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COST OF CAPITAL AND CAPITAL STRUCTURE

COST OF CAPITAL AND CAPITAL STRUCTURE. Lesson 6. Corporate Finance. Castellanza, 13 th October, 2010. Cost of capital. Def: is the expected rate of return that the market requires in order to attract funds to a particular investment. (cost of capital/rate of return) Characteristics:

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COST OF CAPITAL AND CAPITAL STRUCTURE

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  1. COST OF CAPITAL AND CAPITAL STRUCTURE Lesson 6 Corporate Finance Castellanza, 13th October, 2010

  2. Cost of capital Def: is the expected rate of return that the market requires in order to attract funds to a particular investment. (cost of capital/rate of return) Characteristics: it is it is market driven it is forward-looking it is usually measured in nominal terms (including expected inflation) Capital refers to the components of a capital structure: debt and equity

  3. Cost of equity (Ke) indirect way (CAPM) opportunity cost: the cost of foregoing the next best alternative investment at a specific level of risk rf = free risk return P = premium

  4. i = interest rate t = tax rate of the company (interests are tax-deductible expenses) Kd = f. interest rate bankruptcy risk tax benefits Cost of debt (Kd)

  5. Weighted average cost of capital (WACC) To be used when the objective is to value the entire capital structure of a company. E = equity, D = net financial debt or Net Financial Position Ke > WACC > Kd

  6. Capital structure Def: the capital structure of a firm is broadly made up of its amounts of equity and debt Components: equity (shareholder’s equity, corporate reserves, earnings) debt (ST and LT debts, corporate bonds, commercial papers …) quasi-equity (convertible bonds, mezzanine financing)

  7. Capital structure (cont’d) Debt versus Equity Fixed claims High priority on cash flows Tax deductible Fixed Maturity No management control Residual claims Lowest priority on cash flows No tax deductible Infinite life Management control _____________________________________________ Hybrids (Quasi-equity) Debt Equity

  8. Capital structure – costs and benefits of debt (cont’d) Benefits of debt Tax benefits when you borrow money, you are allowed to deduct interest expenses from your income to arrive a taxable income. This reduces your taxes. When you use equity you are not allowed to deduct payments to equity (such as dividends) to arrive at taxable income Adds discipline to management if you are manager of a firm with no debt, and you generate high income and cash flows each year, you tend to become complacent. The complacency can lead to inefficiency and investing in poor projects Costs of debt Bankruptcy costs Agency costs Loss of future flexibility

  9. The financing mix question In deciding to raise financing for a business, is there an optimal mix of debt and equity? If yes What is the trade-off that let us determine the optimal mix?

  10. If: taxes = 0 and extraord. rev.-exp. = 0 Maximization of shareholders’ return (ROE) ROE = [ROI + (D/E) * (ROI – i)] Net profit EBIT ROI = ROE = E CI D Interests expenses Leverage = i = E Net Debt E = Equity D = Net Debt or Net Financial Position CI = Capital invested = D + E i = interest rate paid on Net Debt

  11. Relationship between ROE and ROI (cont’d) Considering taxes: ROE = [ROI + (D/E) * (ROI – i)] * (1-t) t = tax rate (taxes/EBT) Considering extraordinary revenues/expenses: ROE = [ROI + (D/E) * (ROI – i)] * (1-t) * (1-s) s = (net extraordinary rev.-exp./earnings before net extraordinary rev.-exp.)

  12. Relationship between ROE and ROI : Example

  13. Relationship between ROE and ROI : Example ROE = [ ROI + ( D / E ) * ( ROI – i) ] * (1 – t) ROE = [11,2% + (12.000/10.300) * (11,2% – 5,0%)] * (1-31,6%) ROE = [11,2% + (1,17) * (6,2%)] * (68,4%) ROE = [11,2% + 7,2%] * (68,4%) ROE = 18,4% * 68,4% = 12,6%

  14. Relationship between ROE and ROI Decrease ROE Decrease ROI Decrease self-financing Increase of debt Increase cost of debt 14

  15. Leverage Leverage = D / E D = total financial debt or Net Financial Position E = equity Using leverage it is possible to increase debt in order to increase return on equity • D/E = 1 neutral situation • D/E > 1 situation to monitor • D/E < 1 situation to exploit 15

  16. Modigliani – Miller theory Hp: in an environment where there are no taxes, bankruptcy risk or agency costs (no separation between stockholders and managers), capital structure is irrelevant. the value of a firm (V) is independent of its debt ratio (D/E). The cost of capital of the firm will not change with leverage. V Va D/E

  17. Modigliani – Miller theory (cont’d) The effect of taxes V Vi =Vu + Vats Vi Vi = value of levered firm Vu = value of unlevered firm Vats = actual value of tax shields Va D/E

  18. Trade-off theory The effect of bankruptcy costs V Value of levered firms without bankruptcy costs Vi Vabc Value of levered firms Vl Vl = Vu+Vats-Vabc Vats Value of unlevered firms Vu D/E Vabc = actual value of bankruptcy costs Vats = actual value of tax shields

  19. Picking order theory Internal Financing sources External • Self-financing • Debt • Increase of equity Profitability Net Debt Level

  20. Financing mix decision Macroeconomic context (capital markets) Industry (maturity, capex, risk, etc.) Firm’s characteristics (market position, financial-economic situation…) Financial needs’ characteristics

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