CAPITAL

STRUCTURE
& COST OF CAPITAL
SHENAL RAJAKARUNANAYAKE
DEPARTMENT OF INDUSTRIAL MANAGEMENT
FACULTY OF BUSINESS
UNIVERSITY OF MORATUWA
Equity Vs Debt
Equity Debt
Return Dividend Interest
Rights Legal ownership of the Repayment of Capital
entity
Effect on Income Appropriation of PAT Charge against PBT
Statement
Interest on winding up of Residual Preferential, Ranking
the entity before equity holders
Tax implications Appropriation of Post-tax Interest payments are tax
profits deductible
Value of Equity

When Equity if valued using book values,

The Book Value of Equity = Ordinary Share Capital + Reserves

When Equity if valued using market values,

The Market Value of Equity = No: of shares x Share Price
Debt Finance

Debt finance tends to be relatively low risk for

the debt-holder as it is interest-bearing and can
be secured.
The cost of debt to the company is therefore
relatively low.
However a high level of debt creates financial
risk. Financial risk can be seen from different
points of view.
Debt Finance (Cont’d)

(a) The company as a whole

If a company builds up debts that it cannot pay when they fall due, it
will be forced into liquidation.
(b) Payables
If a company cannot pay its debts, the company will go into liquidation
owing payables money that they are unlikely to recover in full.
 Lenders will thus want a higher interest yield to compensate them for
higher financial risk and gearing.
Debt Finance (Cont’d)
(c) Ordinary shareholders
A company will not make any distributable profits unless it is able to earn
enough PBIT to pay all its interest charges, and then tax.
When the profits are lower or the interest-bearing debts are higher, only
less will be available for shareholders.
Ordinary shareholders will probably want a bigger expected return from
their shares to compensate them for a higher financial risk.
The market value of shares will therefore depend on gearing, because of
this premium for financial risk that shareholders will want to earn.
Gearing
Gearing is concerned with the level of debt in an
entity’s capital structure.
This represents the relationship between fixed debt
capital and shareholder funds. This is also known as
leverage ratio.
TYK
The following is an extract from the balance sheet of Rapunzel PLC at 30th
September 2005;
Ordinary shares of LKR 25 each 2,500,000
Reserves 350,000
7% Preference Shares 250,000
15% unsecured bonds 150,000
The ordinary shares are currently quoted at LKR 50 each, the bonds are
trading at LKR 85 per 100 nominal and the non-redeemable preference shares
at LKR 65 each.
Calculate gearing ratio based on book value and market value.
Effect of Gearing
Higher gearing exists when an entity has a large
proportion of debt capital in relation to equity.
Higher gearing increases the financial risk of the
equity, yet the reward can be in the form of
increased dividends when profits rise.
Low gearing or no gearing may not necessarily be
in the equity investors' best interests because the
entity might then be failing to exploit the
benefits which borrowing can bring.
Factors Deciding Capital Gearing
The type of industry within which the entity operates.
The cost of funds in the market.
The availability of investment opportunities
The extent to which the company can continue to
benefit the “Tax Shield”
Cost of Capital
Cost of Capital must be equivalent to the return
that investors expect to reward them for the risk
taken by investing in a particular financial
instrument.
The cost of capital is the rate of return that the
enterprise must pay to satisfy the providers of
funds, and it reflects the riskiness of providing
funds.
Aspects of the cost of capital
(a) The cost of funds that a company raises and uses, and the
return that investors expect to be paid for putting funds into the
company.
(b) It is therefore the minimum return that a company should
make on its own investments, to earn the cash flows out of which
investors can be paid their return.
The cost of capital can therefore be measured by studying the
returns required by investors, and then used to derive a discount
rate for DCF analysis and investment appraisal.
The COC as an opportunity cost of finance
The cost of capital is an opportunity cost of finance, because it is
the minimum return that investors require.
If they do not get this return, they will transfer some or all of their
investment somewhere else.
Eg: When shareholders invest in a company, the returns that they
can expect must be sufficient to persuade them not to sell some
or all of their shares and invest the money somewhere else.
The yield on the shares is therefore the opportunity cost to the
shareholders of not investing somewhere else.
Cost of Equity
Equity can be raised through a share issue (Externally) &
retained profits. (Internally)
Cost of Equity must relate to the return that equity investors
expect to reward them for the risk borne by the investors.
Thus, measuring cost of equity becomes a difficult task.

Q: Retained profits are a free source of finance. Hence

it is cost free. Evaluate.
Cost of Equity (Cont’d)
New funds from equity shareholders are obtained either from
new issues of shares or from retained earnings. Both of these
sources of funds have a cost.
Shareholders will not be prepared to provide funds for a new
issue of shares unless the return on their investment is
sufficiently attractive.
Retained earnings also have a cost. This is an opportunity cost,
the dividend forgone by shareholders.
 Ke = Cost of Equity
P0 = Market Value of Equity(Ex-dividend)
Dividend Valuation Model D = Annual Dividend

Market price of a share is related to the future dividend

income stream in such a way that the market price is assumed
to be the present value of the future dividend income stream.
(In here share issue costs are ignored)

P0
D0 D0
P0 =
Ke =

Ke P0
Dividend Valuation Model (Cont’d)
Assume LKR 100 shares quoted at LKR 250, dividend just paid
of LKR 20,

Ke = D/P = 20/250 = 0.08 = 8%

What if the question quoted the share price as cum-div ?

Q: Describe, How dividends affect stock prices?

Dividend Valuation Model (Cont’d)
CODEGEN has a dividend cover ratio of 4.0 times and expects zero growth
in dividends. The company has one million $1 ordinary shares in issue and
the market capitalization (value) of the company is $50 million. After-tax
profits for next year are expected to be $20 million.
What is the cost of equity capital?
Total dividends = 20 million/4 = $5 million. Dividend Cover
= PAT / Total dividend
ke = 5/50 = 10%.
A financial metric that measures the number of times
that a company can pay dividends to its shareholders.
Dividend Growth Model
Equity investors will usually expect dividends to increase over
time, rather than remain constant each year in perpetuity.
This model still assumes the market price of a share is equal to
the PV of the dividend income stream from that share.
If we assume the dividend increases by a constant annual
growth rate (g), the market price of a share may be expressed
as:
Dividend Growth Model (Cont’d)

P0
HOW TO
DERIVE?
P0
D0 (1 + g )
Ke = + g
P0
TYK 01
The current market price of a share is LKR 250. A dividend of LKR 20
has just been paid. Assuming the expected annual growth rate for the
dividend is 5% to perpetuity, calculate the cost of equity.
Ke = { 20(1+ 0.05)/250} + 0.05 = 13.4%
The current market price of a share is LKR 200. A dividend of LKR 20
has just been paid. Assuming the dividend is expected to decline by 2%
each year in perpetuity, calculate the cost of equity.
Ke = {20(1 - 0.02)/200} – 0.02 = 7.8%
TYK 01 (Cont’d)
A share has a current market value of $96, and the last dividend was $
12. If the expected annual growth rate of dividends is 4%, calculate the
cost of equity capital.
Ke = [ {12(1 + 0.04)} / 96 ] + 0.04 = 0.13 + 0.04 = 0.17 = 17%
Estimation of the Growth Rate
Year Dividend
(LKR)
2000 15,000
2001 15,500 Calculate the growth rate?
2002 17,200
2003 18,100
S = X ( 1 + r )n
2004 19,000
TYK 02
Year Dividend
1. Calculate the growth rate
2010 150,000 2. The growth rate over the last four years is
2011 192,000 assumed to be expected by shareholders into
the indefinite future. If the company is
2013 206,000 financed entirely by equity and there are
2014 245,000 1,000,000 shares in issue, each with a market
value of $3.35 ex div, calculate Ke
2015 262,350
Gordon’s Growth Model
An increase in the level of investment by a
company will give rise to an increase in future
dividends.
He emphasized two main elements in
determining future dividend growth;
1. Rate of re-investment by the company.
2. Rate of return generated by the investments.
Gordon’s Growth Model g = bR
b = Proportion of earnings retained each year
= (Earnings – Dividends) / Earnings
R = Average Rate of Return on investment
= Earnings / (Book Value of Capital employed)

Assumptions:
 The entity must be fully equity financed
 Retained profits are the only source of additional investment
 A constant proportion of each year’s earnings is retained for reinvestment
 Projects financed from retained earnings earn a constant rate of return.
TYK 02
An entity retains 60% of its earnings for identified capital
investment projects that are estimated to have an average
post tax return of 12%.

Estimate the future dividend growth rate for the entity.

g = bR
◦ = 0.60 x 0.12 = 7.2 %
Weaknesses of the Dividend Growth Model
The model does not incorporate risk.
Dividends do not grow smoothly in reality so "g” is only an
approximation.
The model fails to take capital gains into account, however it is argued
that a change of share
ownership does not affect the present value of the dividend stream.
No allowance is made for the effects of taxation although the model can
be modified to incorporate tax.
It assumes there are no issue costs for new shares.
Capital Asset Pricing Model
The dividend valuation model does not explicitly consider
about RISK. The RISK in here is the actual returns (Dividends)
will not be the same as expected returns.

CAPM enables risk to be incorporated into financial analysis.

Calculate the Ke when equity beta is 1.4 with an expected

market return of 16%. Risk free rate is 10%.
Cost of Debt
01. Irredeemable Debt
These debt can not be redeemed until the maturity.
Plus, debt is a tax-deductible expense.
Hence the relevant cost to an entity is the after-tax cost.

Kd = {i ( 1 – t )} / Po
Kd = Cost of debt (After tax)
i = Annual interest
t = Corporate Tax
Po = Market value of Debt
TYK 03
Assume 7% bonds quoted at LKR 90 (ex-int), interest just
paid and corporation tax is 30%. (Face value is LKR 100)
Calculate the cost of debt?
Kd = 7 ( 1 – 0.30) / 90 = 5.4%
What if LKR 90 was the cumulative interest market price
(That is, the price includes the pending interest payment)
Kd ?
Kd = 7 ( 1 – 0.30 ) / 90 – 7 = 5.90%
Cost of Debt (Cont’d)
02. Redeemable Debt
The cost of redeemable debt is calculated using trial & error method
(Since these bonds can be redeemed before their maturity, we need to consider time
value of money)
In here, all the cash flows associated with the debt from today’s market
value through to the redemption value are discounted.
Calculate the cost of a 7% bond currently quoted at LKR 90. Face value is
LKR 100. It will be redeemed at LKR 101 in 5 years time. Interest and
redemption payments are assumed to be payable at year end and tax is
30% to be immediately recoverable.
Cost of Preference Shares
This is related to the amount of dividend payable on the share. The
dividend is an appropriation from post-tax profits, which means
that it is not allowable for tax.
Kd(PF) = Annual Dividend / Po
Po = Current ex-div Market Price.
A dividend of Rs.7 per LKR 100 preference share and a market
value of LKR 60, calculate the cost of the preferred share.

Kd (PF) = 7/60 = 11.7%

Weighted Average Cost of Capital
Weighted average cost of capital is the average cost of the
company's finance (equity, bonds, bank loans) weighted
according to the proportion each element bears to the total pool
of capital.
This is calculated by weighting the costs of the individual sources
of finance according to their relative importance as sources of
finance.
 TYK
The extracts of JULY company are as follows; (‘000)
Ordinary Shares LKR 50 2500
12% Unsecured bonds 1000
The ordinary shares are quoted at LKR 130 each and the
bonds are trading at LKR 72 per LKR 100 nominal. The
ordinary dividend of LKR 15 has just been paid with an
expected growth rate of 10%. Corporate tax 30%
Calculate WACC.
Assumptions in the use of WACC
01. The capital structure is reasonably constant.
This assumption is necessary because if the capital structure
changes, the weightings in the WACC calculation would change.
02. The new investment does not carry a significantly different
risk profile from that of the existing entity.
- WACC is the entity’s COC, hence it will only be suitable for
appraising a project that shows the same risk profile as the
whole entity.
Assumptions in the use of WACC (Cont’d)
03. The new investment is marginal to the entity.
The calculations of Ke, Kd, Kp are based on small
investments. In other words, they represent marginal COC.
Their use in the WACC calculation is also a marginal cost.
04. All cash flows are level perpetuities.