Chapter 13 Capital Structure and the Cost of Capital

Question 1

Capital Structure: The mix of debt and equity (fund) financing used by a business:

Using Debt to finance a business:

• Reduces the equity needed
• Reduces taxes
  
  • Interest payments are tax deductable
  • Returns to equity holders are not
• ROE = Net income / book value of equity
• Increases risk

The cost of equity is greater than the cost of debt

Answer 1

Capital Structure Theory

• Developed for investor owned businesses
• If the relationship between debt financing and equity value (stock price) were known, the optimal capital structure could be identified

The Trad-off model

• An optimal structure balances the tax advantages of debt financing agains the increased risk of using debt.
• The cost of debt increases as the proportion of debt increases
• The cost of equity also increases with debt financing

Question 2

Most relevant is the weighted average (blended) cost of debt and equity.

Qualitative factors to consider in identifying an optimal capital strucutre:

• The amount of business risk:
  
  • Present even when no debt financing is used
  • Uncertainty in forecasting operating income (EBIT)
  • The more uncertian the forecast, the higher the business risk
  • Measured by the Standard Deviation of ROE assuming no debt financing is used (marekt risk can be identified by the stock’s beta)
  • If zeor debt financing is used, return on equity = return on assets

Answer 2

• The use of debt financing concenrates the business risk borne by equityholders
• The risk added when debt is used is financial risk
• Standard deviation of ROE with debt - Standard deviation or ROE without debt = Financial risk
• The greater the inherent business risk, the less room for debt financing
• Lender and rating agency attitudes
• Reserve borrowing capacity
• Industry Averages
• Asset Structure
  
  • Assets available for collateral

Question 3

Other facotrs that influence business risk:

• Uncertainty about sales volume, sales price, and cost
  
  • Operating leverage - the amount proportion of fixed costs in a business’s cost structure

Total risk = Business risk + Financial risk

Capital Structure theory cannot be used to design an optimal capital structure bucause the cost of equity cannot be estimated with confidence

Question 4

Not-for-profit businesses cannot raise equity from capital markets.

Resources of Equiy Capital:

• Government grants
• Private Contributions
• Excess revenue (retained earnings)

Question 5

Estimate a business’s Corporate Cost of Capital

• A weightd average of the component debt and equity costs
• Used as the baseline required rate of return

Opportunity Cost rate: The rate of return expected on alternative investments similar in risk to the investment being considered

The Capital Components

• Corporate Cost of capital focuses on the permanent capital (long-term capital / debt) and equity
• Short-term capital is usually not included in the cost of capital estimates

Answer 5

Tax Effects

Two different sets of capital costs can be estimated:

• Historical (embedded) costs: Reflect the cost of funds raised in the past
• Marginal (New) costs: measure the cost of funds to be raised in the future

Question 6

Cost of Debt Capital:

Not-for-profit debt

**Tax-exempt component cost of debt = R(R_d) **

**R(Rd) = **annual pmt / par value **

Taxable component cost of debt = R(R_d) x (1 - T)

Question 7

Investor Owned Businesses:

The Cost of equity for investor owned businesses is the return that invesotrs require on the firm’s common stock

Equity raised through retained earnings is NOT FREE. There is opportunity cost. Same cost as new stock sale

Three ways to estimate the cost of equity

1. Capital Asset Pricing Model (CAPM)
2. Discounted Cash flow
3. Debt cost + risk premium

Answer 7

Capital Asset Pricing Model (CAPM)

Security Market Line: Relates risk to return

R(R_e) = RF + (R(R_M) - RF) x b

R(Re) = RF + (RP_M x b)

RF = 10 year T-Bond rate

RP_M = (R(R_M) - RF)= Market risk premium

b = How risky was the stock in the past

Question 8

Discounted Cash flow

• Uses the dividend valuation model

E(R_e) = [E (D₁) / P₀] + E(g)

• E(Re) = R(R_e)
• P₀ is readily available

Question 9

Debt Cost Plus risk premium

• Assums that Stock investments are riskier than debt investments

R(R_e) = R(R_d) + Risk Premium

• Risk premium is not the same as the market premium in CAPM
• Risk Premium is difficult to estimate usually between 3 to 5 percentage points

Question 10

Equity for not-for-profit businesses

1. Contributions and grants
2. Excess of revenues over expenses (retained earnings)

Cost of capital for a fund

1. Zero cost. No return required by the suppliers of equity
2. Opportunity cost = the return on short-term investments
3. Must earn a return on equity to support growth ex. patient load
4. Cost equal to whats required to maintain creditworthiness
5. Expected growth rate sets the minimum required rate of return and hence the minimum cost of equity
6. **Must reflect returns that could be earned on stock of similar investor-owned companues **

Answer 10

Cost of Capital for not-for-profit

3 Approaches

1. Use the cost of equity of a similar publicly traded business
2. Use business’s long-run growth rate
3. Use R(R_e) specified by a ratings agency to maintain creditworthiness.

Question 11

Corporate Cost of Capital

• Combine equity and debt cost estimates

CCC = [W_d x R(R_d) x (1 - T) + [W_e x R(R_e)]

• Represents the cost of each new dollar raised (marginal cost)
• Each dollar raised cosists of debt and equity
• If capital is required by a firm that far exceeds that normally raised, the CCC must be adjusted upward to reflect the higher costs

Question 12

Estimating the Cost of Debt

1. Debt Cost plus risk premium approach
2. Pure Play approach
3. Build-up method
   
   • Size premium
   • Liquidity premium
   • Unique Risk premium