CHAPTER FOUR

BONDS AND STOCK VALUATION AND COST OF CAPITAL

4.1 CONCEPTS OF BOND
A bond is a long-term contract under which a borrower agrees to make payments of interest and
principal, on specific dates, to the holders of the bond or a bond is an instrument or
acknowledgement issued by a business unit or government the amount of loan, rate of interest
and the terms of loan repayment.
Key Characteristics of Bonds
Par value:-It
value:-It is the amount or value stated on the face of the bond. It represents the amount of
the firm’s borrowings and promises to repay at the time of maturity. The par value generally
represents the amount of money the firm borrows and promises to repay on the maturity date.

Face value: The principal amount of a bond that is repaid at the end of the term. Also, par value

Coupon Rate of Interest:-A

Interest:-A bond carries a specific interest rate, which is called the coupon rate.
The interest payable to the bondholder is simply par value of bond multiplied by the coupon rate.
It is annual coupon divided by the face value of a bond. For example, Star Business Group’s
bonds have a $1,000 par value, and they pay $100 in interest each year. The bond’s coupon
interest is $100, so its coupon interest rate is $100/$1,000 =10%. The coupon payment, which is
fixed at the time the bond is issued, remains enforce during the life of the bond. Typically, at the
time a bond is issued, its coupon payment is set at a level that will enable the bond to be issued at
or near its par value. And coupon is stated interest payment made on a bond
Maturity period: - Specified date on which the principal amount of a bond is paid . Every bond
will have maturity period. On completion of the maturity period the principal amount has to be
repaid as per the agreed terms while issuing such bonds call provision. Sometimes bonds may be
issued under a provision that the business unit will have an option to pay back the bond amount
before the maturity period. These are known as callable bonds. Bonds generally have a specified
maturity date on which the par value must be repaid. For example: Star Business Group has
issued a Bond on January 5, 2015, will mature on January 5, 2025. Thus, they have a 10-year
maturity at the time they are issued. Most bonds have original maturities (the maturity at the time
the bond is issued) ranging from 10 to 40 years, but any maturity is legally permissible.
The intrinsic value of a bond:
bond: it is equal to the present value of its expected cash flows. The
coupon interest payments and principal payments are known and the present value is determined
by discounting these future payments from the issuer at an appropriate discount rate or market

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4.2 BOND EVALUATION
The value of any financial asset a stock, a bond, a lease, or even a physical asset such as an
apartment building or a piece of machinery is simply the present value of the cash flows the asset
is expected to produce. The cash flows from a specific bond depend on its contractual features as
described in the previous section. For a standard coupon-bearing bond such as the one issued by
star business groups, the cash flows consist of interest payments during the life of the bond plus
the amount borrowed when the bond matures (usually a $1,000 par value).
Bond can be evaluated by this formula
n C TV
∑t = 1 (1 + r)t . . .. .+ (1 + r )n
PV =

PV = Present value of the bond today

C = Coupon interest
R=coupon interest rate
N = Number of years to maturity
TV= (Terminal
Terminal value repayable):
repayable Par or maturity, value of the bond. This amount must
be paid off at maturity.
Example1: A 10% bond of Birr 1,000 issued with a maturity of five years at par. The discounted
rate is 10%. The interest is paid annually. What would be the bond value?
PV = 100 __ + 100__ 100__ + 100___
100___ + 100___
100___ + 100+ 1000
2 3
(1 + .10) (1 + .10) (1 + .10) (1 + .10)4 (1 + .10)5
= 100 x .9091 + 100x .8264 + 100 x .7513 + 100x .6830 + 1100 x .620
= 90.91 +| 82.64 + 75.13 + 68.30 + 682.99
= 999.97
Example2: A bond of Birr 1,000 at 6% is issued at par. The bond had a maturity period of five
years. As of today five more years are left for final repayment at par. The current discount rate is
10 percent. What is the present value?
PV = 60__ + 60___ + 60 __ + 60 60 + 1000
2 3 4
(1 + .10) (1 + .10) (1 + .10) (1 + .10) (1 + .10)5
= 60 x .9091 + 60 x .8264 + 60 x .7513 + 60 x .683 + 1060 x .6209
= 54.55 + 45.08 + 40.98 + 658.15
= 847.35
Relationship between coupon rate, required yield and price
You are aware that yields change in market place, price of bonds change to reflect the new
required yield. When the required yield on a bond rises above its coupon rate, the bond sells at a
discount. When the required yield on a bond equals its coupon rate, the bond sells at par. When
the required yield on a bond falls below its coupon rate, the bond sells at a premium.
Current yield:
The current yield relates the annual coupon interest to the market price. It is expressed as
Current yield = Annual Interest
Price

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Example 3: A Birr 1000 Bond issued at 12% at par for a period of ten years. Now the market
price of the bond is Birr 950 what is the current yield of the bond?
Current yield = Annual interest = 120 = 0.1263 or 12.63%
Price 950
Yield to maturity
The rate required in the market on a bond.. It is the interest rate that makes the present value of
the cash flows receivable from owning the bond equal to the price of the bond. Mathematically,
it is the interest rate (r), which satisfies the equation.
P= C1 + C2__ + C3__ + Cn___ + FV_
(1 + r) (1 + r) 2 (1 + r) 3 (1 + r) n (1 + r) n
Where, P = Price of the bond, C = Annual interest, FC = Face value & N = Number of years left
to maturity
Any time the calculations of bond required the trial and error method to know the rate of interest
which equates the price of bond.
Example 4: A bond Birr 1000 is issued at par carrying coupon rate of interest of 9 percent. The
bond matures after 8 years. The bond is currently selling for Birr 800. What is the YTM on this
bond?
Given:
800 = 90__90__ + 1000_
(1 + r)t (1 + r)8
= 90 (PVFAr 8 years) + 1000 (PVFr 8 years)
We have to begin with trial and error base.
Let us begin with discount rate of 12 percent.
= 90 (PVFA 12,8 years) + 1000 (PVF12, 8 years)
= 90 (4.968) + 1000 (0.404)
= 851.0
This is more than Birr 800 so we may have to try higher value of discount rate. Let us take 14
percent.
= 90 (PVFA14, 8 years) + 1000 (PVF14, 8 years)
= 90 (4.639) + 1000 (0.351)
= 768.1
The value is less than Birr 800, so let us try at 13 percent.
= 90 (PVFA13 8 years) + 1000 (PVF13 8 years) = 90 (4.800) + 1000 (0.376) = 808
Therefore, it lies between 13% and 14 percent.
= 13 + 808 – 800_ x 1
808 – 768.1 = 13 + 8 =13.3 = 13.2%
40
Example 5: An investor purchased a 15% Birr 500 fully paid bond five years back. The current
market price of the bond is Birr 400. Calculate yield to maturity.
Let us begin with 15%
= 75 (PVFA15 5 years) + 500 (PVF15 5 years) = 75 (3.3522) + 500 (.4972) = 251.42 +
248.60 = 500.08
Since it is greater than 400 we will take 20%

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 = 75 (PVFA20 5 years) + 500 (PVF20 5 years) = 75 (2.9906) + 500 (.402) = 224.295 +
200.95
= 425.245

Even this is greater than 400. Hence we take 24%

= 75 (PVFA24 5 years) + 500 (PVF24 5 years) = 75 (2.745) + 500 (.341)= 205.91 +
170.55 = 376.46
Hence, the YTM lies between 20 – 24
= 20 + 425.24 – 400__ x 4 =20+ 25.24 x 4 = 20 +2.07% = 22.07%
425.24 – 376.46 48.785
4.3 VALUATION OF THE STOCKS
4.3.1 VALUATION OF PREFERENCE STOCKS
Preference shares are hybrid security. They have some features of bonds and some of equity
shares. Theoretically, preference shares are considered a perpetual security but there are
convertible, callable, redeemable and other similar features, which enable issuers to terminate
them within the finite time horizon. Preference dividends are specified like bonds. This has to be
done because they rank prior to equity shares for dividends. However, specifications doesn’t
imply obligation, failure to comply with which may amount to default several preference issues
are cumulative where dividends accumulate over a period of time and equity dividends require
clearance of preference arrears first. Preference shares are less risky than equity because their
dividends are fixed and all arrears must be paid before equity holders get their dividends. They
are however, more risky than bonds because the latter enjoy priority in repayment and in
liquidation. Bonds are scurried also and enjoy protections of principal which is ordinarily not
available to preference shares. Investor’s required returns on preference shares are more than
those on bonds but less than on equity shares.
Since dividends from preference shares are assumed to be perpetual payments, the intrinsic value
of such shares will be estimated from the following equations.
Vp = C_
C_ + C__
C__ + Cn__
(1 + k) (1 + k) 2 (1 + k) n
Vp = Value of perpetual today
C = Constant dividends received
K = required rate of return appropriate
Vps = D__
Kps
Example: - A preference share of Birr 100 each with a specified dividend of Birr 11.5 per share.
Now, if the investors’ required rate of return corresponding to the risk level of a company is
10%, what would be the value of share today?
Vps = D_ D_ = 11.5 = 115.00 Br.
Kps .1
Should be required return increase to 12% what would be the value?
Vps = D_ D_ = 11.5 = 95.83
Kps 0.12
If the market price of the preference share is Birr 125 what would be the yield?

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 Vps = D__
Kps
Kps = D_ = 11.5 = 9.2%
Vps 125

4.3.2 VALUATION OF COMMON STOCK

In case of equity shares, the future stream of earnings or benefits poses two problems. One, it is
neither specified nor perfectly known in advance as an obligation. Resulting this, future benefits
and their timing have both to be estimated in a probabilistic frame work. Two, there are at least
three elements which are positioned as alternative measures of such benefits namely dividends,
cash flows and earnings. Common stock is a type of security that represents ownership of equity
in a company. Holders of common stock own the rights to claim a share in the company’s profits
and exercise control over it by participating in the elections of the board of directors, as well as
in voting regarding important corporate policies.
The valuation of common stock has two methods.
a) Zero growth model
b) Constant growth model
a) Zero growth model
Under this the assumption is the growth of dividend is zero or constant.
Vc = D
K
Vc = Value of common stock, D = Dividend paid and K = the required rate of return
Example: A company pays a cash dividend of Birr 9 per share on common share for an indefinite
period of future. The required rate of return is 10% and the market price of the share is Birr 80.
Would you buy the share at its current price?
Vs = D = 9 = 90
K .10
Yes, value the is more than price; you would consider buying the share.
b) Constant Growth Model
The dividend payable to common stock holders will grow at a uniform rate is future. It can be
written as below.
Vc = Do (1 + g)
k–g
Do = Dividend paid, g = growth rate, k = desired rate of return.
Example:
Example: Alfa Company paid a dividend of Birr 2 per share on common stock for the year
ending March 31, 2003. A constant growth of 10% per annum has been forecast for an indefinite
future. Investors required rate of return is 15%. You want to buy the share at market price quoted
on July 31, 2003 is stock market at Birr 60 what would be your decision?
Vs = Do (1 + g) = 2 (1 + .10) = 2(1.1) 2.20 = 44
k–g 15 - .10 0.05 0 .05
Value is less than price, so you do not buy.

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Ex. Nissan Ltd paid a dividend of Birr 4 per share for the ending march 31, 2003. The growth
rate is 10% forever. The required rate of return is 15%. You want to buy the share at a market
price of Birr 80 in stock exchange. What would you do?

Vc = Do (1 + g)
g) = 4(1+.1) = 4.4 = 88
k–g 0.15-.10 .
Here the price is more than value. Hence, you prefer to buy.
4.4 THE COST OF CAPITAL
The cost of capital is the minimum rate of return that a firm must earn in order to satisfy the
overall rate of return required by its investors. It is also the minimum rate of return a firm must
earn on its invested capital to maintain the value of the firm unchanged. The second definition
considers the cost of capital as a break even rate.
If a firm’s actual rate of return exceeds its cost of capital, the value of the firm would increase. If
on the other hand, the cost of capital is not earned, the firm’s market value will decrease. So the
cost of capital is the rate of return that is just sufficient to leave the price of the firm’s common
stock unchanged.
The cost of capital serves as a discount rate when a firm evaluates an investment proposal.
Suppose a firm is considering investment on a plant. The finance required for this investment is
to be raised by selling a common stock issue. Now, after raising capital, the firm is expected to
provide required rate of return to those who invest on the common stock. This in effect is the
firm’s cost of capital. So to decide to invest on the plant, the minimum rate of return from the
investment at least should be equal to the required rate of return by the common stockholders. If
the required rate of return by the firm’s common stockholders is 13%, then the firm should earn a
minimum of 13% on its investment on the plant. The 13% minimum rate of return that should be
earned by the firm is, therefore, its cost of capital.
Cost of capital is useful as a standard for:
 Evaluating investment decisions (e.g. NPV (+ve or –ve), IRR or PI, etc).
 Designing a firm’s debt policy (the proposition of debt and equity in capital structure).
 Appraising the financial performance of top management (by comparing the actual earned
rate of return and cost of capital).
Specific Cost of Capital
The cost of capital for any particular capital source or security issue is called the specific cost of
capital. It is also called individual cost of capital or component cost of capital.
Each type of capital contained the capital structure of a firm include.
1. Cost of Debt
2. Preferred stock
3. Common stock
4. Retained earnings
4.4.1 Cost of Debt
A firm may borrow funds from financial institutions or public center either in the form of public
depositors of bond for specific period of time at a certain rate of return. The firm’s cost of debt is
the investor’s required rate of return (RRR) on debt adjusted for tax and flotation cost. This is
because interest payment on debt is a tax-deductible expense; it reduces the firm’s taxable
income by the amount deductible interest. Flotation cost is the cost incurred in issuing debt
securities that increases the cost of debt. If commissions, legal and accounting fees are incurred
in issuing the security the company will not receive the full market price rather the selling

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expenses are deducted from the selling price to give the amount the realizes called Net Proceed
(NP). A bond may be issued at par, a discount or at a premium as compared to its face value.
The specific cost of debt can be found by the following formulas:

1
I + (FV −MV )
n
i. Ki= [to compute cost of debt before taxes].
1
(FV + MV )
2
ii. Kd = Ki(1−T) ≈ Kd= Interest rate(1−T) [to obtain after tax cost of debt]

Where:

Ki= Cost of debt before taxes FV = Face value of the bond

Kd= After taxes cost of debt MV = Maturity value of the bond
I = Interest Payment n = Maturity period of the bond.
Example1: a corporation sold a Br. 20 million bond that mature in 25 years at par value. Each
bond has a Br.1, 000 par values and carries a 12% coupon rate (interest rate). Assume a 45% tax
rate. Compute the specific cost of capital for this bond before and after tax effect.
Given: I = 1,000 X 0.12 = Br.120, FV = 1,000, MV = 1,000, r = 12%, T = 45%and n = 25 yrs
i. The specific cost of bond before tax effect is
1 1
I + (FV −MV ) Br .120+ (Br .1,000 – Br .1,000)
n 25
Ki = = = Br.120/Br.1,000 = 12%
1 1
(FV + MV ) (Br .1,000+ Br .1,000)
2 2
Therefore, if a bond is sold at its par value, the cost of the bond and its interest rate are equal
before the tax effect.
ii. The specific cost of bond after tax effect is the actual cost of debt as computed below.
Kd = Ki(1−T) =12%(1−0.45) = 6.6%
Example 2: Assume that the above bond in example 1 is discounted and sold for Br.980 per par.
Compute the after tax cost of debt.
1
Br .120+ (Br .1,000 – Br .980)
25 Br .120+0.8
ki= = =¿ 12.20%
1 Br .990
(Br .1,000+ Br .980)
2
Thus, Kd = 0.1220(1−0.45) = 6.71%
 If a bond is sold at a discount, then the cost of the bond is greater than its interest rate before
tax effect.

Example 1: ABC Company sold Br.100 par value bond that mature in 7 years. The rate of
interest is 15% per year, and the bond will be redeemed at 5% premium on maturity. The firm’s
tax rate is 35%.

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 1
Br .15+ (Br .100 – Br .105)
7 Br .14 .286
Ki = = = 13.94%
1 Br .102 .5
( Br .100+ Br .105)
2

Thus, Kd = 13.94% (1−0.35) = 9.1%

 When a bond is sold at premium, the cost of the bond is less than its interest rate.

Exemplary exercise
The Imaginary Product Co. currently has 300,000 bonds of outstanding with Br.1, 000 face
values. The bonds have 9% coupon rate paid semiannually with a maturity of 15 years and
are currently priced at Br.1, 440 per bond.
a. What is the before and after-tax cost of debt for this firm if the imaginary tax rate for
the firm is 34%?
b. What is the debt’s cost if the bonds were sold at par?

4.4.2 Cost of preferred stock

It is the rate of return that must be earned on the preferred stockholders’ investment to satisfy
their requirement (fixed dividend payment). When a corporation sells preferred stock, it expects
to pay dividends to investors in return for their money capital. The dividend payments are costs
to the firms issuing preferred stock. In order to express this dividend cost as yearly rate, the firm
uses the selling price it receives after deducting flotation costs incurred in issuing the preferred
stocks. The cost of preferred stock can be estimated by dividing the annual preference dividend
by the current market price per share or net proceed; as the dividend can be considered a
continuous (stable) level of payment.
 Preferred stock dividends are either expressed as a stated birr amount or annual percentage.
 Preference capital is never issued with an intention not to pay dividends.
 The cost of preferred stock is not adjusted for taxes, because preference dividend is paid after
corporate tax is paid.
 The cost of preferred stock (Kp) can be estimated through the following formula;
dividend per s h are Dps
Kp = =
net proceed (NP) NP

Example: A preferred stock selling for Br.500 with an annual stated dividend per share of Br.50
requires a flotation cost of Br.10 per share. Determine the specific cost of the preferred stock if
the corporate tax rate is 40%.
Solution-
Dp= Br.50, NP = market price minus flotation cost = Br.500 – Br.10 = Br.490
Dps Br .50
Thus, Kp = = = 10.2%
NP Br .490

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 It implies that the firm must earn 10.2% on preferred stock investment to satisfy the preferred
stock holders’ interest.

Exemplary exercise
XYZ Com. has issued 2 million preferred shares outstanding with a market price of Br.12.
The company has incurred 8% of selling price to complete the issuing procedures. The
preferred shares offer an annual dividend of Br.1.20. What is the cost of preferred shares for
XYZ company?
4.4.3 The Cost of Common Stock
Cost of common stock is a minimum rate of return that the corporation must earn for its common
stock holders in order to maintain the market value of the firm’s equity. However, cost of equity
share is more difficult to calculate than the cost debt or the cost of preferred shares because there
are no fixed contractual payments for equity shares. The cost of equity share capital is
determined by the present value of all future dividends expected to be paid on their share. In case
of equity shares, it is difficult to determine the expected future value. This occurs due to that
many firms do not pay dividends for long period of time either because they choose to finance
their investment or they are not profitable enough.
There are three important techniques to estimate the cost of common stock.

1. Normal dividend-growth: whose dividends are expected to grow at a constant rate of g.

In this case the cost of common stock (Kc) can be found by applying the following
formula.
Do(1+ g) D1
Kc = + g= +g
NP Np
Where:

Kc = cost of common stock g = dividend growth rate

Do = current dividend per share D1 = dividend at the end of 1st year
NP = Net Proceed

Dividend for n period with normal growth rate can be estimated using the formula
Dn = Do (1+ g ¿ ¿n
Example 1: a company’s common stock has recent dividend per share of Br.12. It is found that
the company dividend per share should continue to increase at 6% growth rate. What is the cost
of common stock if a market price of Br.100 with a flotation cost of per share Br.8 is expected
up on selling the stocks?
Do(1+ g) 12(1+6 % )
Kc = + g= + 6% = 0.1383 + 0.06 = 19.83%
NP 92

Example 2: suppose that the current market price of company’s share is Br.90 and the expected
dividend per share next year is Br.4.50. If the dividends are expected to growth at a constant rate
of 8%, the shareholders’ required rate of return is

D1 Br .4 .50
Kc= +g = + 0.08=13 %
NP Br .90

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 2. Zero-Growth Rate:- The dividend valuation method can also be used to estimate the cost
of equity of no-growth. The growth rate will be zero if the firm does not retain any of its
earnings; i.e. the firm follows a policy of 100% pay out dividend policy. In this case,
D1 EPS
Kc = = ,which implies that in a no-growth situation, the expected earnings-
NP NP
price (E/P) ratio may be used as the measure of the cost of equity (where, EPS = Earnings
Per Share).
Example: a firm is currently earning Br.100,000 and its share is sold at a market price of Br.80.
the firm has 10,000 shares outstanding and has no debt. The earnings of the firm are expected to
remain stable, and it has a payout ratio of 100%. What is the cost of equity? If the firm’s payout
ratio is assumed to be 60% and that it earns 15% of rate of return on its investment opportunities,
then what would be the firm’s cost of equity
Solution:
Case 1: The expected growth rate is zero.
D1 EPS Br .10 Br .100,000
Kc = = = = 12.5%, where EPS = =Br .10
NP NP Br .80 10,000
Case 2: The dividend will grow at a normal growth rate. If the firm pays out 60% of its earnings,
the dividend per share will be Br.10 X 0.6 = Br.6, and the retention will be 40%. If the expected
return on internal investment opportunities are 15%, then the firm’s expected growth is 40% X
0.15 = 0.06. Thus the firm’s cost of equity will be
D1 Br .6
Kc= +g = + 0.06=13.5 %
NP Br .80
3. The Capital Asset Model (CAPM):- as per the CAPM, the required rate of return on
equity is given by Kc = Rf + (Rm − Rf)βj.
Where:
Kc = cost of equity Rm = market return
Rf = Risk free rate βj = beta of firm’s share
 Risk free rate (Rf) is the rate obtained on the government treasury securities.
 Market risk premium (Rm −Rf) is measured as the difference between long-term historical
arithmetic averages of market return and the risk free rate.
 Beta j (βj) is the systematic risk of an ordinary share in relation to the overall market.

Example: Assume that the risk free rate is 7%, the expected return in the market is 16% and the
beta for the firm’s common stock is 0.82. Compute the cost of equity using CAPM.

Kc = Rf + (Rm − Rf)βj = 0.07 + (0.16 − 0.07)0.82 = 14.38%

Exemplary exercise: Underestimated Inc.’s common shares currently sell for $36 per share. The
firm believes that its shares should really sell for $54 per share. If the firm just paid, an annual
dividend of $2 per share and the firm expects those dividends to increase by 8 percent per year
forever (and this is common knowledge to the market).
a. What is the current cost of common equity for the firm?
b. What is cost of common equity for the firm as per the it’s belief?
4.4.4 Cost of Retained Earnings

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Retained Earnings (RE) represents profit available to common stockholders that the corporation
chooses to reinvest. The cost of RE costly related to the use of equity shares, If earnings were not
retained, they will be paid out to the common stockholders in dividend form. The cost of retained
earnings is the opportunity cost forgone dividends to the existing shareholders. Thus, its cost is
the same as that of equity shares. Since retained earnings represent the internal source of capital,
it is not necessary to adjust the cost of it for flotation costs. So, specific cost of RE (K RE) is
equated in the same way as the cost of equity was equated. That is,
D1
KRE¿ + g , where MP = market price of existing common stock.
MP

Example: a company’s common stock has recent dividend per share of Br.12. It is found that the
company dividend per share should continue to increase at 6% growth rate. What is the cost of
retained earnings if a market price of Br.100 with a flotation cost of per share Br.8 is expected
up on selling the common stocks?
Do(1+ g) Br .12(1+0.06)
KRE¿ + g= + 0.06 = 18.72%
MP Br .100

4.5 The Weighted Average Cost of Capital (WACC)

WACC estimates the cost of capital structure financed from different sources of finance like
debt, common stock, preferred stock or retained earnings. It is a function of the individual cost of
capital and the percentage of funds provided by different securities holders. The capital structure
weights can be estimated from book value, market value, historical weight or target weight.
 Book value weight- uses accounting book value to measure the proportion of each type of
capital in the firm’s capital structure.
 Market value weight- measures the proportion at its market value.
 Historical weights-can be either book value or market value weights based on actual capital
structure proportion. Such weights however, would represent actual rather than desired
proportions of various types of capital in the capital structure.
 Target weights- can be either book value or market value weights that reflect the firm’s
desired capital structure proportion. However, from strictly theoretical point of view, the
target market value weighting scheme (program) should be preferred.
The following steps are involved for calculating the firm’s WACC.
i. Calculate the cost of specific sources of funds.
ii. Multiply the cost of each source by its proportion in the capital structure.
iii. Add the weighted component costs to get the WACC.
n
Thus, WACC = W1K1 + W2K2 + … + WnKn = ∑ WiKi
t =1

Where: Ki = cost of capital for the ith source.

Wi = percentage of total capital supplied by ith source.
n = number of long-term capital sources.
Example: assume that you are provided with the following information regarding the capital
structure of a corporation found in your locality.

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 Source of finance Market value Specific cost of capital
Debt Br.300,000 8%
Preferred stock 100.000 11%
Common stock 450,000 18%
Retained earnings 150,000 15%
Total Br.1,000,000
Br .300,000 Br .100,000
Debt = =30 %Preferred stock = =10 %
Br .1,000,000 Br .1,000,000
Br .450,000 Br .150,000
Common stock = =45 % Retained earnings = =15 %
Br .1,000,000 Br .1,000,000
WACC = 0.3(0.08) + 0.1(0.11) + 0.45(0.18) + 0.15(0.15) = 13.85%
Interpretation: to satisfy its shareholders or creditors the corporation should get at least 13.85%
annual return from the investment.
The Weighted Marginal Cost of Capital (WMCC)
It is the cost of additional (new) capital raised by a firm from different sources of finance.
WMCC is simply the firm’s WACC associated with its next birr of total new financing. It
reflects the WACC of the last birr raised by the firm. The WMCC increases as more and more
capital is raised during a period. The WMCC is always equal to or greater than, the WACC.
Because the costs of the new financing components rise as larger amounts are raised, the WMCC
is an increasing function of the level of total new financing. Increases in the component
financing costs result from the fact that at a given point in time, the larger the amount of new
financing, the greater the risk to the fund suppliers. Risk rises in response to the increased
uncertainty as to the outcomes of the investments financed with these funds. In other words, fund
suppliers require greater returns in the form of interest, dividend, or growth as compensation for
the increased risk introduced as larger volumes of new financing are incurred.
Example: the corporation in your locality (see the previous example) wanted to raise additional
funds of Br.100, 000 to finance its plant. The corporation raised the Br.100,000 from different
sources such as: Br.20,000 debt, Br.30,000 common stock, Br.30,000 preferred stock and
Br.20,000 retained earnings. The specific cost of capital of each source remains the same.
Compute the WMCC.
Br .20,000 Br .30,000
Debt = = 20% Preferred stock = = 30%
Br .100,000 Br .100,000
Br .30,000 Br .20,000
Common stock = = 30% Retained earnings = = 20%
Br .100,000 Br .100,000
WMCC = WdKd + WpKp + WcKc + WREKRE
= 0.2(0.08) + 0.3(0.15) + 0.3(0.18) + 0.2(0.15) = 14.5%
Interpretation – to satisfy its shareholders or creditors the corporation should earn at least 14.5%
annual return from the investment financed by additional raised funds.
Exemplary exercise
Toshibalaptop producer corp.currently has 20,000bonds outstanding with 9% interest rate paid
semiannually. The bonds have Br.1,000 face value and a maturityof 15 years. Currently the
bonds are priced at Br.1,200.The firm also has issued12,000 preferred shares outstanding with a
market price of Br.12. The preferredshares offer an annual dividend of Br.1.20. Toshiba also has

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 18,000 shares of commonstock outstanding with a price of Br.20per share. The firm is expected
to pay a Br.2.20 common dividend one year from today, and that dividend is expected to
increaseby 5 percent per year forever. If Toshibais subject to a 40 percent tax rate,then what is
the firm’s weighted average cost of capital?

4.6 Capital structure

Capital is the major part of all kinds of business activities, which are decided by the size,
and nature of the business concern. Capital may be raised with the help of various sources. If
the company maintains proper and adequate level of capital, it will earn high profit and they
can provide more dividends to its shareholders.
Capital structure refers to the kinds of securities and the proportionate amounts that make up
capitalization. It is the mix of different sources of long-term sources such as equity shares,
preference shares, debentures, long-term loans and retained earnings.
The term capital structure refers to the relationship between the various long-term sources
financing such as equity capital, preference share capital and debt capital. Deciding the suitable
capital structure is the important decision of the financial management because it is closely
related to the value of the firms
Capital structure is the permanent financing of the company represented primarily by long-term
debt and equity.
Definition of Capital Structure in different perspectives
The following definitions clearly initiate the meaning and objective of the capital structures.
 According to the definition of Gerestenbeg, “Capital Structure of a company refers
to the composition or make up of its capitalization and it includes all long-term capital
resources”.
 According to the definition of James C. Van Horne, “The mix of a firm’s
permanent long-term financing represented by debt, preferred stock, and common
stock equity”.
 According to the definition of Presana Chandra, “The composition of a firm’s
financing consists of equity, preference, and debt”.
 According to the definition of R.H. Wessel, “The long term sources of fund employed
in a business enterprise”.
Example
From the following information, calculate capital structure.
Balance Sheet
Liabilities Assets
Equity share capital 50,000 Fixed assets 25,000
Preference share capital 5,000 Good will 10,000
Debentures 6,000 Stock 15,000
Retained earnings 4,000 Bills receivable 5,000
Bills payable 2,000 Debtors 5,000
Creditors 3,000 Cash and bank 10,000
70,000 70,000

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Calculation of Capital Structures

S. No. Sources Amount Proportion

1. Equity share capital 50,000 76.92
2. Preference share capital 5,000 7.69
3. Debentures 6,000 9.23
4. Retained earnings 4,000 6.16
65,000 100%

4.6.1 Objectives of Capital Structure

Decision of capital structure aims at the following two important objectives:
1. Maximize the value of the firm.
2. Minimize the overall cost of capital.
4.6.2 Capital Structure Theories
Capital structure is the major part of the firm’s financial decision which affects the value of
the firm and it leads to change EBIT and market value of the shares. There is a relationship
among the capital structure, cost of capital and value of the firm. The aim of effective capital
structure is to maximize the value of the firm and to reduce the cost of capital.
There are two major theories explaining the relationship between capital structure, cost
of capital and value of the firm.
1. Traditional Approach
It is the mix of Net Income approach and Net Operating Income approach. Hence, it is also
called as intermediate approach. According to the traditional approach, mix of debt and equity
capital can increase the value of the firm by reducing overall cost of capital up to certain
level of debt. Traditional approach states that the decreases only within the responsible limit
of financial leverage and when reaching the minimum level, it starts increasing with
financial leverage.
Assumptions
Capital structure theories are based on certain assumption to analysis in a single and
convenient manner:
 There are only two sources of funds used by a firm; debt and shares.
 The firm pays 100% of its earning as dividend.
 The total assets are given and do not change.
 The total finance remains constant.
 The operating profits (EBIT) are not expected to grow.
 The business risk remains constant.
 The firm has a perpetual life.
 The investors behave rationally.
2. Modern approach
A. Net Income (NI) Approach

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Net income approach suggested by the Durand, According to this approach, the capital
structure decision is relevant to the valuation of the firm. In other words, a change in the capital
structure leads to a corresponding change in the overall cost of capital as well as the total value
of the firm.
According to this approach, use more debt finance to reduce the overall cost of capital and
increase the value of firm.
Net income approach is based on the following three important assumptions:
1. There are no corporate taxes.
2. The cost debt is less than the cost of equity.
3. The use of debt does not change the risk perception of the investor.
B. Net Operating Income (NOI) Approach
Another modern theory of capital structure suggested by Durand, This is just the opposite of
the Net Income approach. According to this approach, Capital Structure decision is irrelevant
to the valuation of the firm. The market value of the firm is not at all affected by the capital
structure changes.
According to this approach, the change in capital structure will not lead to any change in the
total value of the firm and market price of shares as well as the overall cost of capital.
C. Modigliani and Miller Approach
Modigliani and Miller approach states that the financing decision of a firm does not affect
the market value of a firm in a perfect capital market. In other words MM approach maintains
that the average cost of capital does not change with change in the debt weighted equity mix or
capital structures of the firm.
Modigliani and Miller approach is based on the following important assumptions:
• There is a perfect capital market. • The dividend payout ratio is 100%.
• There are no retained earnings. • The business consists of the same level
• There are no corporate taxes. of business risk.
• The investors act rationally.
4.6 FACTORS IN CAPITAL STRUCTURE DECISIONS
Firms generally should consider the following factors which influence capital structure decisions.
1. Sales stability: - A firm whose sales are relatively stable can safely take on more debt and
incur higher fixed charges than a company with unstable sales.
2. Asset structure: - Firms whose assets are suitable as security for loans tend to use rather
heavily. General purpose assets which can be used by many businesses make good collateral,
whereas special-purpose assets do not. Thus, real state companies are usually highly leveraged,
whereas companies involved in technological research employ less debt.
3. Operating leverage: - Other things the same, a firm with less operating leverage is better able
to employ financial leverage because, as we saw, the interaction of operating and financial
leverage determines the overall effect of a decline in sales on operating income and net cash
flow.
4. Growth rate: - Otherthings the same, faster-growing firms must rely more heavily on external
capital.
5. Profitability: - One often observes that firms with very high rates of return on investment use
relatively little debt. Although there is no theoretical justification for this fact, one practical
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explanation is that very profitable firms simply do not need to do much debt financing. Their
higher rates of return enable them to do most of their financing with retained earnings.
6. Taxes: - Interest is a deductible expense, and deductions are most valuable to firms with high
tax rates. Hence, the higher a firm’s corporate tax, the greater the advantage of debt.
7. Control: - The effect of debt versus stock on management’s control position can influence
capital structure. If management currently has voting control (over 50 percent of the stock), but
is not in a position to buy any more stock, it may choose debt for new financing. One the other
hand, management may decide to use equity if the firm’s financial situation is so weak that he
use of debt might subject it to serious risk of default because, if the firms gores into default, the
mangers will almost surely lose their jobs.
8. Management attitudes: - Since no one can provide that one capital structure will lead to
higher stock prices than another, management can exercise its own judgment about the proper
capital structure. Some management tend to be more conservative than others, and thus use less
debt than the average firm in their industry, whereas aggressive management use more debt in
the quest for higher profits.
9. Lender and rating agency attitude: - Regardless of mangers own analyses of this proper
leverage factors for their firms, lenders and rating agencies attitudes frequently influence
financial structure decisions. In the majority of the cases, the corporations discusses its capital
structure with lenders and rating agencies and gives much weight to their advice.
10. Market conditions: -Conditions
-Conditions in the stock and bond market undergo both long-and short-
run changes that can have an important bearing on a firm’s optimal capital structure.
11. The firm’s internal conditions: - A firm’s own internal condition can also have a bearing on
its target capital structure.
12. Financial flexibility: - maintaining financial flexibility, which from an operational view
point, means maintaining adequate reserve borrowing capacity. Determining an “adequate”
reserve borrowing capacity is judgmental, but it clearly depends on the factors mentioned
previously in the unit, including the firm forecasted need for funds, predicted capital market
conditions, management’s confidence in its forecasts, and the consequences on a capital
shortage.

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