example we knew that if we sold a
  bond the buyer would want a return of 12. What
  would
• happen to this rate of return if we become a
  riskier investment?
• For all investors - Return is a function of k

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WHAT IS RISK?

• In the case of a company - it is the exposure to
  uncertain cash flows for CREDITORS AND
  SHAREHOLDERS.
• Sources of Risk.......
• Business Risk - The risk that results from
• operating in a particular industry
• Financial Risk - The risk that results from the
• company taking on a particular
• capital structure
• The bottom line for investors are the impacts of
  business type and capital structure on earnings.

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1- BUSINESS RISK

• 1. New Competitors
• 2. Technological changes
• 3. Legislative changes
• 4. Changes in consumer taste
• These are risks that are inherent in the
  particular
• line of business. If Company is 100 equity,
  that
• variation in returns to shareholders are 100 a
• result of business risk.

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2- FINANCIAL RISK

• These are risks that result from exposure to
  leverage. If
• company uses debt, the variation in s/holders
  return would be partly attributable to leverage.
  This is because shareholders are exposed to
  increased variability in the rate of return on
  their investment. Financial risk is directly
  proportional to the proportion of debt in its
  capital structure.
• Because of this increase in variability, the more
  the leverage,
• the more the shareholders will require to
  compensate for
• the added risk. As the Company levers up, the
  exposure for creditors becomes greater and they
  will adjust their Kd upward.

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Sources of Capital Determining Their Existing
Costs

• Consider the situation where the company has
  already
• sold some bonds, shares and currently has a loan
  with
• the bank
• Ordinary shares - Re
• Preference shares - Rp

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Sources of Capital Determining Their Existing
Costs

• The cost of the debt
• Bank loan - Kd interest charged x (1-t)
• Debenture Kd
• All this information is freely available. We can
  now calculate the average cost of the money
  already raised. Will this average cost still
  apply if we need some new money to fund new
  investments? Only if we expose the new investors
  the same risk level as the existing investors.

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Conclusion......

• Risk is built into the W.A.C.C
• WACC becomes larger the greater the business risk
• and the financial risk of the firm.
• This risk is reflected in changes in the market
  value of
• the various forms of capital and via NPV analysis
• impacts on the viability of investment/project.

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Conclusion......

• When looking at estimating the cost of capital
  for future projects, this can be done by
  estimating the current W.A.C.C for the firms
  existing capital that has been raised.
• In doing so you make three implicit assumptions
• (i) The future investment is a "normal"
  investment for the firm.
• (ii) The capital raised to finance the future
  investment is in the
• same proportion as the rest of the firms
  capital.
• (iii) Market conditions and valuations will
  remain the same
• between now and the investment.

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Example

• Assume that AMI pays 39 tax and has the
  following balance
• sheet
• Cash 3000 Acc. Payable 6000
• Acc. Receivable 9000 Accruals 4000
• Stock 13000 Notes payable 5000
• Fixed Assets 35000 L/T Debt 10000
• Preferred Stock 5000
• S/holders Fund 30000
• -------- --------
• 60000 60000

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Conclusion......

• Calculate the WACC given
• Banknotes 12 L/T Debt 10.7
• Preferred stock 11.5 Common Equity 16.4
• Solution
• Type Value Weight Cost Weighted Cost