Chapter-4

Bond ands stock valuation

A bond or debenture, akin to a promissory note, is an instrument of debt issued by a
business/governmental unit. In order to under stand the valuation of bonds we need familiarity
with certain bond-related terms.

PAR VALUE- this is the value stated on the face of bond. It represents the amount the firm
borrows and promises to repay at the time of maturity.

COUPON RATE & INTERESR- A bond carries a specific interest rate which is called the
coupon rate. The interest payable to the holder is simply: par value of the bond *coupon rate.

MATURITY PERIOD- Typically corporate bonds have a maturity period of 7-10years,where as

government bonds have maturity periods extending up to 20-25 years. At the time of maturity the
par value plus perhaps a nominal premium is payable to the holder.

BASIC BOND VALUATION MODEL:-Generally the holder of bonds receives a fixed annual
interest payment for a certain number of years and a fixed principal payment at the time of
maturity. Hence, the value of bond is

n I F
+
V= ∑ ( 1+ K d ) ( 1+ K d )n ¿
t
t =1
¿

V= I (PVIFAkd, n) + F (PVIFkd, n)

V= value of bond

I= annual interest payable on the bond

F= principal amount of the bond (par value) repayable at the time of maturity.

n= maturity period of bond

Example1:- A $100 par value bond, bearing a coupon rate of 12% will mature after 8 years. The
required rate of return on this bond is 14%. What is the value of this bond?

The value of bond will be

V= $12(PVIFA14%, 8years) + $100(PVIF14%, 8years)

= 12(4.639) + 100(0.351) = $90.77

Example2:- A $1000 par value bond, bearing a coupon rate of 14%, will mature after 5 years.
The required rate of return on this bond is 13%. What is the value of this bond?

The annual interest payment will be $140 for 5 years and the principal repayment will be $1,000
at the end of 5 years, the value of bond will be
 V= $140(PVIFA13%, 5years) + $1,000(PVIF13%, 5years)

= 140(3.517) + 1,000(0.543) = $1,035.4

YIELD TO MATURITY

F−P
I+
n
YTM =
0.4 F+ 0.6 P

YTM = yield to maturity

I= annual interest payment

F= par value of bond

P= present price of bond

n= years to maturity

Example1:-The price per bond of Zion Limited is $90. The bond has a par value of $100, a
coupon rate of 14%, and a maturity period of 6 years. What is the yield to maturity?

14 + (100-90)/6
YTM = _____________ = 16.67%
0.4 *100 + 0.6*90
Example2:- Suppose the market price of a $1,000 par value of bond, carrying a coupon rate of
9% and maturing after 8 years is $800. What rate of return would an investor earn if he buys this
bond and holds it till its maturity?

90 + (1000-800)/8
YTM = ________________
0.4*1000 + 0.6 *800

90 + (200/8)
= ___________ = 13.068%
400 + 480
BOND VALUES WITH SEMI-ANNUAL INTEREST

Most of the bonds pay interest semi-annually. To value such bonds, we have to work with
a unit period of 6months, and not 1year. The following is the equation

2n I /2 F
+
V= ∑ ( 1+ K d /2 ) ( 1+ K d /2 )2 n ¿
t
t =1
¿

V= I/2(PVIFAkd/2,2n) + F (PVIFkd/2,2n)
V= value of the bonds

I/2 = semi- annual interest payment

Kd/2 = discount rate applicable to a half-year period

F= par value of the bond repayable at maturity

2n= maturity period expressed in terms of half-yearly periods

Example:-

A $100 par value bond carries a coupon rate of 12% and a maturity period of 8 years. Interest is
payable semi-annually. Compute the value of the bond if the required rate of return is 14%.

EQUITY VALUATION: DIVIDEND CAPITALISATION APPROACH

According to the dividend capitalization approach, conceptually a very sound approach,

the value of an equity share is equal to the present value of dividends expected from its
ownership plus the present value of the sale price expected when the equity share is sold. For
applying this approach to equity stock valuation, we will make the following assumptions:

(i) Dividends are paid annually (ii) the 1st dividend is received 1year after the equity
share is bought.

Single period valuation

Where an investor expects to hold the equity share for one year. The price of equity share will be

D1 P1
Po = -------------- +-------------
(1+Ks) (1+Ks)
Po= current price of equity share

D1 = dividend expected a year hence

P1= price of the share expected a year hence

Ks = rate of return required on the equity share

Example: - Prestige’s equity share is expected to provide a dividend of $2 and fetch a price of
$18 a year hence. What price would it sell for now if investors’ required rate of return is 12%?

The current price will be

2 18
Po= ------ + -------- = 17.86
(1+.12) (1+.12)
If price of share expected to grow at a rate of “g” percent annually, then

D1
Po= --------------
Ks-g
Example:-The expected dividend per share on the equity stock of Road king Limited is $2. The
dividend per share of Road king Limited over the past 5 years at the rate of 5% per year. This
growth rate will continue in future. Further, the market price of the equity share of Road king
Limited too is expected to grow at the same rate. What is the fair estimate of the intrinsic value
of the equity share of Road king if the required rate is15%?

Po= 2/0.15—0.05=$20

Expected rate of return

D1
Ks= +g
Po

Example:- The expected dividend per share of Vaibhav Limited is $5. The dividend is expected
to grow at the rate of 6% per year. If the price per share now is $50, what is the expected rate of
return?

Ks= 5/50+0.06 = 16%

Multi period valuation model

1. Valuation with constant dividends:- We assume dividend per share remains

constant year after year
D
P=
Ks
2. Valuation with constant growth in dividends: - Most stock valuation models based on
assumption that dividends tends to increase over time. This is a reasonable hypothesis
because business firms typically grow over a time. If we assume that dividends grow at a
constant compound rate, we will get
Dt = Do (1+g) t,
Where Dt= dividend for year t, Do= dividend for year o,
g= constant compound growth rate.
When the dividend increases at a constant compound rate, the share valuation equation
becomes.

D1
Po =
Ks−g

Example:- Ramesh engineering Limited is expected to grow at the rate of 6% per annum. The
dividend expected on Ramesh’s equity share a year hence is $2. What price will you put on it if
your required rate of return for this is 14%?

The price of equity share will be

2
Po = -------------- = $25
0.14---0.06
COST OF CAPITAL, CAPITAL STRUCTURE

MEANING AND SIGNIFICANCE OF COST OF CAPITAL:

The cost of capital of a firm is the minimum rate of return expected by its investors. It is the
weighted average cost of various sources of finance used by a firm. The capital used by a firm
may be in the form of debt, preference capital, retained earnings and equity shares. A decision to
invest in a particular project depends upon the cost of capital of the firm or the cut off rate which
is the minimum rate of return expected by the investors.

In case a firm is not able to achieve even the cut off rate, the market value of its shares will fall.
In fact, cost of capital is the minimum rate of return expected by its investors which will
maintain the market value of shares at its present level. Hence, to achieve the objective of wealth
maximization, a firm must earn a rate of return more than its cost of capital. The cost of capital
of a firm has a direct relation with the risk involved in the firm. Generally, higher the risk
involved in a firm, higher is the cost of capital.

Cost of capital for a firm may be defined as the cost of obtaining funds, i.e. the average rate of
return that the investors in a firm would expect for supplying funds to the firm.

THREE BASIC ASPECTS OF THE CONCEPT OF COST OF CAPITAL:

1. Cost of capital is not a cost as such. If fact, it is the rate of return that a firm requires to
earn from its projects.
2. It is the minimum rate of return. Cost of capital of a firm is that minimum rate of return
which will at least maintain the market value of the shares.
3. It comprises of three components. As there is always some business and financial risk in
investing funds in a firm, cost of capital comprises of three components:
(a) The expected normal rate of return at zero risk level, say the rate of interest allowed by
banks;
(b) The premium for business risk; and
(c) The premium for financial risk on account of pattern of capital structure.

SIGNIFICANCE OF THE COST OF CAPITAL:

It plays a crucial role in:

 Capital budgeting decisions

 Decisions relating to planning of capital structure.
 Used as a basis for evaluating the performance of a firm
 Helps management in taking so many other financial decisions (such as dividend
policy, capitalization of profits, making the rights issue and working capital.)

CLASSIFICATION OF COST:
 1. Historical Cost and Future Cost: Historical costs are book cost which is related to the
past. Future costs are estimated cost for the future. In financial decisions future costs are
more relevant than the historical cost.
2. Specific Cost and Composite Cost: Specific cost refers to the cost of a specific source of
capital while composite cost is combined cost of various source of capital. It is the
weighted average cost of capital. In case more than one form of capital is used in the
business, it is the composite cost which should b considered for decision-making and not
the specific cost. But where only one type of capital is employed the specific cost of that
type of capital may be considered.
In capital structure decisions, it is the weighted average cost of capital which should be
given consideration.
3. Explicit Cost and Implicit Cost: An explicit cost is the discount rate which equates the
present value of cash inflows with the present value of cash outflows. In other words, it is
the internal rate of return.
Implicit cost also known as the opportunity cost is the cost of the opportunity foregone in
order to take up a particular project. For e.g. the implicit cost of retained earnings is the
rate of return available to shareholders by investing the funds elsewhere.
4. Average Cost and Marginal Cost: An average cost refers to the combined cost of various
sources of capital. It is the weighted average cost of the costs of various sources of
finance.
Marginal cost of capital refers to the average cost of capital which has to be incurred to
obtain additional funds required by a firm. In investment decisions, it is the marginal cost
which should be taken into consideration.

MEASURING THE 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. Debt
2. Preferred stock
3. Common stock
4. Retained earnings
Two important points you should bear in mind about the specific cost of capital. One is that it is
computed on an after-tax basis. Meaning, if there would be any tax implication on the individual
source of capital, it should be considered. In almost all circumstances, the tax implication is only
on debt sources of finance. The second point is that the specific cost of capital is expressed as an
annual percentage or rate like 6%, 9%, or 10%. The cost of capital is not stated in terms of birrs.
The cost of debt
This is the minimum rate of return required by suppliers of debt. The relevant specific cost of
debt is the after-tax cost of new debt. Generally, debt is the cheapest source of finance to a firm
and, hence, the cost of debt is the lowest specific cost of capital. There are two basic
explanations for this. First, debt suppliers, generally, assume the lowest risk among all suppliers
of capital. They receive interest payments before preferred and common dividends are paid.
Since they assume the smallest risk, their return is the lowest. Their lowest return would be the
lowest cost of capital to the firm. Second, raising capital through debt sources entails interest
expense. The interest expense in turn reduces the firm’s income which ultimately would cause
tax payment to be reduced. So raising money in the form of debt results in the smallest tax
burden, and finally, the firm’s cost of debt would be the lowest.

Debt sources of finance may take several forms like bonds, promissory notes, bank loans. Here,
for our convenience we consider bond issue to illustrate the cost of debt.

Computing the cost of new bond issue involves three step: s

i) Determine the net proceeds from the sale of each bond
NPd = Pd – f
Where:
NPd = the net proceeds from the sale of each bond
Pd = the market price of the bond
f = Flotation costs
ii) Compute the effective before tax cost of the bond using the following approximation formula:
Pn − NPd
I+
n
Pn+NPd
Kd = 2
Where:
Kd = The effective before tax cost of debt
I = Annual interest payment
Pn = the par value of the bond
n = Length of the holding period of the bond in years.

iii) Compute the after-tax cost of debt

Kdt = Kd (1 – t)
Where:
Kdt = the after-tax cost of debt
t = the marginal tax rate
Example: Currently, Abyssinia Industrial Group is planning to sell 15-year, Br. 1,000 par-value
bonds that carry a 12% annual coupon interest rate. As a result of lower current interest rates,
Abyssinia bonds can be sold for Br. 1,010 each. Flotation costs of Br. 30 per bond will be
incurred in the process of issuing the bonds. The firm’s marginal tax rate is 40%.

Required: Calculate the after tax cost of Abyssinia’s new bond issue:
Solution:
Given: Pn = Br. 1,000; I = Br. 120 (Br. 1,000 x 12%); n = 15; Pd = Br. 1,010; f = Br. 30;
t = 40%; Kdt =?
Then apply the three steps:
i) NPd = Br. 1,010 – Br. 30 = Br. 980
Br . 1 ,000−Br . 980
Br. 120 +
15
= 12 .26 %
Br . 1 ,000+Br . 980
ii) Kd = 2
iii) Kdt = 12.26% (1 – 40%) = 7.36%
Therefore, the after – tax cost of Abyssinia’s new bond issue is 7.36%. That is, Abyssinia should
be able to earn a minimum of 7.36% to satisfy bondholders. Otherwise, the firm’s value will
decline.
The cost of preferred stock

The cost of preferred stock is the minimum rate of return a firm must earn in order to satisfy the
required rate of return of the firm’s preferred stock investors. It is also the minimum rate of
return a firm’s preferred stock investors require if they are to purchase the firm’s preferred stock.

When a firm raises capital by issuing new preferred stock, it is expected to pay fixed amount of
dividends to the preferred stockholders. So it is the dividend payment that is the cost of the
preferred stock to the firm stated as an annual rate.

The cost of a new preferred stock issue can be computed by following two steps:

i) Determine the net proceeds from the sale of each preferred stock.
NPpf = Ppf – f
Where:
NPpf = Net proceeds from the sale of each preferred stock
Ppf = Market price of the preferred stock
 f = Flotation costs
ii) Compute the cost of preferred stock issue
Kps = Dps__
NPpf
Where:
Kps = the cost of preferred stock
DPs = the pre share annual dividend on the preferred stock
Example: Sefa Computer Systems Company has just issued preferred stock. The stock has 12%
annual dividend and Br. 100 par value and was sold at 102% of the par value. In addition,
flotation costs of Br. 2.50 per share must be paid. Calculate the cost of the preferred stock.
Solution:
Given: Pps = Br. 102 (Br. 100 x 102%); Dps = Br. 12 (Br 100 x 12%); f = Br. 2.50;
Kps =?
Then apply the two steps:

i) NPpf = Br. 102 – Br. 2.50 = Br. 99.50

ii) Kps = Br. 12 =12.06%
=12.06%
Br. 99.50
Therefore, Sefa Company should be able to earn a minimum of 12.06% on any investment
financed by the new preferred stock issue. Otherwise, the firm’s value will decrease.
The cost of common stock

The cost of common stock is the minimum rate of return that a firm must earn for its common
stockholders in order to maintain the value of the firm. A firm does not make explicit
commitment to pay dividends to common stockholders. However, when common stockholders
invest their money in a corporation, they expect returns in the form of dividends. Therefore,
common stocks implicitly involve a return in terms of the dividends expected by investors and
hence, they carry cost.

Generally, common stock dividends are paid after interest and preferred dividends are paid. As a
result, common stock investors assume the maximum risk in corporate investment. They
compensate the maximum risk by requiring the highest return. This highest return expected by
common stockholders make common stock the most expensive source of capital.

The cost of common stock can be computed using the constant growth valuation model.
Ks = D1 + g
 NPo
Where:
Ks = the cost of new common stock issue
D1 = the expected dividend payment at the end of next year
NPo = Net proceeds from the sale of each common stock
g = the expected annual dividends growth rate
The net proceeds from the sale of each common stock (NPo) is computed as follows:
NPo = Po – f
Where:
Po = the current market price of the common stock
f = flotation costs
Example: An issue of common stock is sold to investors for Br. 20 per share. The issuing
corporation incurs a selling expense of Br. 1 per share. The current dividend is Br. 1.50 per share
and it is expected to grow at 6% annual rate. Compute the specific cost of this common stock
issue.
Solution
Given: Po = Br. 20; Do = Br. 1.50; g = 6%; f = Br. 1; Ks =?
Then apply the two steps:
i) NPo = Br. 20 – Br. 1 = Br. 19
ii) Ks = D1 + g = Br. 1.50 (1.06) = 14.37%
Npo Br. 19
Therefore, the firm should be able to earn a minimum return of 14.37% on investments that are
financed by the new common stock issue.

The cost of Retained Earnings

Retained earnings represent profits available for common stockholders that the corporation
chooses to reinvest in itself rather than payout as dividends. Retained earnings are not securities
like stocks and bonds and hence do not have market price that can be used to compute costs of
capital.

The cost of retained earnings is the rate of return a corporation’s common stockholders expect
the corporation to earn on their reinvested earnings, at least equal to the rate earned on the
outstanding common stock. Therefore, the specific cost of capital of retained earnings is equated
with the specific cost of common stock. However, flotation costs are not involved in the case of
retained earnings.
Computing the cost of retained earnings involves just a single procedure of applying the
following formula:
Kr = D1 + g
Po
Where:
Kr = the cost of retained earnings
D1 = the expected dividends payment at the end of next year
Po = the current market price of the firm’s common stock
g = the expected annual dividend growth rate.
Example: Zeila Auto Spare Parts Manufacturing Company expects to pay a common stock
dividend of Br. 2.50 per share during the next 12 months. The firm’s current common stock price
is Br. 50 per share and the expected dividend growth rate is 7%. A flotation cost of Br. 3 is
involved to sale a share of common stock.
Required: Compute the cost of retained earnings
Solution
Given: Po = Br. 50; D1 = Br. 2.50; g = 7%; Kr =?
Then apply the formula:
Kr = D1 + g = Br. 2.50 + 7% = 12%
Po Br. 50
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
In the previous section we have seen how to compute the cost of capital for each individual
source of capital. The specific cost of capital is used in evaluating an investment proposal to be
financed by a particular capital source. Practically, however, investment are financed by two or
more sources of capital. In such a situation, we cannot make use of the individual cost of capital.
Rather we should use the average cost of capital employed by the firm.

The firm’s capital structure is composed of debt, preferred stock, common stock, and retained
earnings. Each capital source accounts to some portion of the total finance. But the percentage
contribution of one source is usually different from another. So we must compute the weighted
average cost of capital rather than the simple average.

The weighted average cost of capital (WACC) is the weighted average of the individual costs of
debt, preferred stock and common equity (common stock and retained earnings). It is also
called the composite cost of capital.
If the weights of the component capital sources are all given, the weighted average cost of capital
can be computed as:
WACC = WdKdt + WpsKps + WceKs
Where:
WACC = the weighted average cost of capital
Wd = The weight of debt
Wps = the weight of preferred stock
Wce = the weight of common equity
Kdt = the after – tax cost of debt
Kps = the cost of preferred stock
Ks = the cost of common equity

The WACC is found by weighting the cost of each specific type of capital by its proportion in
the firm’s capital structure. Weights of the individual capital sources can be calculated based on
their book value or market value.

To illustrate the computation of the WACC, look at the following example.

Muna Tools Manufacturing Company’s financial manager wants to compute the firm’s weighted
average cost of capital. The book and market values of the amounts as well as specific after tax
costs are shown in the following table for each source of capital.

Source of capital Book value Market value Specific cost

Debt Br. 1,050,000 Br. 1,000,000 5.3%
Preferred stock 84,000 125,000 12.0
Common equity 966,000 1,375,000 16.0
Total Br. 2,100,000 Br. 2,500,000

Required: Calculate the firm’s weighted average cost of capital using:

1) book value weights
2) market value weights
Solution:
1) Total book value = Br. 2,100,000
Wd = Br. 1,050,000 = 0.5; Wps = Br. 84,000__ = 0.04; Wce = Br. 966,000 = 0.46
Br. 2,100,000 Br. 2,100,000 Br. 2,100,000
WACC = WdKdt + WpsKps + WceKs
= 0.5 (5.3%) + 0.04 (12.0%) + 0.46 (16.0%)
 = 2.65% + 0.48% + 7.36%
= 10.49%
The minimum rate of return on all projects should be 10.49%. Meaning, Muna should accept all
projects so long as they earn a return greater than or equal to 10.49%

2) Total Market value = Br. 2,500,000

Wd = Br. 1,000,000 = 0.4; Wps = Br. 125,000 = 0.05; Wce = Br. 1,375,000 = 0.55
Br. 2,500,000 Br. 2,500,000 Br. 2,500,000
WACC = 0.4 (5.3%) + 0.05 (12.0%) + 0.55 (16.0%)
= 2.12% + 0.60% + 8.80%
= 11.52%

If the market value weights are used, Muna should accept all projects with a minimum rate of
return of 11.52%
MARGINAL COST OF CAPITAL (MCC)
As a firm tries to have more new capital, the cost of each birr will rise at some point. Thus, the
marginal cost of capital (MCC) is the cost of obtaining additional new capital. Technically
speaking, the MCC is the weighted average cost of the last birr of new capital obtained. So the
concept of marginal cost of capital is discussed in the context of the weighted average cost of
capital.

As a firm raises larger and larger amounts of capital, the weighted average cost of capital also
rises. But the question would be at what point the firm’s costs of debt, preferred stock, and
common equity as well as WACC increase?

The first point, therefore, in computing the MCC is to determine the breaking points where the
cost of capital will increase.
The technical aspects of the MCC can be better understood using an example.

Example: The target capital structure of Shala Corporation and other pertinent data are given
below.
Long-term debt ------------------ 40%; cost of preferred stock (Kps) = 12.06%
Preferred stock -------------------10% cost of retained earnings (Kr) = 14%
Common equity ----------------- 50% cost of common stock (Ks) = 15%
Shala Corporation has Br. 900, 000 available retained earnings. But when the firm fully utilizes
its retained earnings, it must use the more expensive new common stock financing to meet its
equity needs. In addition, the firm expects that it can borrow up to Br. 1,200,000 of debt at 7.3%
after-tax cost. Additional debt will have an after-tax cost of 9.1%.
Required
1) What is the breaking point associated with the
a. Exhausting of retained earnings?
b. Increment of debt between Br. 0 to Br. 1,200,000?
2) Determine the ranges of total new financing where the WACC will rise
3) Calculate the WACC for each range of finance.
Solutions
1) a. Breaking point (BP) common equity = Br. 900,000 = Br. 1,800,000
50%
b. Breaking point (BP) long-term debt = Br. 1,200,000 = Br. 3,000,000
40%
The breaking points computed above can be interpreted as:
Shala can meet its equity needs using retained earnings until its total financed is Br. 1,800,000.
But when total capital required is more than Br. 1,800,000, its equity needs should be met with
common stock. Similarly, until the firm’s total finance need reaches Br. 3,000,000, shala can
raise any debt at 7.3% cost. Any further finance need beyond Br. 3,000,000 will cause the cost of
debt to rise to 9.1%.
2) There are three ranges of finance that could be identified on the basis of the breaking points:
1st Range : Br. 0 to Br. 1,800,000,
2nd Range : Br. 1,800,000 to Br. 3,000,000, and
3rd Range : Br. 3,000,000 and above
3) WACC (1st range) = 0.40 (7.3%) + 0.10 (12.06%) + 0.50 (14%)
= 2.92% + 1.21% + 7.00%
= 11.13%
WACC (2nd range) = 0.40 (7.3%) + 0.10 (12.06%) + 0.50 (15%)
= 2.92% + 1.21% + 7.50%
= 11.63%
WACC (3rd range) = 0.40 (9.1%) + 0.10 (12.06%) + 0.50 (15%)
= 3.64% + 1.21% + 7.50%
= 12.35%
Ex; 1 Ayenew Company’s financing plans for next year include the sale of long -term bonds
with a 10% coupon. The company believes it can sell the bonds at a price that will provide a
yield to maturity of 12% to investors. If its marginal tax rate is 35%, what is Ayenew’s after - tax
cost of debt?
EX.2 Sattelite Share Company plans to sale preferred stock with par value of Br. 50 per share.
The issue is expected to pay quarterly dividends of Br. 1.25 per share and to have flotation costs
of 6% of the par value. The preferred stock sells at 95% of its par.
Required: Calculate the cost of preferred stock to Satellite Share Company.
Ex.3 Repentance Corporation’s share of common stock is currently selling at Br. 75. The firm’s
projected dividend per share during the next year is Br. 3.38 and the expected dividend growth
rate is 8%. Because of competitive nature of the market a Br. 3 per share underpricing is
necessary. In addition, the sale of new common stock involves underwriting fee of Br. 0.60 per
share and other flotation costs of Br. 0.90 per share.
Required: Calculate the cost of common stock for Repentance Corporation.
Ex.4 Zequala Textiles Share Company wishes to measure its cost of retained earnings. The
firm’s stock is currently selling for Br. 57.50. The firm expects to pay Br. 3.40 dividend at the
end of the year. The expected dividend growth rate is 8%.
Required: Determine the cost of retained earnings.
EX.5 on January 1, 2002, the total assets of Zway Share Company were Br. 54 million. There
was no short-term debt. The firm’s optimal capital structure is given below.
Long-term debt Br. 27,000,000
Common equity 27,000,000
Total liabilities and equity Br. 54,000,000

New bonds will have a 10% coupon rate and will be sold at Par. Common stock currently has a
market price of Br. 60 and can be sold with a flotation cost of Br. 6 per share. Dividend yield is
estimated to be 4% and the expected dividend growth rate is 8%
Required: Calculate:
1) the cost of debt assuming s 40% marginal corporate tax rate
2) the cost of common equity (50% common stock and 50% retained earnings)
3) the weighted average cost of capital
Solution:
I. Given: yield to maturity (YTM) = 12%; t = 35%; Kdt =?
Since no flotation cost is indicated here, the YTM of 1 2% to investors represents the effective
before –tax cost of debt for Ayenew company, i.e. Kd = 12%,
Therefore, Kdt = 12% (1 – 35%) = 7.80%
II. Given: Pps = Br. 50 x 95% = Br. 47.50; Dps = Br. 5 (4 x Br. 1.25); f = Br. 3 (Br. 50 x
6%); Kps
Kps = ?
Then, apply the two steps:
- NPps = Br. 47.50 – Br. 3 = Br. 44.50
- Kps = Br. 5 = 11.24%
Br. 44.50
III. Given: Po = Br. 75; D1 = Br. 3.38; g = 8%; f = Br. 4.50 (Br. 3 + Br. 0.60 + Br. 0.90);
Ks = ?
Then, apply the two steps:
- Npo = Br. 75 – Br. 4.50 = Br. 70.50
- Ks = D1+ G = Br. 3.38 + 8% = 13%
Npo Br. 70.50
IV. Given: Po = Br. 57.50; D1 = Br. 3.40; g = 8%; Kr =?
Then, apply the formula:
Kr = D1 + g = Br. 3.40 + 8% = 14%
Po Br. 57.50
V. 1. Since no flotation cost is involved here and the bonds are sold at par value, the effective
before tax cost of debt (Kd) = coupon rate = 10%.
Kdt = 10% (1 – 40%) = 6%
2. Given: Po = Br. 60; f = Br. 6; dividend yield (D1/po) = 4%; g = 8%
Cost of retained earnings (Kr) = D1 + g = 4% + 8% = 12%
Po
Cost of common stock (Ks) = D1 + g = Br. 2.40* + 8% = 12.44%
Npo Br. 60 – Br. 6
* D1= 4%  D1 = 4%  D1 = Br. 2.40
Po Br. 60
 THE THEORY OF CAPITAL STRUCTURE

The two principal sources of finance for a business firm are equity and debt. What should be the
proportion of equity and debt in the capital structure of a firm? How much financial leverage
should the firm employ?

The choice of capital structure is marketing problem. The objective of financial management is
to maximize the share holders wealth, the key issue in the capital structure decision is: what is
the relation ship between capital structure and firm value? Alternatively what is the relation ship
between capital structure and cost of capital? Remember that valuation and coat of capital are
inversely related. The value of firm is maximized when the cost of capital is minimized and vise
versa.

There are different views on how capital structure influence value. Some argue that there
is no relation ship what so ever between capital structure and firm value.

The theory of capital structure is closely related to the firm’s cost of capital. Capital structure is
the mix of the long-term sources of funds used by the firm. The primary objective of capital
structure decisions is to maximize the market value of the firm through an appropriate mix of
long term sources of funds. This mix, called the optimal capital structure, will minimize the
firm’s overall cost of capital. However, there are arguments about whether an optimal capital
structure actually exists.

Capitalization: The term capitalization refers to the total amount of long term funds, i.e. long-
term securities employed by them. Capital structure describes the kinds of securities and their
proportions in the total capitalization of the company.
According to A.S.Dewing defines”the term capitalization is the valuation of the capital which
includes the capital stock and debt.”

Capital structure:
Meaning: capital structure refers to the mix of its capitalization. A company can mobilize its
required capital by issuing different type of securities i.e., equity shares, preference, bonds and
debentures. In other words capital structure is the combination of various kinds of securities are
issued by the company is known as capital structure.
Definition: according to Gerestermberg” capital structure of accompany refers to the makeup of
its capitalization and it include all long term sources, Viz. Loans, reserves, shares and bonds”.
According to EF Brigham capital structure as” the percentage share of each type of capital used
by the firm –debt, preference share capital, equity and retained earnings”.

Financial structure and capital structure

The term financial structure represent the way in which the firm’s assets are financed. It means
the composition of the entire liabilities side of the balance sheet. It includes long term as well as
short term sources of funds.
Capital structure describes the relation ship b/n the various long term forms of financing such as
debenture, preference and equity share capital. It is the permanent financing of the company
represented by share holders funds and long term loans. Capital structure is a part of the financial
structure.
Forms/patterns of capital structure:
Capital structure consists, the following
i. Issuing equity shares only
ii. Issuing both equity shares and preference
iii. Issuing equity shares and debentures
iv. Issuing equity shares, preference, debentures

The arguments center on whether a firm can, in reality, affect its valuation and its cost of capital
by varying the mixture of the funds used. There are four different approaches/theories to the
theory of capital structure:
1. Net operating income (NOI) approach
2. Net income (NI) approach
3. Traditional approach
4. Modigliani–Miller (MM) approach

All four use the following simplifying assumptions:

1. No income taxes are included; they will be removed later.
2. The company makes a 100 percent dividend payout.
3. No transaction costs are incurred.
4. The company has constant earnings before interest and taxes (EBIT).
5. The company has a constant operating risk.

Net income approach;-

The NI approach has been suggested by Durand. Under this approach capital structure decision is
relevant to the valuation of the firm. A firm can minimize the weighted average cost of capital
and increase the market price of the equity shares by using the debit content in its capital
structure.

Assumptions:

a. The cost of debit is less than the cost of equity

b. There are no corporate taxes
c. The use of debt content does not change the risk perception of the investors as a result the
equity capitalization rate odf the company and the debt capitalization rate of the company
remains constant with changes in leverage.

Net operating Income approach (NOI):

This is just opposite of net income approach

According to this approach any changes in the capital structure of a company does not
effect the market value of the firm and the over all cost of capital remain constant irrespective of
the mode of financing. The implication of the above statement is that the over all cost of capital
remains the same whether the debt equity mix is 50:50 or 20:80 or 40:60 under this theory all the
structures are optimum capital structures.

Assumptions:

i. The debt capitalization rate is a constant.

ii. The market capitalizes the value of the firm as whole and therefore the split b/n debt
and equity is not important.
iii. Corporate taxes do not exist
iv. The use of the debt fund having low cost increases the risk of the equity share
holders, but it could result in increases the equity capitalization rate.

Modigliani-Miller approach (MM):

This approach explain the relationship b/n capital structures, cost of capital and value of the firm
under the following 2 respects.

1. When the absence of corporate taxes

2. When corporate taxes are assumed to exist.

A firm that finances its assets by equity and debt is called a levered firm.

A firm that issues no debt and finances its assets entirely by equity is called an unlevered firm.
Assumptions:

i. There are no corporate taxes

ii. There is a perfect market.
iii. 100% payment to shareholders i.e. all the earnings are distributed to the share holders.
iv. There are no transaction costs.
v. All the firms can be grouped in to homogeneous risk classes. Investors expected
earnings have identical risk characteristics.

Under NI approach value of the firm is

V=S+B or V=S+D

Where

V=total market value of the firm

S= market value of the equity share

B= market value of debt

D= market of debt

Market value of equity (s) can be computed as follows

¿
S = Net income /cost of equity or ke
Where NI= earnings available to equity share holders.

K= equity capitalization rate.

Value of Debt is as

B = interest/ cost of debt. Or ∫¿¿

Kd

Where B= value of debt

Value of the firm = value of equity + value of Debt-equity

Note: under NI approach normally Ke given in the problem. If K required you have to find out
with help of following formula.

K=EBIT/V

K= overall cost of capital

V= total value of the firm

Computation of NI

(amount available for equity share holders)

EBIT xxx

Less: interest xx

Profit before tax (PBT) xxxx

Less: tax xxx

Profit after tax (PAT) xxxx

Less: preference dividend

If any amount available for equity xxxx

Net operating income approach (NOI)

Value of the firm according to NOI approach

V= S + B

S=V–B

S= market value of equity shares

V= total market value of firm

B= market value of debt

K- Overall cost of capital

EBIT
V=
K

If we need Ke i.e., equity capitalization rate is

EBIT−I
Ke = ∗100
V −B

If K is not given in the problem, we have to find K with the following formula.

K=Kd [B/V] =Ke=[S/v]

K= overall cost of capital

Kd= cost of debt

B= total debt

V= total value of firm, Ke= equity capitalization rate

S= market value of equity.

Modiglani Miller approach (MM)

Value of the firm

EBIT ( 1−tax )
For unlevered firm V=
Ke

EBIT ( 1−T )
For levered firm V= + B (1−T )
Ke

B= market value of debt T=tax

Traditional approach:

Actually this approach posses certain features of NI approach and some features of NOI under
this aspect there is no separate formula for computing total value of the firm.

Computation of EPS

EBIT xxx

Less: interest xx

Profit before tax (PBT) xxxx

Less: tax xxx

Profit after tax (PAT) xxxx

Less: preference dividend xxxxx

if any amount available for equity xxxx

EPS = Profit available for equity share holders/no.of equity shares

Point of difference:

The term point of indifference refers to that earnings before interest and tax at which
earnings per share or return on share capital is equal for various combination of debt and equity.
Simply it is the point at which the rate of return on capital employed is equal to the rate of
interest on debt.

The point of indifference is computed with the help of following formula.

(X-I1)(I-T)-PD/S1=(X-I2) (I-T)-PD/S2

Where,

X= point of indifference of break even EBIT level

I1= interest under plan 1 or alternative 1

I2= interest under2 or alternative2

T=tax rate

PD= preference dividend

S1=number of equity shares (amount of equity share capital) under plan 1

S2= number of equity shares (amount of equity share capital) under plan 2
Exercises:

1. NCP company LTD has an all equity capital structure consisting of 20,000 equity shares of
$100 each. The management plans to rise $3000, 000 to finance a programme of expansion. The
alternatives of financing are under consideration.
i. issue of 30,00 new shares of $100 each
ii. Issue of 30,000, 8% debentures of 4100 each
iii. Issue of 30,000, 8% preference shares of 4100 each
The company’s expected earnings before interest and taxes (EBIT) are $1,000,000. Determine
the earnings per share in each alternative assuming a corporate tax rate of 50%. Which
alternative is best and why?
2. Ramu Ltd is expecting an annual EBIT of $100,000. The company has $400,000 in 10%
debentures. The equity capitalization rate is 12.5% .The Company proposes to issue additional
equity shares of $100,000 and use the proceeds for redemption of debentures of $100,000.

You are required to calculate the value of firm (V) and overall cost of capital (Ko)?

3. Honda Ltd has an equity capital 6,000 shares of $100 each. The company plans to rise
$400,000 for expansion and modernization. The following alternatives are under consideration.

a. issue of coomon stock

b. issue of common stock for$200,000 and 10% debt for 200,000

c. issue of 10% preference shares for $200,000 AND 10% debt for $200,000.

d. issue of 10% preference shares for $200,000 and 10% debt for 200,000.

The company’s existing earnings before interest and taxes are $400,000. The rate of corporate
tax is 50%. Determine the earnings per share in each plan?

4. Two firms X and Y are identical except in method of financing. Firm X has no debt while firm
Y has $200,000, 5% debentures in financing. Both the firms have a Net Operating income
(EBIT) of $50,000 and equity capitalization rate of 12.5%. The corporate tax rate is 50%.
Calculate the value of the firm using MM Approach.

5. Company Q and R are in the same risk class and identical except that Q uses debt while R uses
equity only. The leveled firm A has 10% debentures of $900,000.

Both the firms earn 20% on their total assets of $1500, 000. The corporate tax rate is 40% and
equity capitalization rate is 15% for all equity company.

i. Compute the value of companies Q and R using Net income Approach.

ii. Compute the value of the companies Q and R using net operating income approach
iii. Calculate the overall cost of capital (Ko) for companies Q and R
6. In considering the most desirable capital structure for a company, the following estimates the
cost of debt and equity capital (after tax) has been made at various levels of debt. Equity mix.

Debt as % of total capital employed cost of debt% cost of equity%

0 5.0 12.0
10 5.0 12.0
20 5.0 12.5
30 5.5 13.0
40 6.0 14.0
50 6.5 14.6
60 7.0 20.0
You are required to determine the optimal-equity mix for the company by calculating
composite cost of capital.

7. A new project under consideration by RNC Ltd requires a capital investment of $15,000,0000.
Interest on term loan is 12% and tax rate is 50%. The financial institutions insist on a debt-equity
ratio of 2:1.

Calculate the point of indifference for the project.