Lecture 8 - Cost of Capital and Structure Flashcards
What is the calculation for WACC
%Equity x Cost of Equity + %Preferred Stock x Cost of Preferred Stock + %Debt x After Tax Cost of Debt capital raised
What does WACC stand for?
Weight Average Cost of Capital
What are the two ways of calculating cost of equity
– Capital Asset Pricing Model (CAPM).
– Gordon/Constant-Growth Model.
What is capital structure
the mixture of debt and equity maintained by a firm
what are firms 2 options when changing their capital structure
active management and passive management
what is active management
Restructuring, selling one type of capital to fund the retirement of other kinds of capital
what is passive management
- waiting for additional incoming capital
- adjust financing mix (debt and equity) over time
what determines the choice between active and passive management
- how quickly the firm is growing
- the flotation costs under the active management approach
- the need for changes to the firms capital structure
what is financial leverage
the extent to which debt securities are used by a firm
Who developed the M&M theorem
- Modigliani and Merton Miller
- 1958
- Perfect World
What are the 4 perfect world assumptions
- no taxes
- no chance of bankruptcy
- perfectly efficient markets
- symmetric info for all participants
what did M&M claim about the capital structure of a company and its value
The capital structure of a company
does not affect its overall value
what is proposition I of M&Ms perfect world
- The value of a leveraged firm is equal to the value of
unleveraged firm (i.e., all-equity = financed firm) - Vʟ = Vᵤ
what is proposition II of M&Ms perfect world
- Explicitly deals with the cost increase of equity capital as a function of the firm’s D/E ratio
What is the effect of leverage on cost of equity
- The cost of equity 𝑖𝐸 increases linearly with
leverage (D/E) - As leverage increases, shareholders take on more
risk, thus they require a higher compensation, i.e.,
return, to hold that risk.
what is the Effect of Leverage on WACC
The WACC stays the same
* As leverage increases, the lower proportion of
expensive equity is offset by a higher proportion of
cheap debt and WACC will remain the same
What does proposition I turn into with corporate taxes
Vᴸ = Vᵁ + DTᶜ
What are some financial distress costs
- loss of consumer and supplier confidence
- potential loss of employees
- declining partnerships with better firms
Proposition I with corporate taxes and bankruptcy
Vᴸ = Vᵁ + DTᶜ - costs of financial distress
Factors affecting firms’ capital structures
- firms with relatively high tax rates should use more debt
- firms with stable and predictable income streams can use more debt
