Cost of Capital and Equity Example for Free

A firm or a business can source its capital either by raising debt or through equity. The composition in which the firm finances its assets through debt or equity forms the Capital Structure of a firm. Therefore , when we talk about a company's capital structure we are basically talking about how a company has set up its financing. This can be seen at the right side of the balance sheet of a company. A company can finance itself by borrowing money i.e. through debt or through equity i.e. ownership of one or more than one owners and many of owners in case of a public company. Definition: "A mix of a company's long-termA debt, specific short-term debt, common equity and preferred equity. The capital structure isA how a firm finances its overall operations and growth byA using different sources of funds." The capital structure also tells us how risky a company is, as generally a company which is financed by debt extensively tends to be more risky. Thus, a firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $30 billion in equity and $70 billion in debt is said to be 30% equity-financed and 70% debt-financed. The firm's ratio of debt to total financing, 70% in this example, is referred Figure showing Capital Structure of a company to as the firm's leverage. In reality, capital structure may be highly complex and include tens of sources. Gearing Ratio is the proportion of the capital employed of the firm which come from outside of the business finance, e.g. by taking a short term loan etc.

ASSUMPTIONS

There is no income tax, corporate or personal. The firm pursues a policy of paying all of its earnings as dividends ie 100% dividend payout ratio is assumed Investors have identical subjective probability distributions of operating income(earnings before income and taxes) for each company The operating income is not expected to grow or decline over time A firm can change its capital structure almost instantaneously without incurring transaction costs. The reasons for taking the above mentioned assumptions are to remove the influence of taxation, dividend policy, varying perceptions about risk, growth and market imperfections so that the influence of financial leverage on cost of capital can be understood with more clarity. DEBT FINANCE EQUITY FINANACE What is it? Money is borrowed from the bank or any other financial institution An investor buys stake in your business ex. shares Pros You retain complete ownership of your business and the profits it generates. Interest payments are generally tax deductible. The investor shares the risk. If business fails, there's no need to pay back to the investor. There are no interest payments - investors need to be paid a share of profits, which could be more than interest. Cons You have to pay interest on your borrowings. You have to repay the amount you borrowed, even if your growth plans don't come off. In most cases, you'll need to offer security for your loan, so this option is difficult if you don't have assets. You share ownership of your business so if it's successful, a share of that success goes to someone else. You lose control of your business. An investor may ask to sit on the board and take part in decision marking. Depending on the option you choose, your investor may take a share of profits.

COST OF DEBT, COST OF EQUITY AND AVERAGE COST OF CAPITAL

Assuming that the debt is perpetual, rD represents the cost of debt.

rD = I / D = Annual interest charges / Market value of debt

When the dividend payout ratio is 100% and earnings constant, rE represents cost of equity

rE = P / E = Equity earnings / Market value of equity

rA is the overall capitalization rate of the firm.

rA = O / V = Operating income / Market value of firm

where V = D + E Since rA is the weighted average cost of capital, it can also be expressed as:

rA = rDD / (D + E) + rEE / (D + E)

NET INCOME APPROACH

According to this approach, the cost of debt, rD, and the cost of equity, rE, remain unchanged when D / E varies. The constancy of rD and rE with respect to D / E means that rA declines as D / E increases. This happens because when D / E increases, rD, which is lower than rE, receives a higher weight in the calculation of rA.

NET OPERATING INCOME APPROACH

According to the net operating income approach, the overall capitalisation rate and the cost of debt remain constant for all degrees of leverage. Hence rA and rD will be constant for all degrees of leverage. Hence cost of equity can be expressed as:

rE = rA + (rA - rD) (D / E)

The critical premise of this approach is that the market capitalises the firm as a whole at a discount rate which is independent of the firm's debt-equity ratio. As a consequence, the division between debt and equity is irrelevant. An increase in the use of debt funds which are apparently cheaper is offset by an increase in the equity capitalisation rate. This happens because investors seek higher compensation as they are exposed to greater risk arising from increase in the degree of leverage. They raise the capitalisation rate rE, as the degree of leverage increases. David Durand has advocated that the market value of a firm depends on it net operating income and business risk. The change in the degree of leverage employed by a firm cannot change these underlying factors. It merely changes the distribution of income and risk between debt and equity without affecting the total income and risk which influence the market value of the firm. Hence the degree of leverage per se cannot influence the market value of the firm.

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