Chapter Three

Raising Finance, Cost of Capital,

Capital Structure and Leverage
Analysis
Sources of Finance
Sources of Finance
Equity Finance
Equity Finance
 Venture Capital
Private financing for relatively new businesses in
exchange for equity.
Also, venture capitalists will want to involve in
running the business because of their need to protect
their investment.
The company should have an “exit” strategy
Sell the company – VC benefits from proceeds from sale
Take the company public – VC benefits from IPO
Many VC firms are formed from a group of investors
that pool capital and then have partners in the firm
decide which companies will receive financing
Some large corporations have a VC division
Venture Capital
 Choosing a Venture Capitalist
Look for financial strength
Choose a VC that has a management style
that is compatible with your own
Obtain and check references
What contacts does the VC have?
What is the exit strategy?

15-8
 Types of Long-Term Debt
Bonds – public issue of long-term debt
Private issues
Term loans
Direct business loans from commercial banks, insurance
companies, etc.
Maturities 1 – 5 years
Repayable during life of the loan
Private placements
Similar to term loans but with longer maturity
Easier to renegotiate than public issues
Lower costs than public issues

15-9
Hybrids
Islamic Finance
Sources of Finance
Why Cost of Capital Is Important?
We know that 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
 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
 Cost of Equity
The cost of equity is the return required by
equity investors on their investment in the
firm given the risk of the cash flows from
the firm
There are two major methods for
determining the cost of equity
Dividend growth model
SML, or CAPM
 The Dividend Growth Model
Approach
Start with the dividend growth model
formula and rearrange to solve for RE
D1
P0 
RE  g
D1
RE   g
P0
 Dividend Growth Model
Example
Suppose that your company is expected to
pay a dividend of $1.50 per share next year.
There has been a steady growth in
dividends of 5.1% per year and the market
expects that to continue. The current price is
$25. What is the cost of equity?
1 .5 0
RE   .0 5 1  .1 1 1  1 1 .1 %
25
 Estimating the Dividend Growth
Rate
To use the dividend growth model, we
must come up with an estimate for g, the
growth rate. There are essentially two ways
of doing this:
(1) Use historical growth rates or
(2) Use analysts’ forecasts of future growth rates.
Example: Estimating the Dividend
Growth Rate
One method for estimating the growth rate is to
use the historical average
Year Dividend Percent Change
2005 1.23 (1.30 – 1.23)
- / 1.23 = 5.7%
2006 1.30 (1.36 – 1.30) / 1.30 = 4.6%
2007 1.36 (1.43 – 1.36) / 1.36 = 5.1%
2008 1.43 (1.50 – 1.43) / 1.43 = 4.9%
2009 1.50
Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%
 Advantages and Disadvantages of
Dividend Growth Model
Advantage – easy to understand and use
Disadvantages
Only applicable to companies currently paying
dividends
Not applicable if dividends aren’t growing at a
reasonably constant rate
Extremely sensitive to the estimated growth rate
– an increase in g of 1% increases the cost of
equity by 1%
Does not explicitly consider risk
 The SML Approach
Use the following information to compute
our cost of equity
Risk-free rate, Rf
Market risk premium, E(RM) – Rf
Systematic risk of asset, 

RE  R f   E (E (RM )  R f )
 Example - SML
Suppose your company has an equity beta
of .58, and the current risk-free rate is 6.1%.
If the expected market risk premium is
8.6%, what is your cost of equity capital?
RE = 6.1 + .58(8.6) = 11.1%
Since we came up with similar numbers
using both the dividend growth model and
the SML approach, we should feel good
about our estimate
Advantages and Disadvantages of
SML
Advantages
Explicitly adjusts for systematic risk
Applicable to all companies, as long as we can
estimate beta
Disadvantages
Have to estimate the expected market risk
premium, which does vary over time
Have to estimate beta, which also varies over
time
We are using the past to predict the future,
which is not always reliable
 Example – Cost of Equity
Suppose our company has a beta of 1.5. The market
risk premium is expected to be 9%, and the current
risk-free rate is 6%. We have used analysts’
estimates to determine that the market believes our
dividends will grow at 6% per year and our last
dividend was $2. Our stock is currently selling for
$15.65. What is our cost of equity?
 Using SML: RE = 6% + 1.5(9%) = 19.5%
 Using DGM: RE = [2(1.06) / 15.65] + .06 = 19.55%
 Cost of Debt
The cost of debt is the required return on our
company’s debt
We usually focus on the cost of long-term debt
or bonds
The required return is best estimated by
computing the yield-to-maturity on the existing
debt
We may also use estimates of current rates
based on the bond rating we expect when we
issue new debt
The cost of debt is NOT the coupon rate
 Example: Cost of Debt
Suppose we have a bond issue currently
outstanding that has 25 years left to maturity.
The coupon rate is 9%, and coupons are paid
semiannually. The bond is currently selling
for $908.72 per $1,000 bond. What is the cost
of debt?
N = 50; PMT = 45; FV = 1000; PV = -908.72; CPT
I/Y = 5%; YTM = 5(2) = 10%
 1 
1 -
 (1  r) t  FV
B o nd V a lue  C   t
 r  (1  r)
 
 Cost of Preferred Stock
Reminders
Preferred stock generally pays a constant
dividend each period
Dividends are expected to be paid every
period forever
Preferred stock is a perpetuity, so we
take the perpetuity formula, rearrange
and solve for RP
RP = D / P0
 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?
RP = 3 / 25 = 12%
 The Weighted Average Cost of
Capital
We can use the individual costs of capital
that we have computed to get our
“average” cost of capital for the firm.
This “average” is 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
 Capital Structure Weights
Notation
E = market value of equity = # of
outstanding shares times price per share
D = market value of debt = # of
outstanding bonds times bond price
V = market value of the firm = D + E
Weights
wE = E/V = percent financed with equity
wD = D/V = percent financed with debt
 Example: Capital Structure
Weights
Suppose you have a market value of equity
equal to $500 million and a market value of
debt equal to $475 million.
 What are the capital structure weights?
 V = 500 million + 475 million = 975 million
 wE = E/V = 500 / 975 = .5128 = 51.28%
 wD = D/V = 475 / 975 = .4872 = 48.72%
 Taxes and the WACC
We are concerned with after-tax cash flows,
so we also need to consider the effect of
taxes on the various costs of capital
Interest expense reduces our tax liability
This reduction in taxes reduces our cost of debt
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 = wERE + wDRD(1-TC)
 Extended Example – WACC - I
Equity Information Debt Information
50 million shares $1 billion in
$80 per share outstanding debt
Beta = 1.15
(face value)
Current quote = 110
Market risk
Coupon rate = 9%,
premium = 9%
semiannual coupons
Risk-free rate = 5%
15 years to maturity
Tax rate = 40%
Extended Example – WACC - II
What is the cost of equity?
RE = 5 + 1.15(9) = 15.35%
What is the cost of debt?
N = 30; PV = -1,100; PMT = 45; FV =
1,000; CPT I/Y = 3.9268
RD = 3.927(2) = 7.854%
What is the after-tax cost of debt?
RD(1-TC) = 7.854(1-.4) = 4.712%
Extended Example – WACC - III
What are the capital structure weights?
E = 50 million (80) = 4 billion
D = 1 billion (1.10) = 1.1 billion
V = 4 + 1.1 = 5.1 billion
wE = E/V = 4 / 5.1 = .7843
wD = D/V = 1.1 / 5.1 = .2157
What is the WACC?
WACC = .7843(15.35%) + .2157(4.712%) =
13.06%
Financial Leverage and
Capital Structure Policy
 Capital Restructuring
We are going to look at how changes in capital
structure affect the value of the firm, all else equal
Financial leverage = the extent to which the
firm relies on debt
Capital restructuring involves changing the amount
of leverage a firm has without changing the firm’s
assets
The firm can increase leverage by issuing debt and
repurchasing outstanding shares
The firm can decrease leverage by issuing new
shares and retiring outstanding debt
 Choosing a Capital Structure
What is the primary goal of financial
managers?
Maximize stockholder wealth
We want to choose the capital structure that
will maximize stockholder wealth
We can maximize stockholder wealth by
maximizing the value of the firm or
minimizing the WACC
 The Effect of Leverage
How does leverage affect the EPS and ROE of a
firm?
When we increase the amount of debt financing, we
increase the fixed interest expense
If we have a really good year, then we pay our fixed
cost and we have more left over for our stockholders
If we have a really bad year, we still have to pay our
fixed costs and we have less left over for our
stockholders
Leverage amplifies the variation in both EPS and
ROE
Financial Leverage, EPS and ROE, example (1)
Current capital structure: No debt
  Recession   Expected   Expansion
EBIT $500,000 $1,000,000 $1,500,000
Interest 0 0 0
Net income 500,000 1,000,000 1,500,000
ROE 6.25% 12.50% 18.75%
EPS $1.25 $2.50 $3.75

Proposed capital structure: Debt = $ 4 mln

  Recession   Expected   Expansion
EBIT $500,000 $1,000,000 $1,500,000
Interest 400,000 400,000 400,000
Net income 100,000 600,000 1,100,000
ROE 2.50% 15.00% 27.50%
EPS $0.50 $3.00 $5.50
 Financial Leverage, EPS and ROE,
example (2)
Variability in ROE
Current: ROE ranges from 6.25% to 18.75%
Proposed: ROE ranges from 2.50% to 27.50%
Variability in EPS
Current: EPS ranges from $1.25 to $3.75
Proposed: EPS ranges from $0.50 to $5.50
The variability in both ROE and EPS
increases when financial leverage is
increased
Degree of Financial Leverage
Percentage change in EPS
Degree of financial leverage 
Percentage change in EBIT

EBIT
Degree of financial leverage 
EBIT  Interest
 Break-Even EBIT
Find EBIT where EPS is the same under
both the current and proposed capital
structures
If we expect EBIT to be greater than the
break-even point, then leverage may be
beneficial to our stockholders
If we expect EBIT to be less than the break-
even point, then leverage is detrimental to
our stockholders
 Capital Structure Theory
Modigliani and Miller (M&M) Theory of
Capital Structure
 Proposition I – firm value
 Proposition II – WACC
The value of the firm is determined by the
cash flows to the firm and the risk of the assets
Changing firm value
 Change the risk of the cash flows
 Change the cash flows
Capital Structure Theory Under Three
Special Cases
Case I – Assumptions
No corporate or personal taxes
No bankruptcy costs
Case II – Assumptions
Corporate taxes, but no personal taxes
No bankruptcy costs
Case III – Assumptions
Corporate taxes, but no personal taxes
Bankruptcy costs
 Case I – Propositions I and II
Proposition I
The value of the firm is NOT affected by changes
in the capital structure
The cash flows of the firm do not change;
therefore, value doesn’t change
Proposition II
The WACC of the firm is NOT affected by
capital structure
 Case I - Equations
WACC = RA = (E/V)RE + (D/V)RD

RE = RA + (RA – RD)(D/E)

RA is the “cost” of the firm’s business risk, i.e., the

risk of the firm’s assets
(RA – RD)(D/E) is the “cost” of the firm’s financial
risk, i.e., the additional return required by
stockholders to compensate for the risk of leverage
 Case I - Example
Data
Required return on assets = 16%; cost of debt = 10%;
percent of debt = 45%
What is the cost of equity?
RE = 16 + (16 - 10)(.45/.55) = 20.91%
Suppose instead that the cost of equity is 25%,
what is the debt-to-equity ratio?
25 = 16 + (16 - 10)(D/E)
D/E = (25 - 16) / (16 - 10) = 1.5
Based on this information, what is the percent of
equity in the firm?
E/V = 1 / 2.5 = 40%
The CAPM, the SML and Proposition II
How does financial leverage affect
systematic risk?
CAPM: RA = Rf + A(RM – Rf)
Where A is the firm’s asset beta and measures
the systematic risk of the firm’s assets
Proposition II
Replace RA with the CAPM and assume that the
debt is riskless (RD = Rf)
RE = Rf + A(1+D/E)(RM – Rf)
 Business Risk and Financial Risk
Business risk – the equity risk that comes from the
nature of the firm’s operating activities.
Financial risk – the equity risk that comes from the
financial policy (the capital structure) of the firm.
 RE = Rf + A(1+D/E)(RM – Rf)
CAPM: RE = Rf + E(RM – Rf)
 E = A(1 + D/E)
Therefore, the systematic risk of the stock depends
on:
 Systematic risk of the assets, A, (Business risk)
 Level of leverage, D/E, (Financial risk)
 Case II – Cash Flow
Interest is tax deductible
Therefore, when a firm adds debt, it
reduces taxes, all else equal
The reduction in taxes increases the cash
flow of the firm
How should an increase in cash flows
affect the value of the firm?
 Case II - Example
Unlevered Firm Levered Firm

EBIT 5,000 5,000

Interest 0 500

Taxable Income 5,000 4,500

Taxes (34%) 1,700 1,530

Net Income 3,300 2,970

CFFA 3,300 3,470

 Interest Tax Shield
Interest Tax Shield = the tax saving attained by a firm
from interest expense.
Assume the company has $6,250, 8% coupon debt and
faces a 34% tax rate.
Annual interest tax shield
 Tax rate times interest payment
 6,250 in 8% debt = 500 in interest expense
 Annual tax shield = .34(500) = 170
Present value of annual interest tax shield
 Assume perpetual debt for simplicity
 PV = 170 / .08 = 2,125
 PV = D(RD)(TC) / RD = DTC = 6,250(.34) = 2,125
 Case II – Proposition I
The value of the firm increases by the present
value of the annual interest tax shield
 Value of a levered firm = value of an unlevered
firm + PV of interest tax shield
 Value of equity = Value of the firm – Value of debt
Assuming perpetual cash flows
 VU = EBIT(1-T) / RU
 VL = VU + DTC
Example: Case II – Proposition I
Data
EBIT = 25 million; Tax rate = 35%; Debt = $75
million; Cost of debt = 9%; Unlevered cost of
capital = 12%
VU = 25(1-.35) / .12 = $135.42 million
VL = 135.42 + 75(.35) = $161.67 million
E = 161.67 – 75 = $86.67 million
The value of the firm increases as total debt
increases because of the interest tax shield.
 Case II – Proposition II
The WACC decreases as D/E increases
because of the government subsidy on
interest payments
RA = (E/V)RE + (D/V)(RD)(1-TC)
RE = RU + (RU – RD)(D/E)(1-TC)
Example
RE = 12 + (12-9)(75/86.67)(1-.35) = 13.69%
RA = (86.67/161.67)(13.69) + (75/161.67)(9)(1-.35)
RA = 10.05%
 Example: Case II – Proposition II
Suppose that the firm changes its capital
structure so that the debt-to-equity ratio
becomes 1.
What will happen to the cost of equity under
the new capital structure?
 RE = 12 + (12 - 9)(1)(1-.35) = 13.95%
What will happen to the weighted average
cost of capital?
 RA = .5(13.95) + .5(9)(1-.35) = 9.9%
 The firms WACC decreases as the firm relies more
heavily on debt financing.
 Case III
Now we add bankruptcy costs
As the D/E ratio increases, the probability of
bankruptcy increases
This increased probability will increase the
expected bankruptcy costs
At some point, the additional value of the
interest tax shield will be offset by the
increase in expected bankruptcy cost
At this point, the value of the firm will start
to decrease, and the WACC will start to
increase as more debt is added
 Bankruptcy Costs
Direct costs
Legal and administrative costs
Ultimately cause bondholders to incur
additional losses
Disincentive to debt financing
Financial distress
Significant problems in meeting debt
obligations
Firms that experience financial distress do
not necessarily file for bankruptcy
 More Bankruptcy Costs
Indirect bankruptcy costs
 Larger than direct costs, but more difficult to measure
and estimate
 Stockholders want to avoid a formal bankruptcy filing
 Bondholders want to keep existing assets intact so
they can at least receive that money
 Assets lose value as management spends time
worrying about avoiding bankruptcy instead of
running the business
 The firm may also lose sales, experience interrupted
operations and lose valuable employees
Static Theory of Capital Structure
A firm borrows up to the point where the
tax benefit from an extra dollar in debt is
exactly equal to the cost that comes from
the increased probability of financial
distress

At this point the firm’s WACC is

minimized
Figure 3.1
Figure 3.2
 Conclusions
Case I – no taxes or bankruptcy costs
 No optimal capital structure
Case II – corporate taxes but no bankruptcy costs
 Optimal capital structure is almost 100% debt
 Each additional dollar of debt increases the cash
flow of the firm
Case III – corporate taxes and bankruptcy costs
 Optimal capital structure is part debt and part
equity
 Occurs where the benefit from an additional dollar
of debt is just offset by the increase in expected
bankruptcy costs
 Managerial Recommendations
The tax benefit is only important if the
firm has a large tax liability
Risk of financial distress
The greater the risk of financial distress, the
less debt will be optimal for the firm
The cost of financial distress varies across
firms and industries, and as a manager you
need to understand the cost for your industry
 The Value of the Firm
Value of the firm = marketed claims +
nonmarketed claims
Marketed claims are the claims of stockholders
and bondholders
Nonmarketed claims are the claims of the
government and other potential stakeholders
The overall value of the firm is unaffected by
changes in capital structure
The division of value between marketed claims and
nonmarketed claims may be impacted by capital
structure decisions
 The Pecking-Order Theory
 Theory stating that firms prefer to issue
debt rather than equity if internal financing
is insufficient.
 Rule 1
 Use internal financing first
 Rule 2
 Issue debt next, new equity last
 The pecking-order theory is at odds with
the tradeoff theory:
 There is no target D/E ratio
 Profitable firms use less debt
 Companies like financial slack
 Observed Capital Structure
Capital structure does differ by industry
There is a connection between different
industry’s operating characteristics and
capital structure
Differences according to Cost of Capital 2008
Yearbook by Ibbotson Associates, Inc.
Lowest levels of debt
Computers with 5.61% debt
Drugs with 7.25% debt
Highest levels of debt
Cable television with 162.03% debt
Airlines with 129.40% debt