Corporate Finance

COST OF CAPITAL AND CAPITAL STRUCTURE

Lesson 6

Corporate Finance

Castellanza,26th October, 2011

Corporate Finance

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

Corporate Finance

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

Ke = rf+ P

Corporate Finance

i = interest ratet = tax rate of the company (interests are tax-

deductible expenses)

Kd = f. interest rate bankruptcy risk tax benefits

Cost of debt (Kd)

Kd = i( 1-t )

Corporate Finance

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

WACC = [Ke E/(E+D)] + [Kd D/(E+D)]

Corporate Finance

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)

Corporate Finance

Capital structure (cont’d)

Debt versus Equity

Residual claimsLowest priority on cash

flowsNo tax deductibleInfinite lifeManagement control

Fixed claimsHigh priority on cash flowsTax deductibleFixed MaturityNo management control

_____________________________________________

Debt Hybrids

(Quasi-equity)

Equity

Corporate Finance

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

Corporate Finance

The financing mix question

In deciding to raise financing for a business, is there an optimal mix of debt and equity?

What is the trade-off that let us determine

the optimal mix?

If yes

Corporate Finance

If: taxes = 0 and extraord. rev.-exp. = 0

Maximization of shareholders’ return (ROE)

ROE = [ROI + (D/E) * (ROI – i)]

ROI = EBIT

CIROE =

Net profitE

i =Interests expensesNet Debt

Leverage = D

E

D = Net Debt or Net Financial Position

E = Equity

i = interest rate paid on Net Debt

CI = Capital invested = D + E

Corporate Finance

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.)

Corporate Finance

Relationship between ROE and ROI : Example

Liabilities

Short term financial loans 6.000

Account payable 3.500

Severance fund 1.500

Long term financial debt 8.000

Equity 5.000

Reserves 4.000

Profit 1.300

29.300

Income Statement

Sales 15.000

Operating expenses -11.000

EBITDA 4.000

Depretiation and amortization -1.500

EBIT 2.500

Interests -600

EBT 1.900

Taxes -600

Net Profit 1.300

Assets

Cash & cash equuivalent 2.000

Account receivable 7.850

Inventories 2.000

Other accounts receivable 2.000

Technical assets 14.500

Intangible assets 950

29.300

Corporate Finance

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%)

Net Debt 12.000

Equity 10.300

Leverage 1,17

ROE 12,6%

ROI 11,2%

i 5,0%

t 31,6%

EBIT 2.500

Net Profit 1.300

ROE = [11,2% + (1,17) * (6,2%)] * (68,4%)

ROE = [11,2% + 7,2%] * (68,4%)

ROE = 18,4% * 68,4% = 12,6%

Corporate Finance14

Relationship between ROE and ROI

Decrease ROI

Increase cost of debt

Decrease ROE

Decrease self-

financing

Increase of debt

Corporate Finance15

Leverage

Leverage = D / E

D = total financial debt or Net Financial PositionE = 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

Corporate Finance

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.

VaVa

D/ED/E

VV

Corporate Finance

Modigliani – Miller theory (cont’d)

The effect of taxes

Vi =Vu + Vats

Vi = value of levered firm

Vu = value of unlevered firm

Vats = actual value of tax shields

VaVa

D/ED/E

VV

ViVi

Corporate Finance

Trade-off theory

The effect of bankruptcy costs

Vl = Vu+Vats-Vabc

Vabc = actual value of bankruptcy costsVats = actual value of tax shields

VuVu

D/ED/E

VV

ViVi Value of levered firms

without bankruptcy costs

Value of levered firms

Value of unlevered firms

VatsVats

VabcVabc

VlVl

Corporate Finance

Picking order theory

1. Self-financing2. Debt3. Increase of

equity

Financing sources

Internal

External

Profitability Net Debt Level

Corporate Finance

Financing mix decision

1. Macroeconomic context (capital markets)

2. Industry (maturity, capex, risk, etc.)

3. Firm’s characteristics (market position, financial-economic situation…)

4. Financial needs’ characteristics