CHAPTER FOUR

BOND AND STOCK VALUATION AND THE COST OF CAPITAL

Chapter objectives:
After studying this chapter, students should be able to:
1. Understand the concept of bond and stock
2. Compute the value of bond and stock
3. Understand the concept of cost of capital
4. Compute cost of capital
5. Understand the concept of capital structure
6. Understand the concept of leverage

4.1. Bond and stock valuation

4.1.1 .Valuation of bonds
Definition of bond and Bond Terminologies

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.

Bonds are “Fixed Income” securities, since the cash flows that the bondholder will receive have
been fixed or pre-specified in the bond contract.

In the case of a firm's insolvency, a bondholder has a priority of claim to the firm’s assets before
the preferred and common stockholders. Also, bond holders must paid interest due them before
dividends can be distributed to the stockholders.

- Par or Face Value: The amount of money that is paid to the bondholders at maturity. For
most bonds this amount is birr 1,000. It also generally represents the amount of money
borrowed by the bond issuer.
- Coupon Rate: The coupon rate, which is generally fixed, determines the periodic coupon
or interest payments. It is expressed as a percentage of the bond's face value. It also
represents the interest cost of the bond to the issuer.
- Coupon Payments: The coupon payments represent the periodic interest payments from
the bond issuer to the bondholder. The annual coupon payment is calculated by
multiplying the coupon rate by the bond's face value. Since most bonds pay interest
semiannually, generally one half of the annual coupon is paid to the bondholders every
six months.
- Maturity Date: The maturity date represents the date on which the bond matures, i.e., the
date on which the face value is repaid. The last coupon payment is also paid on the
maturity date.
- Call provision- is a provision which gives the issuer the right to pay off the bonds under
specified terms prior to the stated maturity date.

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 - Call Date: For bonds which are callable, i.e., bonds which can be redeemed by the issuer
prior to maturity, the call date represents the earliest date at which the bond can be called.
- Call Price: The amount of money the issuer has to pay to call a callable bond (there is a
premium for calling the bond early). When a bond first becomes callable, i.e., on the call
date, the call price is often set to equal the face value plus one year's interest.
- Required Return: The rate of return that investors currently require on a bond.
- Yield to Maturity: The rate of return earned on a bond if it is held to maturity.
Alternatively, it represents the discount rate which equates the discounted value of a
bond's future cash flows to its current market price.

Types of bond
Investors have many choices when investing in bonds, but bonds are classified into four main
types: Treasury, corporate, municipal, and foreign. Each type differs with respect to expected
return and degree of risk.

i. Treasury bonds, sometimes referred to as government bonds, are issued by the federal
government.1 It is reasonable to assume that the federal government will make good on
its promised payments, so these bonds have no default risk. However, Treasury bond
prices decline when interest rates rise, so they are not free of all risks.

ii. Corporate bonds, as the name implies, are issued by corporations. Unlike Treasury bonds,
corporate bonds are exposed to default risk—if the issuing company gets into trouble, it
may be unable to make the promised interest and principal payments. Different corporate
bonds have different levels of default risk, depending on the issuing company’s
characteristics and on the terms of the specific bond.

iii. Municipal bonds, or “munis,” are issued by state and local governments. Like corporate
bonds, munis have default risk. However, munis offer one major advantage over all other
bonds: As we discussed in Chapter 2, the interest earned on most municipal bonds is
exempt from federal taxes and also from state taxes if the holder is a resident of the
issuing state. Consequently, municipal bonds carry interest rates that are considerably
lower than those on corporate bonds with the same default risk.

iv. Foreign bonds are issued by foreign governments or foreign corporations. Foreign
corporate bonds are, of course, exposed to default risk, and so are some foreign
government bonds. An additional risk exists if the bonds are denominated in a currency
other than that of the investor’s home currency. For example, if you purchase corporate
bonds denominated in Japanese yen, you will lose money—even if the company does not
default on its bonds—if the Japanese yen falls relative to the birr.

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Other features:
Several other types of bonds are used sufficiently often to warrant mention.
First, convertible bonds are bonds that are convertible into shares of common stock, at a fixed
price, at the option of the bondholder. Convertibles have a lower coupon rate than nonconvertible
debt, but they offer investors a chance for capital gains in exchange for the lower coupon rate.
Bonds issued with warrants are similar to convertibles. Warrants are options that permit the
holder to buy stock for a stated price, thereby providing a capital gain if the price of the stock
rises. Bonds that are issued with warrants, like convertibles, carry lower coupon rates than
straight bonds.
Another type of bond is an income bond, which pays interest only if the interest is earned. Thus,
these securities cannot bankrupt a company, but from an investor’s standpoint they are riskier
than “regular” bonds.

Yet another bond is the indexed, or purchasing power, bond, which first became popular in
Brazil, Israel, and a few other countries plagued by high inflation rates. The interest rate paid on
these bonds is based on an inflation index such as the consumer price index, so the interest paid
rises automatically when the inflation rate rises, thus protecting the bondholders against inflation.

Definitions of value
 Book value is the value of an asset shown on a firm's balance sheet which is determined by
its historical cost rather than its current worth.
 Liquidation value is the amount that could be realized if an asset is sold individually and not
as part of a going concern.
 Market value is the observed value of an asset in the marketplace where buyers and sellers
negotiate an acceptable price for the asset.
 Intrinsic value is the value based upon the expected cash flows from the investment, the
riskiness of the asset, and the investor's required rate of return. It is the value in the eyes of
the investor and is the same as the present value of expected future cash flows to be received
from the investment.

Valuation: An overview
- Value is a function of three elements:
1. The amount and timing of the asset's expected cash flow
2. The riskiness of these cash flows
3. The investors' required rate of return for undertaking the investment.
Expected cash flows are used in measuring the returns from an investment.
Bond Valuation
The value of a bond is simply the present value of the future interest payments and maturity was
value discounted at the bondholder’s required rate of return.
A. Valuation of bond with finite maturity

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 1. Non-zero coupon bonds: if the bond has a finite maturity with coupon rate we must
consider the interest stream and the maturity value in valuing the bonds.
VB= I I I MV
(1+Kd) + (1+Kd) +---+ (1+Kd) 1+Kd) n
1 2 n+(

= I (1- 1 ) MV
n
(1+Kd) + (1+Kd) n
or VB = INT(PVIFAkd,n) + M(PVIFkd,n)
Where: VB= bond value
kd= the bond’s market rate of interest
mv= the par, or maturity, value of the bond
I= interest paid each year
N =the number of years before the bond matures
Example: Xyz Company wants to purchase bond with birr 1,000 par value with 10% coupon for
9 years maturity. The required rate of the bond is 12%. What is the value of the bond?

Answer: VB = I (1- 1 ) MV
n
(1+Kd) + (1+Kd) n
= 100(1- 1 ) 1,000
9
(1+0.12) + (1+0.12) 9
= 532.82+360.61
= Birr 893.43

2. Zero- coupon bond: Make no periodic interest payment but, interest sold at a deep
discount from its face value.
VB = MV
(1+Kd) n
Example: Xyz Corporation issues zero coupon bond having 10 year maturity with birr 1,000 face
value. What is the value of the bond, if the required rate of return is 12%?
Answer: VB = MV
(1+Kd) n
= 1,000
(1+0.12)10
= Birr 321.99
B. Valuation of bond with Infinite maturity
Perpetuity Bond: It is an ordinary annuity by which payments or receipts continue
forever.
VB = I
Kd
Example: suppose you could buy a bond issued by government that paid birr 50 a year to recover
your preferred rate of return 12%. What is the value of the bond?

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Answer: VB = I
Kd
= 50
0.12
= Birr 416.67
Bond Value: Three Important Relationships
First relationship
A decrease in interest rates (required rates of return) will cause the value of a bond to increase;
an interest rate increase will cause an increase in value. The change in value caused by changing
interest rates is called interest rate risk.
Second Relationship
1. If the bondholder's required rate of return (current interest rate) equals the coupon interest rate,
the bond will sell at par, or maturity value.
2. If the current required rate exceeds the bond's coupon rate, the bond will sell below par value
or at a "discount."
3. If the current required rate is less than the bond's coupon rate, the bond will sell above par
value or at a "premium."
Third relationship
A bondholder owning a long-term bond is exposed to greater interest rate risk than when owning
short-term bonds.

Since the bond's coupon rate, Kc, is fixed for the life of bond, the following \YTM/bond price
relationship is created:

 If YTM > Kc the bond sells at discount below par value.

 If YTM < Kc the bond sells at premium above par value.
 If YTM = Kc the bond sells at par value.

Example: Xyz Corporation is proposing to sell a 5 years bond of birr 1,000 at 10% of coupon
rate per annum. How much is the value of the bond to an investor whose required rate of return is
1- 10%
2- 2- 12%
3- 3- 8%
Answer:
1. Birr 1000
2. Birr 927.91
3. Birr 1079.85
4.1.2. Valuation of stocks
A. Preferred Stock Valuation
Preferred stock represents some degree of ownership in a company but usually doesn't come with
the same voting rights. (This may vary depending on the company.) With preferred shares,
investors are usually guaranteed a fixed dividend forever. This is different than common stock,

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which has variable dividends that are never guaranteed. Another advantage is that in the event of
liquidation, preferred shareholders are paid off before the common shareholder (but still after
debt holders). Preferred stock may also be callable, meaning that the company has the option to
purchase the shares from shareholders at anytime for any reason (usually for a premium).

Some people consider preferred stock to be more like debt than equity. A good way to think of
these kinds of shares is to see them as being in between bonds and common shares. The intrinsic
value of a share of preferred stock is the sum of the present value of dividend payments
discounted at the investor’s required rate of return. If the payments last forever, the value is
found as follows:
Vp = Annual Dividends = DP
Required rate of return Kp
Where:
D=Annual Dividends
Kp= required rate of return
Vp=value of preferred stock
Example: Assume XYZ Corporation pays annual dividend of Br. 50 per each share of its
preferred stock sold. Compute the value a share of preferred stock to an investor who has a
required rate of return of 10%.
Given= D= 50 Rp= 10%
Required: Vp
Solution:
Vp= D/Rp
= 50/0.10= Birr 500
B. Common Stock Valuation
Common stock is, well, common. When people talk about stocks they are usually referring to
this type. In fact, the majority of stock is issued in this form. Common shares represent
ownership in a company and a claim (dividends) on a portion of profits. Investors get one vote
per share to elect the board members, who oversee the major decisions made by management.

Over the long term, common stock, by means of capital growth, yields higher returns than almost
every other investment. This higher return comes at a cost since common stocks entail the most
risk. If a company goes bankrupt and liquidates, the common shareholders will not receive
money until the creditors, bondholders and preferred shareholders are paid.

The value of a share of common stock is equal to the present value of all future dividends it is
expected to provide over an infinite time horizon. It is assumed that dividends will grow at a
constant rate g, (i.e. growth which is expected to continue into the foreseeable future at about the
same rate as that of the economy as a whole; g = a constant), that is less than the required rate of
return, (the minimum rate of return), on a common stock that stockholders consider acceptable.
The assumption Rc > g is necessary mathematical condition for driving the model.
The Gordon Growth Formula, also known as The Constant Growth Formula assumes that a

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company grows at a constant rate forever. This, by the way, is impossible. I mean, it can't grow
forever. You know, if a company doubles in size every 5 years, pretty soon every single person
in the world is their customer and then they can't grow at that rate anymore. (Because the world
population isn't doubling every 5 years)
But, if we go ahead and assume that a company has a constant growth rate, we can use the
following formula to get its value.
Constant Growth Formula Vc = D 1 / ( Rc - g )
Vc = Price i.e. value of the common stock.
D1 = the next dividend. D1 = D0 (1 + g)
Rc = Rate of Return
g = Growth Rate
What is all this D1 and D0 stuff?
D1 is the next dividend
D0 is the last dividend
Well we are assuming that the company has constant growth, right. So we take the last dividend,
multiply it by the growth rate and we can get the next dividend.
Example
Last year’s dividend = birr 1.00
Growth Rate = 5%
Rate of Return = 10%
First figure out D1
D1 = D0 (1 + g)
D1 = 1.00 (1 + .05)
D1 = 1.00 (1.05)
D1 = 1.05
Next use the formula
Vc = D 1 / (Rc - g)
Vc = 1.05 / (10% - 5%)
Vc = 1.05 / 5%
Vc = Birr 21.00
So, if we want to get a 10% rate of return on our money, and we assume that the company will
grow forever at 5% per year, then we would be willing to pay birr21.00 for this stock. That is the
theory anyways.
4.2. Cost of capital
4.2.1. The concept of cost of capital
It is the required rate of return on the various types of financing instruments. Cost of capital is
defined as the minimum rate of return that a firm must earn on its assets in order to satisfy its
investors. We can say that the cost of capital is the rate of return at which the market value of the
firm will remain unchanged.

4.2.3. Specific components of cost of capital

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 A). Cost of Debt.
B). Cost of Preferred Stock.
C). Cost of Common Stock.
D). Cost of Retained Earnings.
A. 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 expenses are deducted from the selling price to give the amount 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 computer 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.
Example 1:A corporation sold a Br. 20 million bond that mature in 25 years at par value. Each
bond has a Br.1,000 par value 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, I = 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.

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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 3: 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%.
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.

Cost of debt is the after tax cost of long-term funds through borrowing. Debt may be issued at
par, at premium or at discount and also it may be perpetual or redeemable.
Debt Issued at Par
Debt issued at par means, debt is issued at the face value of the debt. It may be calculated with
the help of the following formula.
Kd = (1 – t) R
Where,
Kd = Cost of debt capital
t = Tax rate
R = Debenture interest rate
Debt Issued at Premium or Discount
If the debt is issued at premium or discount, the cost of debt is calculated with the help of the

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following formula.
Kd = I x (1 – t)
Np

Where,
Kd = Cost of debt capital
I = Annual interest payable
Np = Net proceeds of debenture
t = Tax rate
Exercise 5
(a) A Ltd. issues Rs. 1,000,000, 8% debentures at par. The tax rate applicable to the company is
50%. Compute the cost of debt capital.
(b) B Ltd. issues Rs. 100,000, 8% debentures at a premium of 10%. The tax rate applicable to the
company is 60%. Compute the cost of debt capital.
(c) A Ltd. issues Rs. 100,000, 8% debentures at a discount of 5%. The tax rate is 60%, compute
the cost of debt capital.
(d) B Ltd. issues Rs. 1,000,000, 9% debentures at a premium of 10%. The costs of floatation are
2%. The tax rate applicable is 50%. Compute the cost of debt-capital.
In all cases, we have computed the after-tax cost of debt as the firm saves on account of tax by
using debt as a source of finance.
Solution
(a) Kd = I (1–t)
Np
= 8,000 × (1 – 0.5)
100,000
= 4%
(b) Np = Face Value + Premium = 100,000+10,000=110,000
= 8,000 × (1 – 0.6)
110,000
= 2.91%
(c) Kd = 8,000 × (1 – t)
95,000
= 3.37%
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(d) Np= Rs. (1,000,000 + 100,000) × 2
100

= 90,000 × (1 – 0.5)
1,078,000
= 4.17% = 1,100,000 – 22,000 = Rs. 1,078,000
B. 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;
dividendpershare Dp
Kp = =
netproceed( 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
Dp Br .50
Thus, Kp = = = 10.2%
NP Br .490
 It implies that the firm must earn 10.2% on preferred stock investment to satisfy the preferred
stock holders’ interest.
C. Cost of Common Stock
Cost of common stock is a minimum rate of return that the corporation must earn for its common

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stockholders 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 two important techniques to estimate the cost of common stock.
a. The Dividend–Growth Model
I. 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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II. 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
b. 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
Rf = Risk free rate
Rm = market return
βj = beta of firm’s share

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- 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%
D. Cost of Retained Earnings
Retained Earnings (RE) represents profit available to common stockholders that the corporation
chooses to reinvest. The cost of RE is 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
4.2.2 Capital structure
4.2.1.1 Capital structures and financial structure;
The term capital structures differ from financial structure. Financial structure refers to the way of firms
assets are financed. In other words, it includes both, long –term as well as short – term source of
funds.
Capital structure is the permanent financing structure of the company represented primarily by long –
term bonds and stockholders’ funds but excluding all short term credit. Thus a company’s capital
structures only a part of its financial structure.
Pattern of capital structure:
In case of a new company the capital structure may be of any of the following three patterns
 Capital structure with common stock only.
 Capital structure with both common stocks and preference stocks
 Capital structure with common stock and long term bonds
 Capital structure with common stock , preference stocks and bonds

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Factors determining capital structure
The capital structure of the company is to be determined initially at the time the company is floated.
Great caution is required at this stage, since the initial capital structure will have long term
implication. Of course, it is not possible to have an ideal capital structure but the management should
set a target capital structure and the initial capital structure should be framed and subsequent changes
in capital structure should be done keeping in view the target capital structure. Thus, the capital
structure decision is a continuous one and has to be taken whenever a firm needs additional finances.
Following are the factor which should be kept in view while determining the capital structure of the
company.
 Trading on equity: a company may raise funds either by issue of stocks or by bonds. Bonds
carry a fixed rate of interest and this interest has to be paid irrespective of profits. Of course
preference stocks are also entitled to a fixed rate of dividend of the company. In case the rate
of return on the total capital employed (ROI) is more than the rate of interest on bonds or rate
of dividend on preference stocks. It is said that the company is trading on equity. Thus the
company can pay a higher rate of dividend than the general rate of earning on the total capital
employed.
 Retained control: the capital structure of a company is also affected by the extent to which the
promoters / existing management of the company is desired to maintain control over the affairs
of the company. The preference stockholders and bondholders have not much say in the
management of the company. It is necessary, therefore, of the promoter to own majority of the
equity share capital in order to exercising effective control over the affair of the company. The
promoter or the existing management is not interested in losing their grip over the affair of the
company and at the same time, they need extra funds. Therefore, they will prefer preference
stocks or bond over common stock so long they help them in retaining control over the
company.
 Nature enterprise: the nature of enterprise also to a great extent affects the capital structure of
the company. Business enterprise which have stability in their earning or which enjoy
monopoly regarding their product may go for bonds or preference stocks since they will have
adopted profits to meet the recurring cost of interest /fixed dividend. This is true in case of
public utility concerns. On the other hand, company’s which do not have this advantage should
rely on equity share capital to a great extent for raising their funds. This is, particularly, true in
case of manufacturing enterprise.
 Legal requirements: the promoters of the company have also to keep in view the legal
requirements which deciding about the capital structure of the company.
 Purpose of financing: the purpose of financing also to some extent affects the capital structure
of the company. In case funds are required for some directly productive purpose, for example
purchase of new machinery, the company can afford to raise the funds by issue of bonds. This
is because the company will have the capacity to pay the interest on bonds out of the profits so
earned. On the other hand, if the funds are required for non productive purpose, providing
more welfare facilities to the employees such as construction of school and hospital building
for company’s employees, the company should raise the funds by issue of common stocks.
 Period of finance: the period for which finance is required also affects the determination of
capital structure of the company. In case funds are require, says for 8 to 10 years, it will be
appropriate to raise them by issuing bonds , even if such funds are raised by issuing of

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 redeemable preference stocks. However, if the funds are required more or less permanently, it
will be appropriate to raise them by issue of equity stock/ common stocks.
 Requirements of inventory: different type of securities are to be issued for different classes if
inventories. Common stocks are best suited for bold or venturesome investors. Bonds are
suited for investors who are very cautions while preference stocks are suitable for investors
who are not cautions. In order to collecting funds from different categories of invests, it will be
appropriate for the company’s to issue different categories of securities. This is particularly
true when a company needs heavy funds.
 Size of company :company’s which are of small size have to really considerable upon the
owners funds for financing such company’s find it difficult to obtain long term debt. Large
companies are generally considered to be less risky by the investor and therefore, they can
issue different types of securities and collect their funds from different sources. They are in a
better bargaining position and can get funds from the sources of their choice.
 Provision for the future: while planning capital structure the provision for future should also
be kept in view. It would always be safe to keep the best security to be issue in the last instead
of issuing all these all these of securities in one installment. In the words of Gerestenberg,’’
manager of corporate financing operations must always think of rainy days or the emergencies.
The general rule is to keep your best security or some of your best security till the last’’
Thus, there are many factors which are to be considered while designing an appropriate capital
structure of a company.

Optimum capital structure

A firm should try maintaining an Optimum capital structure with a view to maintain financial stability.
The Optimum capital structure is obtained when the market value per equity share is the maximum. It
may, therefore, be defined as the relationship of debt and equity securities maximize the value of a
company share in the stock exchange. In case a company borrows and this borrowing helps in
increasing the value of the company’s share in the stock exchange, it can be said that the borrowing
has helped the company in moving toward its Optimum capital structure. In case the borrowing results
in fall the market value of the company’s equity share, it can be said that the borrowing has moved the
company away from its optimal capital structure. At optimal capital structure the average cost of
capital is minimum.
Features of an optimum/ appreciate capital structure
A capital structure will be considered to be appreciate if it possesses following features
 Profitability: the capital structure of the company should be most of profitable. The most
profitable capital structure is one that tends to minimize cost of financing and maximize earning
equity per share.
 Solvency: the pattern of capital structures should be so devised as to ensure that the firm does
not run the risk of becoming insolvent. Excess use of debt threatens the solvency of the
company. The debt content should not therefore, be such that it is increase risk beyond
manageable limits.
 Flexibility: the capital structure should be such that it can be easily maneuvered. To meet the
requirement of changing condition. Moreover it should also be possible for the company to
provide a fund whenever needed to finance is profitable activities.
 Conservatism: the capital structure should be conservative in the sense that the debt content in
the total structure does not exceed the limit which the company can bear. In other words, it
should be such as is commensurate with the company’s ability to generate future cash flow.

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  Control: the capital structure be so devised that it involves minimum risk of loss of control of the
company.
Capital Structure Theory
All firms need operating capital to support their sales. To acquire that operating capital, funds must be
raised, usually as a combination of equity and debt. The mixture of debt and equity that a firm uses is
called its capital structure. Although a firm’s actual levels of debt and equity may vary somewhat
overtime, most seek to keep their financing mix close to a target capital structure. The capital structure
decisions include a firm’s choice of a target capital structure, the average maturity of its debt, and the
specific source of financing it chooses at any particular time it raises new funding. Similar to operating
decisions, managers should make capital structure decisions designed to maximize the firm’s value.

The capital structure of a given business organization should be at the composition of debt and equity
at which weighed average cost of capital is minimized and the value of the firm is maximized. This
composition of debt and equity is said to be optimal capital structure and this debt-equity composition
should be a target capital structure for an organization. Firms should first analyze a number of factors,
and then establish a target capital structure. This target may change over time as conditions change,
but at any given moment, management should have a specific capital structure in mind. If the actual
debt ratio is below the target level, expansion capital should generally be raised by issuing debt,
whereas if the debt ratio is above the target, equity should generally be issued.
Capital structure policy involves a trade-off between risk and return:
 Using more debt raises the risk borne by stockholders.
 However, using more debt generally leads to a higher expected rate of return on equity.
Higher risk tends to lower a stock’s price, but a higher expected rate of return raises it. Therefore, the
optimal capital structure must strike a balance between risk and return so as to maximize the firm’s
stock price.
Four primary factors influence capital structure decisions.
1. Business risk or the riskiness inherent in the firm’s operations if it used no debt. The greater the
firm’s business risk, the lower its optimal debt ratio.
2. The firm’s tax position. A major reason for using debt is that interest is deductible, which
lowers the effective cost of debt. However, if most of a firm’s income is already sheltered from
taxes by depreciation tax shields, by interest on currently outstanding debt, or by tax loss carry-
forwards, its tax rate will be low, so additional debt will not be as advantageous as it would be
to a firm with a higher effective tax rate.

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 3. Financial flexibility or the ability to raise capital on reasonable terms under adverse conditions.
Corporate treasurers know that a steady supply of capital is necessary for stable operations,
which is vital for long-run success. They also know that when money is tight in the economy,
or when a firm is experiencing operating difficulties, suppliers of capital prefer to provide
funds to companies with strong balance sheets.
4. Managerial conservatism or aggressiveness. Some managers are more aggressive than others;
hence some firms are more inclined to use debt in an effort to boost profits. This factor does
not affect the true optimal or value-maximizing capital structure, but it does influence the
manager determined target capital structure.
Traditional theory
As per traditional theory percentage change in dividend (D) is greater than percentage change in cost
of stock (Ks) as we increase debt financing. In fact this trend has its own limit; this trend is true until
we reach at some specified debt level which is termed as optimal capital structure. Until we reach at
this level debt financing has positive impact on the value of the firm. On the other hand, percentage
change in dividend (D) is less than percentage change in cost of stock (Ks) after certain financial
leverage level (the optimal capital structure). This change (i.e. D< Ks) is a result of trait of bankruptcy
as debt goes beyond the optimal point; from this point on debt financing has a negative impact on the
firm’s value.
Modigliani and Miller: Proposition I and II; No Taxes
Modern capital structure theory began in 1958, when Professors Franco Modigliani and Merton Miller
(M & M) published what has been called the most influential finance article ever written. M & M’s
study was based on some strong assumptions, which included the following:
1. There are no brokerage costs.
2. There are no taxes.
3. There are no bankruptcy costs.
4. Investors can borrow at the same rate as corporations.
5. All investors have the same information as management about the firm’s future investment
opportunities.
6. EBIT is not affected by the use of debt.
Modigliani and Miller imagined two hypothetical portfolios. The first contains all the equity of an
unlevered firm, so the portfolio’s value is VU, the value of an unlevered firm.
Because the firm has no growth (which means it does not need to invest in any new net assets) and
because it pays no taxes, the firm can pay out all of its EBIT in the form of dividends. Therefore, the
cash flow from owning this first portfolio is equal to EBIT.

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Now consider a second firm that is identical to the unlevered firm except that it is partially financed
with debt. The second portfolio contains all of the levered firm’s stock (SL) and debt (D), so the
portfolio’s value is VL, the total value of the levered firm. If the interest rate is kd, then the levered
firm pays out interest in the amount kdD.
Because the firm is not growing and pays no taxes, it can pay out dividends in the amount EBIT −
kdD. If you owned all of the firm’s debt and equity, your cash flow would be equal to the sum of the
interest and dividends: kdD + (EBIT −kdD) = EBIT
Therefore, the cash flow from owning this second portfolio is equal to EBIT. Notice that the cash flow
of each portfolio is equal to EBIT. Thus, M & M concluded that two portfolios producing the same
cash flows must have the same value.
VL = VU = SL + D (
Modigliani and Miller proposition I & II: the Effect of Corporate Taxes
In 1963, M & M published a follow-up paper in which they relaxed the assumption that there are no
corporate taxes. The Tax Code allows corporations to deduct interest payments as an expense, but
dividend payments to stockholders are not deductible.
The differential treatment encourages corporations to use debt in their capital structures. This means
that interest payments reduce the taxes paid by a corporation, and if a corporation pays less to the
government then more of its cash flow is available for its investors. In other words, the tax
deductibility of the interest payments shields the firm’s pre-tax income. As in their earlier paper, M &
M introduced a second important way of looking at the effect of capital structure: The value of a
levered firm is the value of an otherwise identical unlevered firm plus the value of any “side effects.”
While others have expanded on this idea by considering other side effects, M & M focused on the tax
shield:
VL = VU + Value of side effects = VU + PV of tax shield (15-6)
Under their assumptions, they showed that the present value of the tax shield is equal to the corporate
tax rate, T, multiplied by the amount of debt, D:
VL = VU + TD (15-7)
With a tax rate of about 40%, this implies that every birr of debt adds about 40 cents of value to the
firm, and this leads to the conclusion that the optimal capital structure is virtually 100% debt. M &M
also showed that the cost of equity, rs, increases as leverage increases but that it doesn’t increase quite
as fast as it would if there were no taxes. As a result, under M & M with corporate taxes the WACC
falls as debt is added.

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 4.2.3 Leverages
Meaning of leverage
The dictionary meaning of the term leverage refers to an increase means of accomplishing some
purpose. For example leverage helps us in lifting heavy object, which may not be otherwise possible.
However in the area of finance, the term leverage has a special meaning. It used to describe the firm’s
ability to use fixed cost asset or funds to magnify the return to its owners.

Jams horns has defined leverage as ‘the employment of an asset or funds for which the firm pays a
fixed cost of fixed return’. Thus, according to him, leverage results as a result of the firm employing
an asset or source of funds which has a fixed cost (or return). The former may be termed as’’ fixed
operating cost ‘, while the later may be termed ‘fixed financial cost’. It should be noted that fixed cost
or return is the fulcrum of leverage. If a firm is not required to pay fixed cost of fixed return, there will
be no leverage.

Since fixed cost or return has to be paid or incurred irrespective of the volume of output or sales, the
size of such cost of return has considerable influence over the amount of profits available for
shareholders. When the volume of sales changes; leverage helps in quantifying such influence. It may,
therefore, be defined as relative change in profit due to change in sales. A high degree of leverage
implies that there will be a large profit due to relatively small change in sales and vice versa. Thus,
higher is the leverage, higher is the risk and higher is the expected return.

Types of leverage
There are three types of leverage
a. Operating leverage
b. Financial leverage
c. Composite leverage / combined leverage.
A. operating leverage
The operating leverage may be defined as the tendency of the operating profit to vary of
disproportionately with sales. It is said to exist when a firm has to pay a fixed cost regardless of
volume of output or sales. The firm is said to have a high degree of Operating leverage if it employees
a greater amount of fixed cost and a small amount of variable cost. On the other hand, a firm will have
low operating leverage when it employees a greater amount of variable cost and a small amount of
fixed costs. Thus the degree of operating leverage depends upon the amount of fixed elements in the
cost structure.
It measures operating risk; the chance of incurring loss and the variability in returns because of change
in production and sales.

Formula: the operating leverage can be calculated by the following formula.

Contribution
Operating leverage = -----------------------
EBIT
Notes
1. contribution =net sales - variable costs
Contribution = fixed cost + EBIT
2. EBIT =Net sales – variable cost –fixed cost
EBIT= Contribution - fixed cost
3. EBIT can also be called as operating profit

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 4. EBIT means earnings before interest and tax
5. Higher operating leverage = higher the risk
Lower operating leverage = Lower the risk
6. Operating may be favorable or unfavorable.
If contribution exceed the fixed cost ----- favorable
If contribution not exceed the fixed cost -----unfavorable
Degree of operating leverage (DOL)
It is the Percentage change in EBIT resulting from a percentage change in the sales. This is calculated
using the following formula.

% change in operating income (EBIT) = % change in sale x degree of operating leverage (DOL)

% changes in EBIT
DOL = ------------------------------------------
% changes in sales
Notes
Changes in EBIT
1. %changes in EBIT = --------------------------------
Base EBIT

Changes in sales
2. % changes in sales = ----------------------------
Bases sales

B. Financial leverage
The financial leverage may be defined as the tendency of the residual net income to vary
disproportionately with operating profit. It indicates the change that takes place in the taxable income
as result of change in the operating income. It signifies the existence of fixed interest / fixed dividend
bearing securities such as bonds and preferred stock along with the common equity in the total capital
structure of the company, is described as financial leverage where in the capital structure of the
company, the fixed interest/dividend bearing securities are greater as compared to the equity capital
the leverage is said to be larger. In a reverse case the leverage will be said to be smaller.

Financial leverage is also sometimes termed as ‘’trading on equity’’. However, most of the author on
financial management is of the opinion that the term trading on equity should be used for the term
financial leverage only when financial leverage is favorable. The company resorts to trading on equity
with the objective of giving the equity shareholders a high rate of return than the general rate of
earning on capital employed in the company, to compensate them for the risk that they have to bear.

Case A-: if no preferred stock dividend:

EBIT
Financial leverage = -------------------------
EBT
EBIT=earnings before interest and tax
EBT= earnings before tax

Case B-: if preferred stock dividend is due:

EBIT
Financial leverage = -------------------------
EBIT –I-Pd/ (1-t))

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EBIT = earnings before interest and tax
I= fixed interest on bonds
Pd=fixed preference dividend on preferred stock s
T=shareholder tax rate
 Financial leverage may be favorable or unfavorable
 If earnings exceed than the fixed interest /dividend- favorable
 If earnings not exceed than the fixed interest /dividend- unfavorable

Degree of financial leverage

Degree of financial leverage is defined as the percentage change in the EBT (taxable income)/ NI
resulting from a percentage change in EBIT. This is calculated using the following formula.

%change in taxable income (EBT) = % change in operating income (EBIT) X degree

of financial leverage

Degree of financial leverage(DFL) = %change in EBT

-------------------
%change in EBIT
Note
1. %change in EBT = change in EBT
-------------------
base EBT
2. %change in EBIT= change in EBIT
-------------------
base EBIT

C. Composite leverage / combined leverage

Operating leverage measures percentage change in operating profit (EBIT) due to percentage change
in sales. It explains the degree of operating risk. Financial leverage measure the percentage change in
taxable income (EBT) on account of percentage change in operating profit (EBIT). Thus, it explains
the degree of financial risk. Both these leverage are closely concerned with the firm’s capacity to meet
its fixed costs (both financial and operating.) In case both leverages are combined, the result obtained
will disclose the effect of change in sales over change in taxable income (EBT).
Composite leverage thus, expresses the relationship between revenue on account of sales (i.e.
contribution) and taxable income (EBT). It helps in finding out the resulting percentage change in
taxable income on account of percentage change in sales. This can be computed as follows.

Composite leverage(CL)= operating leverage x financial leverage

CL= OL x FL
Combined leverage (CL) = contribution X EBIT
EBIT EBT
Therefore ,

Combined leverage (CL) = contribution

EBT
Degree of Composite leverage (DCL):
Degree Composite leverage(DCL) is defined as the percentage change in the EPS resulting
from a percentage change in sales. This is calculated using the following formula.

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 DCL=DOL x DFL
or
Degree of Composite leverage = %change in EBIT x % changes in EPS
%change in sales % changes in EBIT
Therefore ,

Degree of Composite leverage = %change in EPS

%change in Sales
Higher the operating leverage = higher the risk
Lower the operating leverage = lower the risk

Degree of leverage: - when the relationship between the change in one amount and the corresponding
change in another amount is ‘’quantified’’; it is degree of leverage.
There are two types of income statements:
A) Traditional or functional income statement Accounting based – expenses are classified by
functional area.
B) Contribution or variable costing income statement/ Economic based - cost or expenses are
classified according to cost behaviors as fixed and variable.
Thus the contribution income statement is useful for leverage analysis.

Contribution Income statement

Sales (net) ------------------------------------- xxxx
Less: variable cost ----------------------------------- (xxx) DCL
Contribution ----------------------------------- xxx
Less: Fixed cost -------------------------------------- (xxx) DOL
EBIT (operating profit) ----------------------- xxx
Less: interest on bonds ------------------------------- (xx) DFL
EBT---------------------------------------------- xxx
Less: taxes (50%) ------------------------------------- (xx)
EAT-------------------------------------------- xxx
Less: preference stock dividend--------------------- (xx)
Earnings available to common stock holder -- xxx

Earning available common stock holder

Earnings per share = -----------------------------------------------
No. of outstanding common stocks
Example:
Examine the following table. The table shows expenses classified into the useful grouping of (1)
operation expense and (2) financial expense, such that interest is treated as a financial expense rather
than operating expense.

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 Table 5.1
Financial data for company x
Starting Point (Baseline) 2% Increase Over Starting Point
Sales @ 20 per unit birr1, 100,000 birr1, 122,000
Less: Variable cost (60% of sales) (660,000) (673,000)
Contribution margin 440,000 448,000
Less: Fixed operating costs (400,000) (400,000)
Operating Income (EBIT) 40,000 48,800
Less: Interest cost (30,000) (30,000)
Taxable Income (EBT) 10,000 18,800
Less: Taxes (30%) (3,000) (5,640)
Net income birr7,000 birr13,160
No. of c/s outstanding 5,000 5,000
EPS birr1.4 birr2.63

Required: compute the degree of leverage for

a) operating leverage
b) financial leverage
c) combined leverage
By the give percentage change over starting point

Solution
a) operating leverage

DOL = % changes in EBIT

% changes in sales

% changes in EBIT = Change in EBIT

Base EBIT
= 48,800 – 40,000 = 0.22 = 22%
40,000
% changes in sales = Change in sales
Base sale
= 1,122,000 – 1,100,000 = 0.02 = 2%
1,100,000

Therefore DOL = 0.22/0.02 = 11

From the above analysis if sales increased by 2% the operating income increases by 22%

Proof = 40,000 x 22% + 40, 000 = 48, 800

Or alternatively

DOL = Base Contribution margin

Base EBIT

= 440, 0000 = 11
40,000

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 b) financial leverage

Degree of financial leverage (DFL) = %change in EBT

%change in EBIT
%change in EBT = Change in EBT
Base EBT
%change in EBT = 18,800 – 10,000 = 0.88 = 88%
10,000
%change in EBIT = Change in EBIT
Base EBIT
= 48,800 – 40,000 = 0.22 = 22%
40,000
Therefore DFL = 0.88/0.22 = 4
Or alternatively;
DFL = Base Operating income (EBIT)
Base Taxable income (EBT)
= 40,000 = 4
10,000
%change in EBT = %change in EBIT X DFL
= 22% X 4 = 88%
From the above analysis if operating income increased by 22% (from birr 40,000 to birr
48,800, then taxable income increased by 88%; (i.e. birr10,000 to birr18,800).

Proof = birr 10,000 X 88% + birr10,000 = birr18,800

c) Combined leverage
DCL = %change in EBT
% changes in sale
%change in EBT = Change in EBT
Base EBT
%change in EBT = 18,800 – 10,000 = 0.88 = 88%
10,000
% changes in sales = Change in sales
Base sale
= 1,122,000 – 1,100,000 = 0.02 = 2%
1,100,000
Therefore, DCL
= 0.88/0.02 = 44
Or
DCL = DOL X DFL
= 11 X 4 =44
OR
Degree of Composite leverage = %change in EPS
%change in Sales
%change in EPS = Change in EPS
Base EPS
2.63 -1.4 = 0.878 = 88%
1.4

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 % changes in sales = Change in sales
Base sale
= 1,122,000 – 1,100,000 = 0.02 = 2%
1,100,000
Therefore DCL =0.88/0.02 = 44

Therefore if sales increased by 2% (i.e. from birr 1,100,000 to birr 1,122, 000; then taxable
income increases by 88% (i.e.; from 410,000 to birr 18,800)
4.2.4. The overall cost of capital
Weighted Average Cost of Capital (WACC)
Every company has a capital structure - a general understanding of what percentage of debt comes
from retained earnings, common stocks, preferred stocks, and bonds.

The weighted average cost of capital (WACC)

 It measures a firm’s overall cost of capital.
 Capital structure is the mixture of capital used to finance firm’s assets.
 Percentage of each type of capital source:
o Long-term debt.
o Preferred stock.
o Common stock.
WACC is the mean of all component costs of capital, weighted according to the percentage of each
component in the firm’s optimal capital structure

By taking a weighted average, we can see how much interest the company has to pay for every birr it
borrows. This is the weighted average cost of capital.
Capital Component Cost Times % of capital structure Total
Retained Earnings 10% X 25% 2.50%
Common Stocks 11% X 10% 1.10%
Preferred Stocks 9% X 15% 1.35%
Bonds 6% X 50% 3.00%
TOTAL 7.95%
So the WACC of this company is 7.95%.

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