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Capital Structure For SFAD

This document provides an example calculation of the weighted average cost of capital (WACC) for a company with different capital structures (debt to equity ratios). It shows that WACC remains constant even as the capital structure changes, supporting Modigliani-Miller theory that capital structure does not affect a company's value. A second example then incorporates corporate taxes, demonstrating that WACC changes with capital structure when taxes are considered.

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Madeeha Khan
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69 views10 pages

Capital Structure For SFAD

This document provides an example calculation of the weighted average cost of capital (WACC) for a company with different capital structures (debt to equity ratios). It shows that WACC remains constant even as the capital structure changes, supporting Modigliani-Miller theory that capital structure does not affect a company's value. A second example then incorporates corporate taxes, demonstrating that WACC changes with capital structure when taxes are considered.

Uploaded by

Madeeha Khan
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as XLSX, PDF, TXT or read online on Scribd
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Formula

RL = Ru + D/E * (Ru - Rd) Cost Weights


Example Cost of E 20% 40%
RL 20% Cost of D 16% 60%
D WACC
E ?
Interest Rate Rd 16%
Ru ? WACC = #VALUE!
Tax
0.20 = Ru + 60/40 * (Ru - 0.16)
D/E = 1.25

0.2 = Ru + 1.5 Ru - 0.24 D= 1.25


E= 1.00
0.2 + 0.24 = 2.5 Ru 2.25
D= 0.56
Ru = 0.44/2.5 E= 0.44

Ru = 17.6%

Example
Ru 17.60%
RL ?
Debt 60%
Equity 40%
Interest Rate 16%
RL =17.6%+60%/40%*(17.6%-16%)
RL = 20%

Formula
WACC = RL * E/(D+E) + Rd * D/(D+E) WACC =
WACC = 20% * 40% + 16% *60%
WACC = 17.6%

Capital Structure
Case Debt Equity Rd (Interest) Ru RL WACC
1 0% 100% 17.60% 17.60%
2 10% 90% 16% 17.78% 17.600%
3 20% 80% 16% 18.00% 17.600%
4 30% 70% 16% 18.29% 17.600%
5 40% 60% 16% 18.67% 17.600%
6 50% 50% 16% 19.20% 17.600%
7 60% 40% 16% 20.00% 17.600%
8 70% 30% 16% 21.33% 17.600%
9 75% 25% 16% 22.40% 17.600%
10 90% 10% 16% 32.00% 17.600%
11 95% 5% 16% 48.00% 17.600%

Rd RL WACC 60%
16% 17.78% 17.60% 50%
16% 18.00% 17.60%
40%
16% 18.29% 17.60%
16% 18.67% 17.60% 30%
16% 19.20% 17.60% 20%
16% 20.00% 17.60% 10%
16% 21.33% 17.60%
0%
16% 22.40% 17.60% 1 2 3 4 5 6 7 8 9
16% 32.00% 17.60%
16% 48.00% 17.60%

This graph shows that WACC is constant even when we change capital structure (Debt level). If WACC is constant then i
the same hence commpany's profitability remains the same. Therefore, it doesn't matter if a company takes a lot of deb
debt, proving MM theory.
Wtd. Avg
8.00%
9.60%
17.60%

Debt is twice its equity


D/E = 2
D 2
E 1
3
D 0.666667
E 0.333333

Notes
All equity firm, no debt

Formula in column F:
RL = Ru+ D/E *(Ru-Rd)

Formula in column G:
WACC = RL*E/(D+E) +
Rd*D/(D+E)
Formula in column F:
RL = Ru+ D/E *(Ru-Rd)

Formula in column G:
WACC = RL*E/(D+E) +
Rd*D/(D+E)

Rd
RL
WACC

5 6 7 8 9 10

If WACC is constant then it means that cost is


company takes a lot of debt, some debt or no
Formula
RL = Ru + D/E * (Ru - Rd)* (1 - T) D + E = 100%
Example RU = WACC
RL 20%
D/E 1.5 D = 60% & E = 40%
Interest Rate 16%
Ru ?
Tax 25%

0.20 = Ru + 1.5 * (Ru - 0.16) * (1-25%)

Ru = 17.88% WACC = Cost of Equity * Wt of Equity + Cost of Debt * Wt o


WACC = 17.88% *100% + 16% * 0 (1-25%)
WACC = 17.88%

Reverse Example
Ru 17.88%
RL ?
Debt 60%
Equity 40%
Interest Rate 16%
Tax 25%
RL = Ru + D/E * (Ru - Rd)* (1 - T)
RL = 20.00%

Formula
WACC = RL * E/(D+E) + Rd * D/(D+E)*(1-T)

WACC = 15.20%

Case Debt Equity Rd (Interest) Ru RL WACC


1 0% 100% 16% 17.88% 17.88%
2 10% 90% 16% 18.04% 17.44%
3 20% 80% 16% 18.24% 16.99%
4 30% 70% 16% 18.49% 16.54%
5 40% 60% 16% 18.82% 16.09%
6 50% 50% 16% 19.29% 15.65%
7 60% 40% 16% 20.00% 15.20%
8 70% 30% 16% 21.18% 14.75%
9 80% 20% 16% 23.53% 14.31%
10 90% 10% 16% 30.59% 13.86%
11 95% 5% 16% 44.71% 13.64%
Rd RL WACC 25%
16% 18.04% 17.44%
20%
16% 18.24% 16.99%
16% 18.49% 16.54% 15%
16% 18.82% 16.09%
16% 19.29% 15.65% 10%
16% 20.00% 15.20%
5%
16% 21.18% 14.75%
16% 23.53% 14.31% 0%
1 2 3 4 5 6 7 8

This graph shows that WACC changes when we change capital structure (Debt level).
quity + Cost of Debt * Wt of Debt * (1-T)

Notes
All equity firm, no debt

Formula in column F:
RL = Ru+ D/E *(Ru-Rd)*(1-T)

Formula in column G:
WACC = RL*E/(D+E) +
Rd*D/(D+E)*(1-T)
Rd
RL
WACC

4 5 6 7 8 9 10
Re = Rf + Bi (Rm – Rf)
Share price = 90, Government bond rate = 12%,
Share price fluctuates twice as average market, 100
Tax rate = 20%
Cost of Equity = 12% + 2(14.5%-12%) = 17%
rate = 12%,
age market, 100 index return = 14.5%

%) = 17%

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