Cost of Capital and capital structure

Question 1

What is the cost of equity?

Answer 1

The cost of equity is the return investors expect to achieve on their shares in a company.

The rate of return an investor requires is based on the level of risk associated with the investment.

Equity shareholders are the last investors to be paid out of company profits, as well as the last to be paid on the winding up of a company.

Equity investors face the greatest risk of all investors and therefore demand a higher rate of return to justify the risk taken.

There are two methods of determining the cost of equity:

1. the capital asset pricing model
2. the dividend valuation model

Question 2

Capital asset pricing model?

Answer 2

Capital asset pricing model

The capital asset pricing model (CAPM) was developed by Sharpe (1964) and Lintner (1965) as a means to measure the
cost of equity.

The model studies and establishes an equilibrium relationship between the expected returns from each security and its associated risks.

It can be used to assess risk in individual company shares or a portfolio of securities.

The cost of equity capital obtained under CAPM is called the risk-adjusted discount rate (RADR).

Once the market portfolio has been established, the required rate of return for any security can be calculated using this model provided the beta factor (see page 210 of book) is known.

Question 3

Risk-adjusted discount rate

Answer 3

Risk-adjusted discount rate

The risk inherent in a project depends on the type of activity involved.

Higher risk does not necessarily make a project unattractive.

The RADR is the rate used to discount a risky asset or investment such as real estate.

It represents the required periodical returns by investors to compensate for the higher risk involved.

The higher the risk involved in the project, the higher the discount rate.

The cash flows from riskier assets will be discounted at a higher rate. This adjusted discount rate is typically referred to as expected rate of return. It forms the basis for CAPM.

The RADR is based on the risk-free rate (RFR) (such as a short-term interest rate from government securities or a fixed
deposit rate) and a risk premium for the riskier assets.

Question 4

What is the RADR based on?

Answer 4

The RADR is based on the risk-free rate (RFR) (such as a short-term interest rate from government securities or a fixed deposit rate) and a risk premium for the riskier assets.

RADR = RFR + risk premium
Where:
RADR = Risk-adjusted discount rate
RFR = Risk-free rate

Question 5

Unsystematic risks?

Answer 5

Unsystematic risks:

Are risk factors specific to a particular company or industry which can be eliminated or diversified away in a large portfolio of shares. These risks are not impacted by political and economic factors.

Examples include:

weak labour relations, adverse press reports and strikes.

These are different for different companies; they might even cancel each other out in some circumstances.

Studies have shown that if the portfolio consists of 15 to 20 shares, then most of the unsystematic risk tends to be diversified.

Question 6

Systematic risk (or market risk) ?

Answer 6

Systematic risk (or market risk)

Relates to the markets and the economy.

It is largely caused by macroeconomic factors and affects all the shares in the market.

It is unavoidable and cannot be diversified.

An example may be an economic recession affecting both the markets and the economy of the country.

The level to which each share will be affected will differ, although it is known that all shares will be affected.

It should be noted that, even in a severe recession like that caused by the Covid-19 pandemic, there might be a small number of companies doing well.

This is usually for a specific reason that affects a niche market.

A good example relating to the Covid-19 pandemic would be companies providing remote working solutions, such as Zoom or Cisco, due to the large increase in people working from home.

Question 7

Systematic risk is different in different industries….Explain?

Answer 7

The degree of systematic risk is different in different industries. For instance, the food retailing sector faces lower systematic risk in comparison to the hospitality sector, as food is a necessity.

Irrespective of a recession, people will still
require their daily essentials.

It is possible for an investor to select shares with a low systematic risk. Thus, investors
need to select shares that will provide returns over and above its risk-free rate of return.

The CAPM suggests that investors can eliminate the unsystematic risk and thus reduce the overall risk by choosing an
optimal portfolio.

It assumes that investors will behave rationally.

Question 8

Measuring systematic risk and calculating RADR.

Answer 8

Measuring systematic risk and calculating RADR.

The CAPM assumes that unsystematic risk can be diversified and eliminated, whereas systematic risk cannot be eliminated and diversified.

Investors will expect a higher return from shares with a higher systematic risk.

Therefore, it is important to measure systematic risk.

The steps involved in CAPM are:

1. measuring the systematic risk
2. linking the systematic risk with the required rate of return

read page 209 and 210 of book

Question 9

Linking ß with required returns: the security market line

Answer 9

RADR = RFR + ß (RM – RFR)

Where:

• RFR = Risk-free rate
• RM = return on stock market portfolio
• ß = risk premium statistically derived

*RM – RFR = market risk premium (the expected return on the market minus the risk-free rate).

Question 10

Worked example 12.2 page 211 in linking ß with the required return

Answer 10

Nayu plc has a ß of 1.40 and the market return is 14%.

The RFR is 10%. Calculate the cost of equity
based on the CAPM.

Solution:

RADR = RFR + ß (RM – RFR)

RADR = 10 + 1.4(14 – 10) = 10 + 5.6 = 15.6%

The cost of equity of Nayu plc is 15.6%

Question 11

Assumptions of CAPM?

Answer 11

Assumptions of CAMP

1. Investors are rational and possess full knowledge about the market.
2. Investors expect greater returns for taking greater risks.
3. It is possible for an investor to diversify the unsystematic risk by actively managing the portfolio.
4. Borrowing and lending rates are equal.
5. There are no transaction costs.

6 There is no taxation and no inflation

Question 12

Criticisms of CAPM

Answer 12

Criticisms

1. Research has shown that the linearity of the SML has been lost with changes of gradient at different levels of ß during some periods.
2. There are practical difficulties in deriving the systematic risk and the ß of any company as trading on the stock
   market is subject to numerous factors.
3. Companies with more than one division and company channel might have different systematic risks for each division – yet ß is derived on the basis of a single share price.
4. The CAPM is a one-year model and is relevant for a year only.

Question 13

Cost of equity using the dividend valuation model

Answer 13

Cost of equity using the dividend valuation model

The dividend valuation model (or dividend growth model) states that the value of the company/share is the present value of the expected future dividends discounted at the shareholders’ required rate of return.

Question 14

Cost of equity using the dividend valuation model calculation?

Answer 14

Assuming a constant growth rate in dividends:

P = D0 (1 + g) ÷ (Ke – g)

Where:

• P = current share price
• D0 = current level of dividend
• g = estimated growth rate in dividends

If we need to derive Ke, the formula can be rearranged to:

Ke = [D0 (1 + g) ÷ P0] + g

D0 (1 + g) is the dividend at the end of the year (D1).

Question 15

Worked example 12.3 page 212 of book

Answer 15

Worked example 12.3

Nehi plc has £1 equity shares in issue with a market value of £1.20 per share.

A dividend of 15p per share has just been paid.

Estimate the cost of equity required by the equity shareholders if the rate of growth in dividends is 6%.

Solution
Ke = [D0 (1+g) ÷ P] + g

Ke = [15(1 + 0.06) ÷ 120] + 0.06 = (15.9 ÷ 120) + 0.06 = 0.1925 = 19.25%

The cost of equity of Nehi plc is 19.25%

Question 16

Costs of Debt page 212 - calculate

Answer 16

Irredeemable debt is a perpetual debt which is never repaid.

The cost of debt after tax is calculated using the following equation.

Kd = I (1–t) / Sd

Where:

• Kd = Cost of debt capital
• I = Annual interest
• t = Corporate tax rate
• Sd = Market price of the debt

The higher the rate of corporate tax payable by the company, the lower the after-tax cost of debt capital.

The cost of any debt with no tax relief and the cost of preference shares is calculated using the following equation.

Kd = I ÷ Sd

Question 17

Worked example 12.4 page 213

Sanepa Ltd has issued 10% irredeemable debentures with a face value of £100.

The current market price is £95.

The corporate tax rate is 20%. Calculate the cost of debt for the company before and
after tax.

Answer 17

Solution

Cost of debt before tax:

Kd = I ÷ Sd

Kd = 10 / 95 = 10.5%

Cost of debt before tax is 10.5%.

Cost of debt after tax:

Kd = I (1–t) / Sd

10 (1 – 0.20) / 95 = 8.4%

Cost of debt after tax is 8.4

Question 18

Redeemable debt?

Answer 18

Redeemable debt is usually repaid at its nominal value (at par) but may be issued as repayable at a premium on nominal value. It is repayable at a fixed date (or during a fixed period) in the future.

A company raises redeemable debt to pay back at a fixed future date. The cost of debt on redeemable debt can be calculated by the internal rate of return (IRR).

The internal rate of return is a method used for investment appraisal that calculates the rate of return at which the net present value of all the cash flows (both positive and negative) from a project or investment is equal to zero.

It evaluates the profitability and the attractiveness of potential investments

Question 19

Weighted average cost of capital?

Answer 19

The weighted average cost of capital (WACC), commonly referred to as the company’s cost of capital, represents
the minimum return that a company must earn on its existing assets.

It reflects the weighted average rate of return a company is expected to pay to all the providers of long-term finance.

The weights are the fraction of each financing source in the company’s total capital.

WACC is influenced by the external market.

The WACC is derived by averaging a company’s cost of equity and cost of debt according to the market value of each
source of finance. The appropriate weights are the target capital structure weights expressed in market value terms.

WACC = Ke × E / E + D + Kd (1–t) × D / E + D

Where:

• WACC = Weighted average cost of capital
• E = Total market value of equity
• D = Total market value of debt
• t = Corporate tax rate

Question 20

What is capital investment?

Answer 20

Capital investment refers to funds invested by a company for furthering its objectives such as replacement of a non-current asset, expansion of its production capacity or diversification to a new product line.

Capital structure decisions are involved whenever funds are to be raised for financing a capital investment. Raising funds generates a new capital structure in terms of its quantity, mix and forms of capital.

Question 21

Factors affecting capital structure

Answer 21

Factors affecting capital structure as as follows:

1. Financial leverage or gearing
2. Growth
3. Cost & control principle
4. Cost principle
5. Market condition
6. Tax exposure
7. Other factors
8. Risk Principle

Question 22

Factors affecting capital structure are listed below. Explain each one.

1. Financial leverage or gearing
2. Growth
3. Cost & control principle
4. Cost principle
5. Market condition
6. Tax exposure
7. Other factors
8. Risk Principal

Answer 22

1. Financial leverage or gearing

Debt is normally cheaper than equity.

Earnings per share (EPS) will increase with use of long-term debt and preference share capital if the company yields a return higher than cost of debt.

However, increasing the use of a high level of long-term debt or gearing also increases risks for the shareholder because fixed interest must be paid each year before the company is able to pay dividends.

It reduces the earnings of shareholders if the rate of interest is more than the expected rate of earnings of the company.

2. Growth

Equity financing is popular in start-ups and high growth industries, such as the technology sector. The high cost of servicing the debt restricts growth.

3. Cost & Control principle

Debt capital is cheaper than equity capital because debt is considered to be a less risky investment compared to investing in shares. The interest on debt is deductible for corporate tax purposes, making debt capital even cheaper.

No such deduction is allowed for dividends.
Based on the cost principle, debt financing should minimise the cost of capital and maximise the EPS.

Control Principle:

When funds are raised through equity capital, excepting a rights issue to existing shareholders, the control of the existing shareholders (owners) over the company’s affairs is diluted or adversely affected.

The number of the company’s shareholders will increase when funds are raised by issuing equity shares. Conversely, when funds are raised through debt capital, there is no effect on the control of the company because the debenture holders have no control over the affairs of the company.

Debt may be preferred over equity to minimise possible risk of loss of control.

5. Market condition

A company’s capital structure can be affected by the market and economic conditions.

For example, the interest rate to borrow may be higher in a struggling market due to economic uncertainties when compared to the market under a ‘normal’ state.

6. Tax exposure

The tax deductibility of the debt interest payments can make debt financing attractive.

7. Other factors

Other factors that influence capital structure decision making may include:

• government regulations (such as tax rates)
• trends in capital markets
• the capital structure of other companies
• flotation costs

When making a decision about the optimum mix of debt and equity, the capital structure should be conservative (for example, debt financing should not be used at excessive levels). It should be easily manageable and easily understood by investors. Debt should only be used to the extent that it does not threaten the solvency of the company.

Question 23

How does the risk Principle affect the capital structure?

Answer 23

Risk principle

There are three risks associated with this principle.

1. Company risk is the risk of variability of earnings resulting in an inadequate profit, or even a loss, due to uncertainties in the company.

Company risk can be internal as well as external.

Internal risk is caused by poor product mix, inadequate resources, absence of strategic management and so on.

External risk is influenced by numerous factors, including competition, the overall economic climate and government regulations. In reality, there is little that a financial manager can do to alter the company risk due to external factors.

2. Operating risk

Is the risk of disruption of the core corporations of a company resulting from breakdowns in internal procedures, people and systems.

It may be caused by inadequate policies, system failures, criminal activity and loss faced by litigations against the company.

It measures the risk from operating costs that are fixed. Operating gearing is the proportion of fixed costs a company has relative to its variable costs. There may only be limited opportunities for altering operating gearing.

3. Financial risk

Refers to the risk from financing. It is the risk of default when the company may not be able to cover its fixed financial costs. The extent of financial risk depends on the leverage of the company’s capital structure.

A company with debt financing has higher financial risk. A company should be in a position to meet its obligations in paying the loan and interest charges as and when these fall due.

The risk associated with how the company is
financed can be most easily controlled by changing the level of financial gearing

Question 24

Business risk, operating gearing and financial gearing. What is included in each?

Answer 24

1. Business risk:

(internal and external factors associated with being in the business)

2. Operating gearing:

(risk from operating costs that are fixed)

3. Financial gearing (risk from financing
   associated with debt)

Question 25

Financial gearing?

Answer 25

Financial gearing measures the proportion of debt a company has relative to its equity. It is a measure of a company’s financial leverage (also called ‘trading on equity’) and shows the extent to which its operations are funded by interest bearing lenders versus shareholders.

Financial gearing can be calculated using one of the following two formulae:

1. Equity gearing =

Debt borrowing + preference share capital / Ordinary share capital + equity

or Debt / Equity x 100

2. Total or capital gearing =

Debt borrowing + preference share capital /
Total long-term capital

3. Interest gearing

Interest gearing shows the percentage of profit absorbed by interest payments on borrowings.

It measures the impact of gearing on profits. It is calculated as:

Interest gearing =

Debt interest + preference dividends / Operating profit

Question 26

Problems around high level gearing?

Answer 26

Problems around high levels of gearing:

A high level of gearing implies a higher obligation for a company to pay interest when using debt financing.

It has a higher risk of insolvency than equity financing.

While dividends on equity shares need only be paid when there are sufficient distributable profits, the interest on debt is payable regardless of the operating profit of a company.

Other problems associated with high gearing include:

1. bankruptcy risk increases with increased gearing;
2. agency cost and restrictive conditions imposed in the loan agreements constrain management’s freedom of action, such as restrictions on dividend levels or on the company’s ability to borrow;
3. after a certain level of gearing, companies will have no tax liability left against which to offset interest charges (tax
   exhaustion);
4. companies may run out of suitable assets to offer as security against loans with high gearing;
5. gearing increases the cost of borrowing; and
6. directors have a natural tendency to be cautious about borrowing and the related solvency issues.

Question 27

Gearing and the cost of debt (Kd) and WACC

Answer 27

Gearing and the cost of debt (Kd) and WACC

The overall cost of capital initially falls due to the introduction of debt, which is cheaper than equity.

The low cost of debt immediately reduces WACC until a point at which the increase in gearing causes both the cost of equity (Ke) and the cost of debt (Kd) to increase.

This causes WACC to increase.

Point X is the optimal level of gearing, after which the cost of capital carries on increasing as debt and gearing increase.

In the traditional approach, the financial manager should raise debt finance until it achieves the optimal level of gearing – that which gives the cheapest overall cost of capital.

Once achieved, the optimum level of gearing must be maintained by keeping the same ratio of gearing (part equity/part debt) in future financing.

Question 28

Limitations of the traditional view

Answer 28

Limitations of the traditional view

1. The traditional theory illustrates the importance of gearing and the optimal balance between equity and debt, but does not quantify the effect of changes in gearing. It locates the optimal point by trial and error.
2. The traditional theory of capital structure ignores other real-world factors such as corporate tax rates and the
   investment habits of investors.
3. It is based on the following assumptions:

a. the company distributes all of its earnings as a dividend

b. the company’s total assets and revenue are fixed

c. only debt and equity financing is available

d. investment habits remain rational
l
e. there are no taxes

Question 29

The Modigliani and Miller (1958) approach: without taxes

Answer 29

The Modigliani and Miller (1958) approach: without taxes

Modigliani and Miller (1958) argued that the relationship between the cost of capital, capital structure and the valuation
of the company should be explained by the net operating income approach.

Under this approach, the levels of operating
income influence market value.

This is known as the capital structure irrelevancy theory.

It suggests that the valuation of a company and the weighted average cost of capital are irrelevant to the capital structure of a company.

The basic concept of Modigliani and Miller’s (MM) approach is that the value of a company is independent of its capital
structure.

Market value is determined solely by investment decisions.

When the gearing increases, the increase in the cost of equity (associated with the higher financial risk) exactly offsets the benefit of the cheaper debt finance.

As WACC remains unchanged, the value of a leveraged company is the same as the value of an unleveraged company if they operate in the same type of company and have similar operating risks.

The value of a company depends upon the future operating income generated by its assets.

The MM hypothesis can be explained through two propositions.

Question 30

The Modigliani and Miller (1958) approach: without taxes continued..

Answer 30

MM proposition I

With the assumption of no taxes, capital structure or leveraging does not influence the market value of the company.

It assumes that debt holders and equity shareholders have the same priority in the earnings of a company and that the
earnings are split equally.

MM proposition II

The cost of equity is a linear function of the company’s debt equity ratio.

With an increase in gearing, the equity
investors perceive a higher risk and expect a higher return, increasing the cost of equity.

The rate of return required by shareholders (Ke) increases in direct proportion to the debt/equity ratio.

As the gearing increases, the cost of equity rises just enough to offset any benefits conferred by the use of apparently cheap debt (Kd). This means that WACC remains constant at all levels of gearing. This is illustrated in Figure 12.7.

Under the MM theory, the company value depends upon future operating profits. The essential point made by M&M is that the company’s cost of capital is independent of the way in which investment is financed. Arbitrage (market pressures) will ensure that two identical companies, with same company risk and identical provisions before interest and tax (PBIT), will have the same overall market value and cost of capital irrespective of their gearing level

Question 31

Assumptions of the MM approach without taxes?

Answer 31

Assumptions of the MM approach without taxes:

1. No corporate taxation.
2. No transaction costs relating to buying and selling securities or bankruptcy costs.
3. Perfect capital markets with a symmetry of information. An investor will have access to same information that a company would and they react rationally.
4. The cost of borrowing is the same for investors and companies.
5. Debt is risk free

Question 32

The Modigliani and Miller (1963) approach with taxes: the trade-off theory?

Answer 32

The Modigliani and Miller (1963) approach with taxes: the trade-off theory:

The impact of tax cannot be ignored in the real world, since debt interest is tax deductible.

Modigliani and Miller revised their theory in 1963 to recognise tax relief on interest payments.

The actual cost of debt is less than the nominal cost of debt because of tax benefits.

However, the same is not the case
with dividends paid on equity.

The trade-off theory advocates that a company can use debt as long as the cost of distress or bankruptcy does not exceed the value of tax benefits. This is illustrated in Figure 12.8.

As gearing increases, the cost of equity (Ke) increases in direct proportion with gearing.

However, as the overall cost of debt after tax relief (Kd(1-t)) is lower than the nominal cost of debt (Kd), investor returns are less volatile. This leads to lower increases in Ke, causing the WACC to fall as gearing increases.

Therefore, gearing up reduces the WACC and increases the market value of the company.

The optimal capital structure is 99.9% gearing. This means the higher the debt, the lower the WACC and the higher the market value. The company should use as much debt as possible.

Question 33

Criticisms of the MM trade-off theory?

Answer 33

Criticisms of the MM trade-off theory

1. It ignores bankruptcy risk. In practice, companies never gear up to 99.9%. As gearing increases, so does the possibility of bankruptcy.

If the company is considered to be risky, the share price will go down, increasing the
company’s WACC.

2. Restrictive conditions in the loan agreements associated with debt finance can constrain a company’s flexibility to make decisions (such as paying dividends, raising additional debt or disposing of any major fixed assets).
3. After a certain level of gearing, companies may no longer have any tax liability left against which to offset interest
   charges. Kd(1–t) simply becomes Kd due to tax exhaustion.
4. High levels of gearing may not be possible with companies exhausting assets to offer as security against loans.
5. Different risk tolerance levels between shareholders and directors may impact the gearing level.
6. It can be argued that directors have a tendency to be cautious about borrowing.

Question 34

Real world approaches:

Answer 34

Real world approaches:

Pecking order theory

The ‘pecking order’ theory popularised by Myers and Majluf (1984) was developed as an alternative theory on capital
structure.

It states that companies have the following order of preference for financing decisions:

• retained earnings
• straight debt
• convertible debt
• preference shares
• equity shares

The reasoning is that as companies are risk averse and will prefer retained earnings to any other source of finance, they will choose debt and equity last of all.

They invariably prefer internal finance over external finance. The costs of borrowing also follow the same order, equity shares being the most expensive.

The value of a project depends on how it is financed. If a company follows the pecking order approach, only projects funded with internal funds or with relatively safe debt will be accepted.

Risky projects funded by risky debts or equity will be rejected.

Question 35

Real world factors?

Answer 35

Real world factors

Companies take a balanced approach in the real world, whereby the different theories can be reconciled to make the correct financing decisions. Capital structures can also be affected by other factors such as growth, market conditions and tax exposure.

Companies consider the signalling effect of raising new finance by assessing the impact of the new finance on a company’s statement of profit or loss and OCI and statement of financial position.

Profitable companies will tend to drift away from their optimal gearing position over time – known as ‘gearing drift’, whereby the level of the debt-equity ratio gradually decreases as accumulated retained earnings help to increase the value of equity.

Companies tend to increase their gearing positions by occasionally issuing debt, paying a large dividend or buying back shares.