After studying this module, you should be able to: 1. Define the overall cost of capital 2. Calculate the cost of individual components of a firms’ overall cost of capital, cost of debt, cost of preferred stock and cost of equity 3. Calculate the firm WACC 4. Be able to define the term capital structure. 5. Explain the traditional approach to capital structure and the valuation of a firm. 6. Discuss the relationship between leverage and the cost of capital as originally set forth by Modigliani and Miller
Capital Structure concern with the right hand side of the balance sheet. It is the collection of securities a firm issues to raise capital from investors. There are only two ways in which a business can make money ( raise capital) a) Debt financing. The essence of debt is that you promise to make fixed payment in the future (interest payments and repaying principal). If you fail to make those payments, you lose control of your business. b) Equity financing. With equity, you do get whatever cash flows are left over after you have made debt payments In other words, capital structure is the mix of the long term sources of funds used by the firm. It is the relationship between debt and equity capital. This is also called the firm’s capitalization. It is a proportion of firm’s permanent long-term financing represented by debt, preferred stock, and common stock equity. Capital structure is different from financial structure which is the mix of all items that appear on the right-hand side of the company’s balance sheet. The relationship between financial and capital structures can be expressed in equation form: Prepared by:Rahayu Abdull Razak Page 1
Financial Structure – Current liabilities = Capital Structure A firm’s financial structure is often described by the debt ratio.
Financial leverage The relationship between the two sources of finance, debt and equity, gives measures of the gearing of the company. A financial leverage is the degree to which a firm uses borrowed money to make money. The more debt a company uses, the greater the leverage it employs on behalf of its owners. A company with a high proportion of debt to equity is highly geared ( levered) and a company with a low proportion of debt to equity is low geared ( unlevered). Gearing ( leverage) has important implications for the long-term stability of a company because of its impact on financial risk. Company need to closely monitor their gearing ratios to endure that their capital structures aligns with their financial strategy.
One way to determine at what level the company should consider using debt is by calculating break even EBIT. Below the break even, there is no benefit in debt financing. Above the break even amount, the owner benefit from financial leverage. Example: Jordan enterprise is looking at two possible capital structures in a world without taxes. Currently, the firm is an all-equity firm with $12 million in assets and 2 million shares outstanding. The market value of each stock is $6. The CEO is thinking of leveraging the firm by selling $6 million of debt financing and retiring stock in a debt for equity swap. The cost of debt is 8% annually. Current Assets Liabilities Equity Number of shares Interest expense $12,000,000 $0 $12,000,000 2,000,000 0 Propose $12,000,000 $6,000,000 $6,000,000 1,000,000 $480,000 ( 8% x $6,000,000)
Prepared by:Rahayu Abdull Razak
When the two sets of capital structure have equal EPS, then that amount of EBIT is called break even EBIT. In this example break even EBIT is $960,000. As such below breakeven EBIT, the all equity firm has higher EPS for the owners and above breakeven EBIT, the leveraged firm has a higher EPS for the owner. The decision on capital structure is related to the company’s expected earnings; the more the earnings, the more debt we should use to finance the company.
The following factors should be...