CAPITAL STRUCTURE

& COST OF CAPITAL

Capital Structure

It is the way a firm finance itself for investment and operations

(Assets), through using equity, debt or a combination of both. And
it is needless to say that a dept can be short, intermediate or long
term.
Debt
Short term debt
Less than a year

Buying on credit, a factory buys raw materials and pays at a later

date
Trade credit is more flexible and costs less than a bank loan
Unless the buyer succeeds to pay in time he will not get a discount

Trade Credit

A bank loan

Short term loan for the banks

Capital Structure

Equity

1) Common stock

Represent the ownership interest, or equity of the corporations.

We have to distinguish between three values
Par value (stated or face value) what is written on the stock
Book value the accounting value of the equity as shown on the balance sheet
Market value the value of the stock in the market
Advantages for common stock holders
They have the right to vote
Get a percentage of profits as dividends in case the firm decided to give it
The right to sell the stock
Limited liability
One of the greatest disadvantages of the common stock is that in case of
bankruptcy they get their money (their share in the corporation) after
everyone else. They are residual claimers

Capital Structure
2)Preferred stock
An equity security that is much like common
stock except that they take a fixed percentage
out of the profits each year, and in case of
bankruptcy they get their claim before common
3)Retained Earning
Profits = RE + Dividends
It is the part of the profit that the firm decides
for keep it inside the firm in order to reinvest it
ock holders

Capital Structure

Long term debt

Financial institutions like banks and insurance firms usually

use it
It is important to determine the interest rate and payment
date.
It is also important to determine the kind of Mortgaging
(guarantee) for the loan

Loans

Bonds

It is a long term debt, gives its holder a right (claim) on the

issuer future assets or income at maturity date.
The holder also has a claim on the interest written on the
bond

COST OF CAPITAL
Prepared by: Dr. Dina Nassib

Cost Of Capital

Topics
8

Cost of Capital Components

Debt
Preferred
Common Equity

WACC

Composite
Risk Adjustments
WACC with Flotation Costs

What is WACC?
9

A company has different sources of

finance, namely common stock, retained
earnings, preferred stock and debt (capital
components).
Weighted average cost of capital (WACC) is
the average after tax cost of all the
sources. It is calculated by multiplying the
cost of each source of finance by the
relevant weight and summing the products
up.

Capital components & Component

cost
10

All Capital Components have on feature in

common; The investors who provided the
funds expect to receive a return on
investment.
The required rate of return on each capital
component is called component cost.
While the cost of capital used to analyze
capital budgeting decisions should be the
weighted average cost of capital ( WACC)

Sources of Long-term Capital

Long-Term
Capital
Long-Term
Debt
rd

Preferred
Stock
rps

Common
Stock
rs

Retained
Earnings
rce
11

New
Common
Stock
re
10-11

WACC
Weighted Average Cost of Capital
12

WACC = wdrd(1-T) + wpsrps + wcers(10.10

Where:

wd = % of debt in capital structure

Weight w = % of preferred stock in capital structure
ps
s
wce = % of common equity in capital structure
rd = firms cost of debt
Component
costs rps= firms cost of preferred stock
rs = firms cost of equity
T = firms corporate tax rate

1. Cost of Debt
13

Determine the rate of return that debt

holders require; rd.
The required rate of return to debt holders
is not equal to the companys cost of debt,
as interest payments are deductible.
Therefore the cost of debt to the firm is
less than the rate of return required by
debt holders.

NCCs Cost of Debt (rd)

14

Rd = Interest Rate (1-T)

Example:
If NCC co. can borrow at an interest
Rate of 11% and it its tax rate is 40%
What is its cost of debt after tax?
Rd(1-T)= 11% (1- 0.4)
Rd = 6.6%

2. Cost of Preferred Stock,

(rps)

15

Some firms use preferred stock as part of

their permanents financing mix.
Preferred dividends are not tax deductible,
therefore no tax adjustment is made when
calculating the cost of preferred stock.
Flotation costs for preferred stocks are
significant.
The cost of preferred stock is calculated by
dividing the preferred Dividend, Dps by the
net issuing prices Pn , which is the price the

NCCs Cost of preferred stock:

PP = $100

$10 Dividend

r ps

D ps
Pps ( 1 F )

F = 2.5%

(10 - 3)

Where:
Dps = Preferred dividend
PPS = Preferred stock price
F = Flotation cost %

r ps

$10

10.3%
$100 ( 1 .025 )
16

3. Cost of Common Equity

17

Two Ways to raise equity financing:

Directly

Issue new shares of common stock

Indirectly

Reinvesting earnings not paid out as

dividends
Use retained earnings

18

Funding with New Common

Equity

Mature firms rarely issue new

equity

High flotation costs

Negative signal to the market
Downward pressure on stock price

Cost of Retained Earnings

19

Earnings can be reinvested or paid out

as dividends.
Investors could buy other securities,
earn a return.
Thus, there is an opportunity cost if
earnings are reinvested.

20

Cost for Reinvested

Earnings

Opportunity cost: The return

stockholders could earn on alternative
investments of equal risk

They could buy similar stocks and earn

rs, or company could repurchase its own
stock and earn rs

rs = the cost of reinvested

earnings
= the cost of equity

Three ways to determine

the cost of equity, rs:
21

1. CAPM: rs = rRF + (RM - rRF)

= rRF + (RPM)
2. DCF:

rs

= D1/P0 + g

3. Own-Bond-Yield-Plus-Risk
Premium:
rs

= rd + Bond RP

Three ways to determine

the cost of equity, rs:
22

1. CAPM: rs = rRF + (RM - rRF)

= rRF + (RPM)
2. DCF:

rs = D1/P0 + g

3. Own-Bond-Yield-Plus-Risk
Premium:
rs = rd + Bond RP

CAPM Cost of Equity - Steps

23

1.
2.

3.
4.

Estimate risk-free rate (rRF)

Estimate market risk premium (RPM)
or expected return on the market
(RM)
Estimate beta ().
Substitute into CAPM( Capital Asset
Pricing Model).

Estimating rRF
24

Common stock = long-term security

T-Bills more volatile than T-Bonds

Most analysts use the rate on a longterm (10 to 30 years) government bond
as an estimate of rRF

Estimating RPM or RM

Historical - Ibbotson & Associates

1926-most recent year

6.5% arithmetic mean - if constant risk
aversion
4.9 % geometric mean best future
estimate

Ex Ante = Forward-Looking

D1

Return
Expected

g rRF RPM R M Required Return

If market
in
equilibrium:
M
P0
Value Line
or Reuters

Historical or
analysts
estimates

25

RPM Estimate #1
RPM = 11.73%

rM Estimate (Reuters, Spring 2008)

Forward-looking RPM:

Dividend yield on S&P500 = 2.61% r D0 ( 1 g ) g

M
P0
Dividend growth rate = 13.20%
rM=[0.0261(1+.132)]+0.132=16.15%
Long-term T-Bond rate = 4.42%
16.15% - 4.42% = 11.73%

Problems:

Past = future?
Growth rates sensitive to period
measured

26

RPM Estimate #2
RPM = 17.79%

rM Estimate (Spring 2008)

Forward-looking RPM:

Reuters S&P500 dividend yield = 2.61%

Yahoo Earnings growth rate = 19.1%
rM=[0.0261(1+.191)]+0.191=22.21%
22.21% - 4.42% = 17.79%

rM

D0 ( 1 g )
g
P0

Problems:

Earnings growth dividend growth

1-year growth rate long-term growth
Analysts accuracy
27
Differing analysts opinions

Estimating RPM (or RM)

28

RPM = Equity risk premium

RM

Most analysts use a rate of 5% to 6.5%

for the market risk premium
S&P500 index return =proxy for the
market return

RPM=RM- rRF
Brigham-Daves RPM = [3.5, 6.5]

Estimating Beta -
29

Beta estimates vary

Beta estimates are noisy

Historical Beta

Wide confidence interval

4-5 years/monthly or 1-2 years/weekly
Adjusted Beta
Fundamental Beta

Multinational issues

NCCs CAPM Cost of Equity

30

Example

rRF = 8% RPM = 6%
rs 1.1
= rRF + (RM - rRF )
=
= 8.0% + (6.0%)1.1
rs = 14.6%

NCCs DCF (Discounted Cash Flow)

Cost of Equity, rs
31

D1 = $2.40
P0 = $32
g=
7%
D1
D0(1+g)
rs
+g=
+g
P0
P0
=
$2.40 + 0.07
=
$32
= 0.075 +
= 0.07
14.5%

Final Estimate of rs
Method
CAPM

Estimat Used by
e
14.6%
74% - 85%

DCF

14.5%

16%

rd + RP

14.7%

Non-public

Average

14.6%
32

Topics
33

Cost of Capital Components

Debt
Preferred
Common Equity

WACC

Composite
Risk Adjusted
WACC with Flotation Costs

WACC
Weighted Average Cost of Capital
34

WACC = wdrd(1-T) + wpsrps + wcers(10.10

Where:

wd = % of debt in capital structure

Weight w = % of preferred stock in capital structure
ps
s
wce= % of common equity in capital structure
rd = firms cost of debt
Component
costs rps= firms cost of preferred stock
rs= firms cost of equity
T = firms corporate tax rate

WACC Weights
35

Weights =percentages of the firm

that will be financed by each
component
If possible, always use the target
weights for the percentages of the
firm that will be financed with the
various types of capital

NCCs WACC
Weighted Average Cost of
Capital
Component
Debt (before
tax)
Preferred Stock
Common equity

w
r
0.30 11.0%
0.10 10.3%
0.60 14.6%

WACC = wDrD (1- T)+ wPsrPs +

Example
wcrs
NCC: 30% debt, 10% Preferred, 60% Equity

WACC =0.3(11%)(1-.40)+0.1(10.3%)+0.6(14.6%)
WACC = 11.77%
36

Self Test Problem

37

Longstreet communication Inc. has the

following capital structure, which it considers
to be optimal : debt =25%, preferred stock =
15% and common stock= 60%.
LCIs tax rate is 40% and investors expects
earnings and dividends to grow at a constant
rate of 6% in the future. LCI paid a dividend of
$3.70 per share last year (D0), and its stock
currently sells a price of $60 per share.
Treasury bonds yield 6% , the market risk
premium is 5%, and LCIs beta is 1.3.

Self Test Problem

38

1.

2.

Preferred : New preferred could be sold to the

public at a price of $100 per share, with a
dividend of $9. Flotation costs of $5 per share
would be incurred.
Debt: debt could be sold at an interest Rate of
9%.
Questions
Find the component costs of debt, preferred
stock, and common stock.
Calculate the WACC for LCI.