2022

FIN 3004 – CORPORATE FINANCE

CHAPTER 2
CAPITAL STRUCTURE

READING

• Chapter 14 &16, Fundamentals of Corporate Finance;

Stephen A. Ross, Randolph W. Westerfield, Bradford D.
Jordan; McGraw‐Hill (2010).

CHAPTER OUTLINE

2.1. Sources of Capital

2.2. Cost of Capital

2.3. Capital Structure and Financial Leverage

2.4. Break-even analysis

2.5. Operating Leverage and Total Leverage

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2.1. Sources of Capital
Capital is wealth in the form of money or assets,
taken as a sign of the financial strength of firm and
assumed to be available for development or
investment.
Based on the nature of ownership:
o Equity Capital
o Debt Capital

2.1.1. Debt Capital
Debt Capital (Liabilities) refer to the debts or
obligations that arise during the course of its
business operation.
o Current Liabilities: short‐term financial obligations
that are due within one year
o Non‐current Liabilities: long‐term financial
obligations that are due over one year
 Sources of liabilities: Bank loans, Trade credit, Bond.

2.1.2. Equity Capital
 Equity Capital is the capital that shareholders
contributed without any promise of repayment.
 Sources of Equity Capital:
o Initial Contribution
o Additional Paid‐in Capital
o Retained Earning
o Revaluation Reserve
o Treasury Shares.
o Common stocks.

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Equity Capital versus Debt Capital

Advantages Disadvantages
‐ No interest and  ‐ More expensive
Equity  repayment ‐ Sharing the 
Capital requirement ownership
‐ Reduce the debt ratio
‐ Cheaper ‐ Interest and 
Debt  ‐ Tax advantage repayment 
Capital ‐ Financial leverage requirement
‐ Not sharing the   ‐ Default risk
ownership ‐ High debt ratio

2.2. Cost of Capital
Why cost of capital is important?
 The return earned on assets depends on the risk of those
assets.
 The return to an investor is the same as the cost to the
company.
 Our cost of capital provides us with an indication of how
the market views the risk of our assets.
 Knowing our cost of capital can also help us determine
our required return for capital budgeting projects.

Cost of Capital vs Required Return
 The required return is the same as the appropriate
discount rate and is based on the risk of the cash flows.
 We need to know the required return for an investment
before we can compute the NPV and make a decision
about whether or not to take the investment.
 We need to earn at least the required return to
compensate our investors for the financing they have
provided.
 Required return, appropriate discount rate, and cost of
capital

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2.2.1. Cost of Equity 

 Cost of equity: The return that equity investors

require on their investment in the firm.
 There are two main methods for determining the
cost of equity:
a. Dividend growth model (DGM)
b. SML or CAPM

a. The dividend growth model approach

Assumptions:
1. Dividends grow at a constant rate (g).
2. The constant growth rate will continue for an infinite
period.
3. The required rate of return is greater than the
infinite growth rate (g)

a. The dividend growth model approach

 The share price is the current value of all expected

cash flow in the future. Suppose shareholder holds the
share forever, the cash flow would be the dividends.

Po :  present value of share
Dn : expected dividend in year n
ks : required return on the investment

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a. The dividend growth model approach

D1 D2 D3 Dt
P0    . . . ...
1ks  1ks  1ks  1ks 
1 2 3 t

D1  D0 (1 g)1
D2  D0 (1 g)2
D3  D0 (1 g)3 D0 (1  g ) D
P0   1
... ks  g ks  g
DN  D0 (1 g)N

a. The dividend growth model approach

o D0  : Dividend just paid 
o D1 : The next period’s projected dividend
o g : The constant growth rate of dividends
o Ks : Required return on the stock.

a. The dividend growth model approach –
Example 2.1
Suppose the ABC paid a dividend of $4 per share last
year. The stock currently sells for $60 per share. You
estimate that the dividend will grow steadily at a rate of
6% per year into the indefinite future.
What is the cost of equity capital for ABC ?

DGM model using Yahoo Finance data:

https://www.youtube.com/watch?v=nhJaAC0BUVQ

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Example 2.1 - Calculations

Ks = D1/P0 + g
= $4.24/60 + 0.06
= 13.7%

• The cost of equity is 13.07%

Estimating Dividend Growth Rates

• Use historical growth rates:
Example: Suppose we observe the following  for 
some company:

Estimating Dividend Growth Rates

The expected growth rate, g :
(9.09 + 12.50 + 3.70 + 10.71)/4 = 9%

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Advantages and disadvantages of 
dividend growth model method
Advantage: 
o Easy to understand and use
Disadvantages:
o Only applicable to companies currently paying 
dividends
o Not applicable if dividends aren’t growing at a 
reasonably constant rate
o Extremely sensitive to the estimated growth rate 
o Does not explicitly consider risk

b. The SML approach
Compute cost of equity using the SML
o Risk‐free rate, Rf
o Market risk premium, E(RM) – Rf
o Systematic risk of asset, 

RE  R f   E ( E ( RM )  R f ))

b. SML approach ‐ Example 2.2
Company’s equity beta = 1.2
Current risk‐free rate = 7%
Expected market risk premium = 6%
What is the cost of equity capital?
RE  7  1.2( 6 )  14.2%
CAPM model using Yahoo Finance data:
https://www.youtube.com/watch?v=0iKp3ztoCik
More examples: https://www.youtube.com/watch?v=rPY2wGyOtGM

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Advantages and disadvantages of 
SML method
Advantages
o Explicitly adjusts for systematic risk.
o Applicable to all companies, as long as beta is
available.
Disadvantages
o Must estimate the expected market risk premium,
which does vary over time.
o Must estimate beta, which also varies over time.
o Relies on the past to predict the future, which is
not always reliable.

Cost of equity ‐ Example 2.3

Data:
o Beta = 1.2 
o Market risk premium = 8% 
o Current risk‐free rate = 6% 
o Analysts’ estimates of growth = 8% per year 
o Last dividend = $2 
o Current stock price = $30
What is the cost of equity capital?

Example 2.3 ‐ Calculations 

Using SML:  RE = 6% + 1.2(8%) = 15.6%

Using DGM: RE = [2(1.08) / 30] + .08 = 15.2%

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2.2.2. Cost of debt

Cost of debt: The return that lenders require on

the firm’s debt.
We usually focus on the cost of long‐term debt or
bonds.

2.2.2. Cost of Debt
Method 1: Compute the yield to maturity on existing
debt.
o The cost of debt is NOT the coupon rate.
Method 2: Use estimates of current rates based on
the bond rating expected on new debt.
More details: 
https://corporatefinanceinstitute.com/resources/knowledge/finance/c
ost‐of‐debt/
https://www.youtube.com/watch?v=CSkPlxEe‐dY
https://www.youtube.com/watch?v=cuOkK3TCBHg (how to estimate 
COD in practice)

2.2.2. Cost of Debt
Bond valuation – Coupon Bond:
c – coupon rate
y – yield to maturity
n – maturity
FV – Face value (or par value)
A – coupon:  A = FV * c
PV = A [1‐ (1+y)‐n ]/ y + FV / (1+y)n

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2.2.2. Cost of Debt – Example 2.4
 Suppose the General Tool Company issued a 30‐year,
7% bond 8 years ago. The bond is currently selling for
96 percent of its face value, or $960.
 What is General Tool’s cost of debt?

Answer:
Yield to maturity = 7.37 %
General Tool’s cost of debt, RD = 7.37 %

2.2.3. Cost of Preference shares
Reminders:
o Preference shares generally pay a constant
dividend every period.
o Dividends are expected to be paid every period
forever.
Preference share valuation is an annuity, so we take
the annuity formula (P0 = D/ RP ), rearrange and solve
for RP.
RP = D/P0

2.2.3. Cost of Preference shares –
Example 2.5

 Your company has preference shares that have

an annual dividend of $3. If the current price is
$25, what is the cost of a preference share?

 RP = 3 / 25 = 12%

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2.2.4. Weighted average cost of 
capital (WACC)
 Use the individual costs of capital to compute a
weighted “average” cost of capital for the firm.
 This “average” = the required return on the
firm’s assets, based on the market’s perception
of the risk of those assets.
 The weights are determined by how much of
each type of financing is used.

a. Determining the weights for the 
WACC
 Weights = percentages of the firm that will be
financed by each component.
 Always use the target weights, if possible.
o If not available, use market values.
WACC = wERE + wPRP + wDRD(1‐ TC)

Capital structure weights
Notation
o E = market value of equity = # of outstanding
shares times price per share
o P = market value of preferred stock = # of
outstanding shares times price per share
o D = market value of debt = # of outstanding
bonds times bond price
o V = market value of the firm = D + E
Weights
o wE = E/V = percent financed with equity
o wp = P/V = percent financed with preferred stock
o wD = D/V = percent financed with debt
wE + wP + wD = 1

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Capital structure weights – Example 
2.6  
Suppose you have a market value of equity equal to
$500 million and a market value of debt equal to
$475 million.
o What are the capital structure weights?
• V = 500 million + 475 million = 975 million
• wE = E/D = 500 / 975 = .5128 = 51.28%
• wD = D/V = 475 / 975 = .4872 = 48.72%

b. Taxes and the WACC 
We are concerned with after‐tax cash flows, so we
need to consider the effect of taxes on the various
costs of capital.
Interest expense reduces our tax liability.
o This reduction in taxes reduces our cost of debt.
o After‐tax cost of debt = RD(1‐TC).
Dividends are not tax deductible, so there is no tax
impact on the cost of equity.

WACC = (E/V) x RE + (P/V) x RP +  (D/V) x RD x (1‐ TC)

WACC ‐ Example 2.7

 Equity information  Debt information
o 50 million shares o $1 billion in outstanding 
o $80 per share debt (face value)
o Beta = 1.15 o Current quote = 110% of 
o Market risk premium  its face value.
= 9% o Coupon rate = 9%, 
o Risk‐free rate = 5% semiannual  coupons
o 15 years to maturity
 Tax rate = 40%
Use CAPM to find RE

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WACC ‐ Example 2.7

What is the cost of equity?
o RE = 5 + 1.15(9) = 15.35%
What is the cost of debt?
o RD = 7.854%
What is the after‐tax cost of debt?
o RD(1‐TC) = 7.854(1‐.4) = 4.712%

WACC ‐ Example 2.7

 What are the capital structure weights?
o E = 50 million (80) = 4 billion
o D = 1 billion (1.10) = 1.1 billion
o V = 4 + 1.1 = 5.1 billion
o wE = E/V = 4 / 5.1 = .7843
o wD = D/V = 1.1 / 5.1 = .2157

 What is the WACC?

o WACC = .7843(15.35%) + .2157(4.712%) =
13.06%

WACC – Example 2.8

Market value Cost of capital
No. Capital
(milion VND) (%)
1 Debt 2.700 10
2 Preferred stocks 180 10.3
3 Common stocks 4.500 15
4 Retained earnings 1.620 14
Total 9.000

WACC? If Tax rate = 25%

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2.3.1. Capital Structure and 
Financial Leverage
 Capital structure: percentage of debt and equity
used to fund the firm’s assets
 Debt‐Equity Ratio:
Debt‐Equity Ratio = Total Debt/Total Equity

2.3.2. Capital structure and 
Cost of capital 
What is the primary goal of financial
managers?
o To maximize shareholder wealth
We want to choose the capital structure that
will maximize shareholder wealth.
We can maximize shareholder wealth by
maximizing firm value or minimizing WACC.

2.3. Capital structure and 
Cost of capital 
We will want to choose the firm ’ s capital
structure so that the WACC is minimized.
A particular debt–equity ratio represents the
optimal capital structure if it results in the lowest
possible WACC.
Optimal capital structure is sometimes called the
firm’s target capital structure.

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2.3.3. Financial Leverage

?
Capital Shareholders’
structure wealth

Debt ratio EPS/ROE

EXAMPLE 2.9 Unit: $1,000

The economic status

Recession Expected Expansion
Iterm Cor. A Cor.B Cor. A Cor.B Cor. A Cor.B
Asset 1000 1000 1000 1000 1000 1000
Debt 0 500 0 500 0 500
Equity 1000 500 1000 500 1000 500
Debt‐equity ratio 0 1 0 1 0 1
EBIT 80 80 120 120 220 220
Return on asset 0.08 0.08 0.12 0.12 0.22 0.22
Interest (r=12%) 0 60 0 60 0 60
Earning before tax 80 20 120 60 220 160
Income Tax (t=25%) 20 5 30 15 55 40
Net income 60 15 90 45 165 120
ROE 6% 3% 9% 9% 17% 24%
NS (share price =$20) 50 25 50 25 50 25
EPS 1.20 0.60 1.80 1.80 3.30 4.80

2.3.3. Financial Leverage
Variability in ROE:
o Firm A: ROE ranges from 6% to 17%
o Firm B: ROE ranges from 3% to 24%
Variability in EPS:
o Firm A: EPS ranges from $1.2 to $3.3
o Firm B: EPS ranges from $0.6 to $4.8
The variability in both ROE and EPS increases when
financial leverage is increased.

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2.3.3. Financial Leverage

Financial leverage: is the use

of debt and preferred stock
in capital structure
Financial leverage refers to
the extent to which a firm
relies on debt.
The more debt financing a
firm uses in its capital
structure, the more financial
leverage it employs.

2.3.3. The Effect of Financial Leverage
How does leverage affect
the earnings per share
(EPS) and return on equity
(ROE) of a firm?
o Leverage amplifies the
variation in both EPS
and ROE.
When we increase the
amount of debt financing,
we increase the fixed
interest expense.

Break‐even EBIT
 Find EBIT where EPS is the same under both
the current and proposed capital structures:
EPS debt = EPS no debt

 If expected EBIT > break‐even EBIT => leverage

is beneficial to stockholders
 If expected EBIT < break‐even EBIT => leverage
is detrimental to stockholders

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Break‐even EBIT (cont.)

2.3.4. Degree of Financial Leverage 
(DFL)
To estimate the effect of financial leverage to EPS,
we use the Degree of Financial Leverage (DFL)

 This illustrates how many percentages of EPS

changes when EBIT changes 1%

2.4. Break‐even Analysis

 Break‐even analysis entails the estimation of the

safety margin for an entity based on revenue and
associated costs.
 Break‐even analysis is useful in the
determination of the level of production or in a
targeted desired sales mix.
 Accounting break‐even point: is simply the sales
level that results in a zero project net income.

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Fixed costs versus Variable costs

 Fixed costs: Costs that do not change when the

quantity of output changes during a particular
time period.
 Variable costs: Costs that change when the
quantity of output changes.

2.4. Break‐even Analysis
Q – Total units sold
p – Selling price per unit
F – Fixed cost
v – Variable cost per unit
At the break‐even point:
P x QBE = F + v x QBE
F
Q ୆୉ ൌ
pെv

2.4. Break‐even Analysis

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2.5.1. Operating Leverage

Operating leverage is the degree to which a firm

or project relies on fixed costs.
 A firm with low operating leverage will have low
fixed costs compared to a firm with high
operating leverage.
 Example 2.10:

2.5.1. Operating Leverage

To estimate the effect of operating leverage, we

use the Degree of Operating Leverage (DOL)

This illustrates how many percentages of EBIT

changes when Q changes 1%.

2.5.2. Total Leverage
By combining the degree of leverage with the
degree of financial leverage we obtain the
degree of total leverage (DTL)

This illustrates how many percentages of EPS

changes when Q changes 1%

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