SUMMARY NOTES
BY
STEPHEN ODHIAMBO
CAPITAL STRUCTURE THEORIES
3.1 INTRODUCTION
A firm is typically financed by the owners and borrowings from outsiders. In finance terms we say
that a firm is financed using equity and debt capital. Both debt and equity come at a cost to the firm
and thus the firm must find the best combination that minimizes the cost. A firm can issue dozens
of distinct securities in countless combinations that maximizes its overall market value. It is
important to ask ourselves whether these attempts to affect its total valuation and its cost of capital
by changing its financial mix, are worthwhile. Several theories have been advanced to explain the
would be best combination which is subject to our discussion in this chapter.
Before considering these theories we revisit the concept of cost of capital that was learned in
business finance.
Lecture outline
3.1 Introduction
3.2 Cost of capital
3.3 Capital structure
3.3.1The net income approach (NI)
3.3.1.Net operating income (NOI) approach
3.3.3Traditional approach to capital structure
3.3.4The Modigliani-Miller (MM) Hypothesis
3.4 Financial & operational leverage
Learning outcomes
By the end of this lesson you should be able to;
i. Determine the cost of the individual components of capital
ii. Explain the concept of capital structure
iii. Advise a firm on the best combination of capital components under given conditions
3.2 COST OF CAPITAL
Usually the cost of debt is lower than the cost of equity. This is so because debt is a fixed
obligation while equity is not. However, firms cannot operate on debts alone since this will
1
, subsequently increase the risk of bankruptcy (that is the firm being unable to meet its fixed
obligations). This risk of bankruptcy is also associated with the stability of sales and earnings. A
firm with relatively unstable earnings will be reluctant to adopt a high degree of leverage since
conceivably it might be unable to meet its fixed obligations at all.
Note: Financial leverage is the change in the EPS induced by the use of fixed securities to finance a
company's operation.
3.2.1 Cost of Debt:
The cost of debt to a firm can be given by the following formulae:
Kd = Annual interest charges
Market value of outstanding debt
Where Kd is the yield of the company's debts. The market value of outstanding debt will therefore
be given by the following formulae.
Market value of debt = Annual interest charges
Kd
Kd is the before tax cost of debt. However, the effective cost of debt is the after tax cost because
interest on debt is tax deductible. The effective cost of debt (Kb) therefore is
Kb = Kd (I - T)
Where Kb is the effective (after tax) cost
T is the corporate tax rate
3.2.2 Cost of Preferred Stock
Preferred dividend is not tax deductible and therefore the tax adjustment is required when
considering the cost of preferred stock. The cost is therefore:
Kp = Dp
Pr
Where Dp is the annual preferred dividend
2
BY
STEPHEN ODHIAMBO
CAPITAL STRUCTURE THEORIES
3.1 INTRODUCTION
A firm is typically financed by the owners and borrowings from outsiders. In finance terms we say
that a firm is financed using equity and debt capital. Both debt and equity come at a cost to the firm
and thus the firm must find the best combination that minimizes the cost. A firm can issue dozens
of distinct securities in countless combinations that maximizes its overall market value. It is
important to ask ourselves whether these attempts to affect its total valuation and its cost of capital
by changing its financial mix, are worthwhile. Several theories have been advanced to explain the
would be best combination which is subject to our discussion in this chapter.
Before considering these theories we revisit the concept of cost of capital that was learned in
business finance.
Lecture outline
3.1 Introduction
3.2 Cost of capital
3.3 Capital structure
3.3.1The net income approach (NI)
3.3.1.Net operating income (NOI) approach
3.3.3Traditional approach to capital structure
3.3.4The Modigliani-Miller (MM) Hypothesis
3.4 Financial & operational leverage
Learning outcomes
By the end of this lesson you should be able to;
i. Determine the cost of the individual components of capital
ii. Explain the concept of capital structure
iii. Advise a firm on the best combination of capital components under given conditions
3.2 COST OF CAPITAL
Usually the cost of debt is lower than the cost of equity. This is so because debt is a fixed
obligation while equity is not. However, firms cannot operate on debts alone since this will
1
, subsequently increase the risk of bankruptcy (that is the firm being unable to meet its fixed
obligations). This risk of bankruptcy is also associated with the stability of sales and earnings. A
firm with relatively unstable earnings will be reluctant to adopt a high degree of leverage since
conceivably it might be unable to meet its fixed obligations at all.
Note: Financial leverage is the change in the EPS induced by the use of fixed securities to finance a
company's operation.
3.2.1 Cost of Debt:
The cost of debt to a firm can be given by the following formulae:
Kd = Annual interest charges
Market value of outstanding debt
Where Kd is the yield of the company's debts. The market value of outstanding debt will therefore
be given by the following formulae.
Market value of debt = Annual interest charges
Kd
Kd is the before tax cost of debt. However, the effective cost of debt is the after tax cost because
interest on debt is tax deductible. The effective cost of debt (Kb) therefore is
Kb = Kd (I - T)
Where Kb is the effective (after tax) cost
T is the corporate tax rate
3.2.2 Cost of Preferred Stock
Preferred dividend is not tax deductible and therefore the tax adjustment is required when
considering the cost of preferred stock. The cost is therefore:
Kp = Dp
Pr
Where Dp is the annual preferred dividend
2
