Capital Structure and

the Cost of Capital :

Theory and Evidence

Oleh :
Bambang Sutrisno (1406512732)

The Capital Structure Question and The Pie Theory

The value of a firm is defined to be the sum of the value of

the firms debt and the firms equity.

V=B+S

where B is the market value of the debt and S is the

market value of the equity.
If the goal of the firms
management is to make the
firm as valuable as possible,
then the firm should pick the
debt-equity ratio that makes
the pie as big as possible.

The Capital Structure Question

There are really two important questions:

1. Why should the stockholders care about maximizing firm
value? Perhaps they should be interested in strategies that
maximize shareholder value.
2. What is the ratio of debt-to-equity that maximizes the
shareholders value?
As it turns out, changes in capital structure benefit the
stockholders if and only if the value of the firm increases.

Capital Structure Theory

MM I & II

Trade-off Theory

Signaling Theory

Pecking Order Theory

Market Timing

The Cost of Equity Capital

Choices of a Firm with Extra Cash

The discount rate of a project should be the expected return

on a financial asset of comparable risk.

Estimating the Cost of Equity Capital with the CAPM

Under the CAPM, the expected return on stock can be written as :

where RF is the risk free rate and RM RF is the difference between

the expected return on the market portfolio and the riskless rate. This
difference is often called the expected excess market return or market
risk premium.
We now have the tools to estimate a firms cost of equity capital. To do
this, we need to know three things :
1. The risk-free rate, RF

2. The market risk premium, RM RF

3. The stock beta,

Example : Cost of Equity

Suppose the stock of the Quatram Company, a publisher of college

textbooks, has a beta () of 1.3. The firm is 100 percent equity
financed; that is, it has no debt. Quatram is considering a number of
capital budgeting projects that will double its size. Because these new
projects are similar to the firms existing ones, the average beta on new
projects is assumed to be equal to Quatrams existing beta. The risk
free rate is 5 percent. What is the appropriate discount rate for these
new projects, assuming a market risk premium of 8.4 percent?
We estimate the cost of equity, RS, for Quatram as :
RS = 5% + (8.4% x 1.3)
= 5% + 10.92%
= 15.92%

Cost of Debt

The cost of debt is the required return on our companys

debt.

The after-tax cost of debt can be written as :

After-tax cost of debt = (1 Tax rate) x Borrowing rate

Cost of Preferred Stock

Reminders
Preferred

generally pays a constant dividend

every period

Dividends

are expected to be paid every period

forever

Preferred stock is a perpetuity, so we take the

formula, rearrange, and solve for r

r = C / PV

Example : Cost of Preferred Stock

Your company has preferred stock that has an

annual dividend of $3. If the current price is $25,
what is the cost of preferred stock?

r = 3 / 25 = 12%

Weighted Average Cost of Capital

If a firm uses both debt and equity, the cost of

capital is a weighted average of each. This works
out to be :

where RS is the cost of equity and RB is the cost of

debt.

Weighted Average Cost of Capital

Interest is tax deductible at the corporate level. The aftertax cost of debt is :

Cost of debt (after corporate tax) = RB x (1 tc)

where t is the corporations tax rate.

Assembling these results, we get the average cost of

capital (after tax) for the firm :

Because the average cost of capital weighs the cost of

equity and the cost of debt, it is usually referred to as the
weighted average cost of capital (RWACC).

Example 1 : WACC

Consider a firm whose debt has a market value of $40

million and whose stock has a market value of $60 million
(3 million outstanding shares of stock, each selling for $20
per share). The firm pays a 5 percent rate of interest on its
new debt and has a beta of 1.41. The corporate tax rate is
34 percent. (Assume that the security market line (SLM)
holds, that the risk premium on the market is 9.5 percent
(somewhat higher than the historical equity risk premium),
and that the current Treasury bill rate is 1 percent.) What is
this firms RWACC?

Example 1 : WACC

To compute the RWACC, we must know (1) the after-tax cost of debt, RB x
(1 tc), (2) the cost of equity, RS, and (3) the proportions of debt and
equity used by the firm. These three values are determined next :

(1) The pretax cost of debt is 5 percent, implying an after-tax cost of 3.3
percent (= 5% x (1 0.34)).

(2) We calculate the cost of equity capital by using the SML :

(3) We compute the proportions of debt and equity from the market values
of debt and equity. Because the market value of the firm is $100 million
(= $40 million + $60 million), the proportions of debt and equity are 40
and 60 percent, respectively.

Example 1 : WACC

The cost of equity, RS, is 14.40 percent, and the after-tax cost of debt,
RB x (1 tc) is 3.3 percent. B is $40 million and S is $60 million.
Therefore :

The above calculations are presented in table form below :

Example 2 : Project Evaluation and the WACC

Suppose a firm has both a current and a target debt-equity ratio of 0.6,
a cost of debt of 5.15 percent, and a cost of equity of 10 percent. The
corporate tax rate is 34 percent. What is the firms weighted average
cost of capital?

Our first step calls for transforming the debt-equity (B/S) ratio to a debtvalue ratio. A B/S ratio of 0.6 implies 6 parts debt for 10 parts equity.
Because value is equal to the sum of the debt plus the equity, the debtvalue ratio is 6/(6 + 10) = 0.375. Similarly, the equity-value ratio is
10/(6+10) = 0.625. The RWACC will then be :

Example 2 : Project Evaluation and the WACC

Suppose the firm is considering taking on a warehouse renovation

costing $60 million that is expected to yield cost savings of $12 million a
year for six years. Using the NPV equation and discounting the six
years of expected cash flows from the renovation at the RWACC,
we have:

Should the firm take on the warehouse renovation? The project has a
negative NPV using the firms RWACC. This means that the financial
markets offer superior investments in the same risk class (namely, the
firms risk class). The answer is clear : The firm should reject the
project.

A Model with Business Disruption and Tax-Deductible Interest

Leland (1994) and Leland and Toft (1996) have modeled the value of a firm
assuming that the present value of business disruption costs and the present
value of lost interest tax shields are affected by the firms choice of capital
structure. The result is an optimal capital structure that is defined by a trade-off
between the value created by the present value of the interest tax shield, and
the value lost from the present value of business disruption costs as well as the
present value of lost interest tax shields.

Optimal capital structure as a trade-off between the interest tax shield

and business disruption costs

Business Disruption Costs : Evidence

Business disruption costs are incurred before as well as during

bankruptcy and include lost business and lost investment opportunities.

Evidence on business disruption costs is provided by Altman (1984).

Altman provides an estimate (for a sample of 19 firms, 12 retailers, and
7 industrials that went bankrupt between 1970 and 1978) that compares
expected profits, computed from time-series regressions, with actual
profits. The arithmetic average indirect bankruptcy costs were 8.1% of
firm value three years prior to bankruptcy and 10.5% the year of
bankruptcy. A second method uses unexpected earnings from analysts
forecasts for a sample of 7 firms that went bankrupt in the 1980-1982
interval. Average indirect bankruptcy costs were 17.5% of value one
year prior to bankruptcy.

Altmans evidence suggests that total bankruptcy costs (direct and

indirect) are sufficiently large to give credibility to a theory of optimal
capital structure based on the trade-off between gains from leverageinduced tax shields and expected bankruptcy costs.

Agency Costs : Another Equilibrium Theory of Optimal Capital Structure

Optimal capital structure determined by minimizing total agency costs

Agency Costs : Another Equilibrium Theory of Optimal Capital Structure

The figure illustrates the Jensen-Meckling argument for an optimal

capital structure based on the agency costs of external equity and debt
(in a world without taxes). Agency costs of external equity are assumed
to decrease as the percentage of external equity decreases, and the
agency costs of debt are assumed to increases.

The figure illustrates a case where total agency costs are minimized
with an optimal capital structure between 0% and 100%-an interior
solution. If the agency costs of external equity are low, as may be the
case for a widely held firm, then optimal capital structure can result as a
trade-off between the tax shelter benefit of debt and its agency cost.

Empirical Evidence Concerning Capital Structure

1. Cross-Sectional Studies
Modigliani and Miller (1958) use cross section equations on data taken
from 43 electric utilities during 1947-1948 and 42 oil companies during
1953. They estimate the weighted average cost of capital as net operating
cash flows after taxes divided by the market value of the firm. When
regressed against financial leverage (measured as the ratio of the market
value of debt to the market value of the firm), the results were :

where d is the financial leverage of the firm and r is the correlation

coefficient. These results suggest that the cost of capital is not affected by
capital structure (because the slope coefficients are not significantly
different from zero) and therefore that there is no gain to leverage.

Empirical Evidence Concerning Capital Structure

Weston (1963) criticizes the Modigliani-Miller results on two counts.

First, the oil industry is not even approximately homogeneous in
business risk (operating leverage); second, the valuation model from
which the cost of capital is derived assumes that cash flows are
perpetuities that d not grow. When growth is added to the cross-section
regression, the result for electric utilities becomes

where A is the book value of assets (a proxy for firm size) and E is the
compound growth in earnings per share (1949-1959). Since WACC
decreases with leverage, Westons results are consistent with the
existence of a gain to leverage.

Empirical Evidence Concerning Capital Structure

2. Evidence Based on Exchange Offers and Swaps
For a sample containing 106 leverage-increasing and 57 leveragedecreasing exchange offers during the period 1962 through 1976,
Masulis (1980) found highly significant announcement effects. For the
Wall Street Journal announcement date and the following day, the
announcement period return is 7.6% for leverage-increasing
exchange offers and -5.4% for leverage-decreasing exchange offers.

These results are possibly consistent with three theories : (1) that
there is a valuable tax shield created when financial leverage is
increased, (2) that debtholders wealth is being expropriated by
shareholders in leverage increasing exchange offers, and (3) that
higher leverage is a signal of managements confidence in the future
of the firm.

Empirical Evidence Concerning Capital Structure

3. Time-Series Studies : Announcement Effects
It is interesting to take empirical results on dozens of different
corporate events and compare them. Smith (1986) suggests that they
be compared in two different dimensions events that increase
financial leverage (a favorable signal) and those that imply favorable
future cash flow changes.
All leverage-decreasing events have negative announcement effects,
and all leverage-increasing events, save one, have positive
announcement effects. The exception is the new issue of debt
securities, where Dann and Mikkelson (1984), Eckbo (1986), and
Mikkelson and Partch (1986) found negative but insignificant
announcement effects. This result is also consistent with the pecking
order theory. The majority events with no leverage change had
insignificant announcement effects.
Announcements with favorable (unfavorable) implications for the future
cash flows of the firm such as investment increases (decreases) and
dividend increases (decreases) were accompanied by significant
positive (negative) effects on shareholders wealth.