APITAL STRUCTURE, LEVERAGE,

AND COST OF CAPITAL

ACC09 FINANCIAL MANAGEMENT
PART 2

Where weve been...

Basic Skills: (Time value of
money, Financial Statements)
Investments: (Stocks, Bonds,
Risk and Return)
Corporate Finance: (The
Investment Decision - Capital
Budgeting)

Where were going...

Corporate Finance: (The
Financing Decision)
Cost of capital
Capital Structure
Dividends

FINANCING ISSUES

WHEN ARE BONDS SOLD

AT PREMIUM AND
DISCOUNT?
STRATEGY:
STRATEGY:
Pay still 8%, but sell less
than P1,000

At a P1,000 fund,
investment alternatives
in the market offer a
return on investment of
10%
Your company who is in
need of funds will offer a
P1,000 par nominal
interest of 8%
More likely they will NOT
buy your bonds with
their money

Pay still 8%, but sell higher

than P1,000

At a P1,000 fund,
investment alternatives
in the market offer a
return on investment of
7%
Your company who is in
need of funds will offer a
P1,000 par nominal
interest of 10%
More likely they WILL
buy your bonds with
their money

HOW ARE BONDS

PRICED?
Cash flow Analysis related to
Bonds

T0=
Bond
Price(+)

T1n=
Interest
Payments(-)

Tn=
Principal
Payment (-)

Based on
Coupon
Interest
The Price
of the
Bonds is
simply
equal to
the PV of
its Future
Cash Flows

Converted to
Present Value
using Discount
or Effective
Rate

Example 1:
5-yr bonds with a par of
P1,000 with a stated
interest of 10%,with a
discount interest of 12% is
going to be sold at:
PV of Coupon Interest
= P1,000 x 0.10 interest x
3.6048

PV Principal
= P1,000 x 0.56743 PVF
PV of FCF
=360.48+567.4=927.91
@Discou
nt

HOW ARE BONDS

PRICED?
Cash flow Analysis related to
Bonds

T0=
Bond
Price(+)

T1n=
Interest
Payments(-)

Tn=
Principal
Payment (-)

Based on
Coupon
Interest
The Price
of the
Bonds is
simply
equal to
the PV of
its Future
Cash Flows

Converted to
Present Value
using Discount
or Effective
Rate

Example 2:

5-yr bonds with a par of

P1,000 with a stated
interest of 10%,with a
discount interest of 8% is
going to be sold at:
PV of Coupon Interest
= P1,000 x 0.10 interest x
3.9927

PV Principal
= P1,000 x 0.68051 PVF
PV of FCF
=399.27+680.51=1,079.78
@Premiu
m

2011 Long-term Debt-to-Asset

Ratios
These
Firms had
been
document
ed as
PROFITAB
LE
2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible Web site, in whole or in part.

FINANCING ISSUES

CAPITAL
STRUCTURE
Capital structure defines how much of the resources of
the company is coming from external creditors, from
preferred shareowners, from ordinary shareholders, and
which part of any asset change is supported from
accumulated profits.
Growth rate and stability of future sales
Competition in the industry
FACTORS TO
Composition of assets
CONSIDER IN
Risk averseness of owners and management
DECIDING
Control of owners and management
THE OPTIMAL
Impression of lenders about the industry and
CAPITAL
the entity
STRUCTURE
Tax effects
Optimal Capital Structure is when the WACC is at its lowest and the
Shares price is highest

Current and Proposed Capital

Structures
Market value of assets
is P10,000,000

P1,000,000
10%

P1,000,000
10%

Current

Proposed

P1,000,000

P1,000,000

10%

10%

Assets

P10,000,000

P10,000,000

Equity

P10,000,000
1/10=10%

P5,000,000
1/5=20%

Expected EBIT
Required return on assets

Debt

P5,000,000

Debt-to-equity ratio

1.0

Shares outstanding

200,000

100,000

P50

P50

6%

Share price
Interest rate on debt

What is the expected return on equity with the new capital

structure?

FINANCING ISSUES

Concepts of Leverage

ASSOCIATED WITH COST STRUCTURE ASSOCIATED WITH CAPITAL STRUCTU

Operating Leverage

Financial Leverage

Use of more fixed costs

relative to variable costs
Increases variability of
operating income
(EBIT)
Increases risk (business
risk)
May be measured by
fixed asset turnover
(sales / fixed assets)
EBIT/ SALES

Use of borrowed
money to enhance
effectiveness of equity
More volatile net
income
More risk (financial
risk)
Measured by the debt
ratio
EBIT/ NI

FINANCIAL
LEVERAGE
Using debt to magnify both the RISK and EXPECTED RETURN
on a firms investments.
The use of debt, leads to a higher stock beta.

principles

Substituting long-term debt for equity increases both the level of

expected returns to shareholders as well as the risk
(dispersion) of those expected returns.
The level of expected returns to shareholders is measured by
earnings per share or ROE.

Does Financial Leverage Increase

Firm Value?
If the company changes the capital structure to 50%
debt, 50% equity:

Expected EPS increases from

P5 to P7.

Expected EBIT

Required return on assets

Proposed
BecauseCurrent
of the increased
risk,
P1,000,000
P1,000,000
expected
shareholder
return
increases 10%
from 10% to 14%.
10%

Assets

HTMC
Equity value if shareholders
EPS = P7 in perpetuity.
Debt

Debt-to-equity ratio

P10,000,000
Market
Value

P7 P5,000,000
P50
14%P5,000,000

1.0

P50

P50

6%

Substituting debt for equity will increase EPS, but

200,000
100,000
does not maximize the firms value.

Shares outstanding
Share price

Interest rate on debt

2012 Cengage Learning. All Rights Reserved. May not be scanned,

copied or duplicated, or posted to a publicly accessible Web site, in whole

Agency Costs And

Capital Structure

Agency costs arise as soon as entrepreneurs sell

fractions of their firms to outside investors.
Entrepreneur enjoys private benefits of control
(perquisites), but bears only part of the cost of
perks.

Debt helps mitigate these costs, but debt has its own
agency costs.
Agency costs of
outside debt

Expropriate bondholders wealth by

paying excessive dividends.

Bondholders protect themselves with positive and

negative covenants in lending contracts.

The Agency Cost / Tax Shield TradeOff Model Of Corporate Leverage

Companies trade off corporate tax and agency cost
benefits of equity against the costs of bankruptcy and
agency costs of debt.
Firm value V maximized at a unique optimal debt level:
V Levered = V Unlevered + PV tax shields PV bankruptcy costs
+ PV agency costs of outside equity
PV agency costs of outside debt

2012 Cengage Learning. All Rights Reserved. May not be

The Trade-Off Model of Corporate

Leverage

2012 Cengage Learning. All Rights Reserved. May not be scanned,

Leverage and Stocks Price

oDuring periods of good performance, leverage
enhances results in terms of ROE and EPS
oLeverage adds variability (risk) to financial
performance when operating results change
oThese effects push stock prices in opposite
directions
Real Investor Behavior and Optimal Capital
Structure
LOW leverage =>POSITIVE EFFECT on
investors
HIGH leverage =>DECREASES stock price
As leverage increases, its effect goes from
positive to negative

The Arguments on the Trade-Off

The Pecking-Order
Theory
theory

Managers tend to maintain a stable dividend policy.

1.
2.

Firms prefer internal financing to external financing*.

A firm will issue the safest external security first.

OPTIMAL CAPITAL STRUCTURE

Results to:
the highest possible stocks value
and
least cost of financing.

21

OPTIMAL CAPITAL STRUCTURE

Results to:
the highest possible stocks value
and
least cost of financing.

22

Cost of Debt
For the issuing firm, the cost
of debt is:
the rate of return required
by investors,
adjusted for flotation costs
(any costs associated with
issuing new bonds), and
adjusted for taxes.

Example: COST OF DEBT

If a firm borrows at
12.5% interest rate
and faces a 40%
marginal tax rate on
its taxable income,
what is the after-tax
cost of debt capital to
the firm?

Cost of Preferred
Stock
Finding the cost of
preferred stock is
similar to finding the
rate of return except
that we have to
consider the flotation
costs associated with
issuing preferred stock.

Example: COST OF
PREFERRED
If a firm issues preferred
stock, it will pay a
dividend of Php8 per year
and should be valued at
Php75 per share. If
flotation costs amount to
Php1 per share, what is
the cost of preferred
stock for the firm?

Cost of Common Stock

There are two sources of
Common Equity:
1) Internal common equity
(retained earnings).
2) External common equity
(new common stock
issue).

Cost of Equity

Cost of Internal Equity

Since the stockholders own
the firms retained earnings,
the cost is simply the
stockholders required rate of
return.
Why?

If managers are investing

stockholders funds,
stockholders will expect to
earn an acceptable rate of
return.

Example: COST OF
COMMON
If a firm pays a dividend of
Php20 per share on
common stock that sells
for Php200 per share and
the growth rate of
dividend payments is
expected to be 5% per
year, what is the cost of
equity capital for this firm?

WEIGHTED AVERAGE COST OF

CAPITAL (WACC)
weighs the percentage cost of
each component by the
percentage of that component
in the financial structure.

31

Weighted Cost of
Capital
Source

Cost

debt
preferred
common

7.5%
10.81%
15%

Capital
Structure
20%
10%
70%

Weighted Cost of Capital

(20% debt, 10% preferred, 70%
common)

Weighted cost of capital =

.20 (7.5%) + .10 (10.81%)
+ .70 (15%)
= 13.08%

COMMON MISTAKES IN WACC

COMPUTATION
Failure to use market values to
determine the weights.*
Failure to estimate the
component costs of WACC on an
after-tax, cash flow basis.
Failure to compare WACC with
expected returns
When Expected returns exceed or
at least equal required returns,
investment proposals are
acceptable.

34

BREAKPOINTS
Amount of capital financed
using assuming different
sources of capital

35

COMPREHENSIVE PROBLEM
Dillion Labs has asked its financial
manager to measure the cost of
each specific type of capital as well
as the weighted average cost of
capital. The weighted average cost
is to be measured by using the
following weights: 40% long-term
debt, 10% preferred stock, and 50%
common stock equity (retained
earnings, new common stock, or
both). The firms tax rate is 40%.
36

COMPREHENSIVE PROBLEM
Debt. The firm can sell for
P980 a 10-year, P1,000-par
value bond paying annual
interest at a 10% coupon rate.
A flotation cost of 3% of the par
value is required in addition to
the discount of P20 per bond.

37

COMPREHENSIVE PROBLEM
Preferred stock. Eight
percent (annual dividend)
preferred stock having a par
value of P100 can be sold for
P65. An additional fee of P 2
per share must be paid to the
underwriters.

38

COMPREHENSIVE PROBLEM
Common stock. The firms
common stock is currently (at
2006 year-end) selling for P 50
per share. Its dividend
payments have been
approximately 60% of earnings
per share in each of the past 5
years. The following table
shows
Year past
Year EPS: EPS
EPS reported
2006
2005
2004

6.23
5.83
5.44

2003
2002

5.09
4.76
39

COMPREHENSIVE PROBLEM
Requirement/s:
It is expected that to attract
buyers, new common stock must
be underpriced P5 per share, and
the firm must also pay P3 per
share in flotation costs. Dividend
payments are expected to
continue at 60% of earnings.
Calculate the specific cost of each
source of financing. (Assume that
kr = ks )
40

COMPREHENSIVE PROBLEM
Requirement/s:
It is expected that to attract buyers, new
common stock must be underpriced P5
per share, and the firm must also pay P3
per share in flotation costs. Dividend
payments are expected to continue at
60% of earnings.

If earnings available to common

shareholders are expected to be P7
million, what is the break point
associated with the exhaustion of
retained earnings?
41

COMPREHENSIVE PROBLEM
Requirement/s:
It is expected that to attract buyers,
new common stock must be
underpriced P5 per share, and the firm
must also pay P3 per share in flotation
costs. Dividend payments are expected
to continue at 60% of earnings.

Determine the weighted average

cost of capital between zero and
the break point calculated in
number 2 above.
42