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What Is The Cost Of Capital Structure Finance Essay

Paper Type: Free Essay Subject: Finance
Wordcount: 5463 words Published: 1st Jan 2015

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The cost of capital is the cost of a company’s funds (both debt and equity), or, from an investors point of view “the expected return on a portfolio of all the company’s existing securities”. It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.

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In order to be a worthwhile investment, the expected return on equity is greater than the cost of capital. The capital cost of the return to capital is expected to earn in an alternative investment with similar risk. If a project similar to the average risk to the company’s business, it is reasonable to use the company’s average cost of capital underlying the ratings. The company’s securities are typically in the debt and equity, the expected, both because of the cost of debt and equity costs of determining the company’s capital.

The cost of debt is relatively simple to calculate, since the interest rate is paid. In practice, the interest rates paid by the company modeled as a risk-free rate plus a risk component (risk premium), which also includes the expected probability (and the amount of recovery given default). For companies with similar credit risk or the interest rate is largely exogenous (to be explained by the use of “external” in this context).

The cost of equity is more challenging to calculate as capital is not a fixed return to investors. Than the cost of the loan, the cost of equity, broadly defined as the estimated risk-adjusted returns that investors require, which yields a barely known. The cost of equity, therefore, conclude by comparing the investment and other investment (like) with similar risk profiles to determine the “market” cost of equity.

If the cost of debt and equity costs have been established, a combination of the weighted average cost of capital (WACC), calculated. The WACC is then used to estimate the discount rate for project cash flows.

In this paper I will explain, first, 1 chapter, the “capital” as well. From the second chapter, “Sources of Capital”, and finally, 3 chapter, “capital” will be explained.


Capital, the most basic conditions for the money. All companies need capital to purchase assets and maintain operations. Corporate capital is available in two main forms: debt and equity. Debt refers to loans and other loans to be repaid in the future, usually with interest. The capital, however, generally do not impose a direct obligation to repay the amount. Instead, investors have a rule in the form of ownership shares in the company.

The capital, wage describes the various means by which the capital of the people who save money for businesses that need money. Such transfers can be direct, which means that a company sells shares or bonds directly to investors, who own a business in return. Transfer of capital can also be made indirectly by investment bank or a financial intermediary such as a bank, broker or an insurance company. The indirect transfer through an investment bank, is selling the business assets of the bank, which in turn sells them to investors. In other words, the easy flow of capital investment bank. The indirect through a financial intermediary, however, a new form of capital, which is actually created. The intermediary bank or fund raise capital to invest and issue its own securities exchange. Then the broker uses the funds to buy stocks and bonds of companies.

1.1 Capital Structure

Because of the small business capital is expensive, it is particularly important for small business owners to define the structure of the target company’s capital. The share capital structure of debt and equity is achieved. Trade-offs are involved: increases the risk of liability to the company’s revenue, which tends to reduce the company’s stock. However, the debt lead to a higher expected return, which tends to increase a company’s share price. As Brigham stated, “The optimal capital structure is the one that strikes a balance between risk and return and thereby maximizes the price of shares and simultaneously reduce the cost of capital.”

Capital structure decision depends on several factors. One of the company’s business risks and risks related to operations, which the company participates. Companies in the hazardous industries, such as high technology, lower than the optimal level of debt than other firms. Another factor in the company’s capital structure involves tax situation. Since interest on debt is tax deductible, debt is usually better to use the company tax rate is high, and not many are able to protect income from taxation.

The third important factor is the company’s financial flexibility, or ability to raise capital in less than ideal conditions. The companies that are able to maintain a strong balance sheet resources generally can be more reasonable terms as other companies in the economic downturn. Brigham suggested that each company has a power reserve borrowing to defend themselves in the future. In general, tends to a stable level of sales, assets, collateral for loans to be good, and the high growth rate using a higher debt than other firms. On the other hand, the companies that have conservative management, high profitability, or poor credit ratings that they want to rely on equity instead.

1.2 The Modigliani and Miller Theorem

1.2.1 Definition

The Modigliani-Miller theorem states that if there are no taxes, bankruptcy costs and asymmetric information, the efficient market, the company’s value affects how it is financed with the equity shares or bonds, or a combination thereof, or what is the dividend policy. The kit is also known as capital structure is essentially irrelevant.

A number of principles underlying rate, which agrees with the adoption of the tax and no taxation. The two main principle is that, firstly, if there is no tax, thus increasing the benefits of power does not create value, and second, that if there are taxes, the benefits in the form of interest tax shield occurs when you leverage and / or elevated.

The price compares to the two companies – one unlevered (ie, funded entirely of their own capital) and the second levered (ie, partially financed by equity and partly debt) – and says that if the same value in all other ways the two companies are identical.

For example, why it must be true, it is assumed that an investor buys a company or a levered or unlevered company. The investor buys shares in the company’s levered or unlevered firm buys shares in a loan of an equivalent amount of money borrowed from the levered company. In both cases, the return on investment should be the same. Thus, the cost of the levered firm is the same as the unlevered firm minus the price of borrowed money, with the value of the levered company’s debt. There is an implicit assumption that the investor’s cost of borrowing money is the same as the levered company, which is not necessarily true in the presence of asymmetric information, or in the absence of efficient markets. A company that is risky debt, as debt-equity ratio increases, the weighted average cost of capital is constant, but there is a higher return on equity, due to a higher risk for shareholders in the company’s debt.

1.2.2 Advantages and Disadvantages of Modigliani and Miller’s Theorem

Advantages: In practice, this can be said that none of the assumptions are met in the real world, but we teach the lot, that capital structure is important because one or more assumptions will be violated. Using mail-equations, economists find the determinant of an optimal capital structure and see how these factors affect the optimal capital structure.

Disadvantages: Modigliani-Miller theorem, which justifies virtually unlimited economic power has been used to increase the economic and financial activities. However, its use also led to increased complexity, lack of transparency and greater risk and uncertainty in these activities. The global financial crisis of 2008, which saw a number of highly leveraged investment banks, has been partly attributed to the excessive leverage concepts.


2.1 Debt Capital

Small businesses can obtain debt capital from various sources. These sources can be divided into two broad categories, public and private sources. Private sources of debt financing according to W. Keith Schilit in The Entrepreneur’s Guide for Preparing a winning business plan and venture capital, such as friends and relatives, banks, credit unions, consumer finance, commercial finance companies, trade financing, insurance, factor companies and leasing companies. Public sources of debt financing from a number of loans granted by the state and federal governments to support small businesses.

Many types of debt financing to small businesses, including a private placement of bonds, convertible debentures, industrial development bonds and leveraged buyouts, but by far the most common type of debt financing in the conventional loan. Credits include the long-term (longer than a year) and short-term (maturity of less than two years), or the loan (for more immediate borrowing needs). These may be approved by the signatory, as the government, or secured to the property, debts, stocks, savings, life insurance, stocks and bonds, and purchased the product on the loan.

In the evaluation of a small company, a loan, Jennifer Lindsey said in his book Guide to the contractor in the capital, the lenders prefer to have a two-year operating history, stable management team, a desirable niche in the industry, market share growth, strong cash flow and the ability to get short-term loan to supplement the funding from other sources. Most lenders require a small business owner to prepare a full proposal for a loan or credit application. The lender will then determine the application taking into account several factors. For example, the lender will consider the small business credit card, and look for evidence of their ability to repay the loan in the form of previous earnings or revenue forecasts. The lender will also consider how much equity in the business, and that management has sufficient experience and skills to function effectively. Finally, the lender seeks to determine whether the small firms in a reasonable amount of guarantee for the loan.

2.1.1 Cost of Debt

The cost of debt is estimated by the risk-free interest rate bonds, whose length is equal to the yield curve for corporate debt and then add a default premium. This is the standard premium will increase in debt increases (since all else being equal, “all other factors,” increased the risk of increasing debt). Since in most cases, the debt burden of the deductible expense is the cost of after-tax cost of debt is expected to be comparable to the cost of equity (after tax). Thus, profitable companies, is debt at a discount. The formula can be written as:

(Rf + credit risk rate)(1-T)

where T is the corporate tax rate and Rf is the risk free rate.

2.2 Equity Capital

Equity capital for small businesses is also available from many sources. Some possible sources of equity include the Farmer family and friends, private investors (the general practitioner, to groups of local business owners to wealthy entrepreneurs known as “angels”), employees, customers and suppliers, former employers, venture capital companies , to investment banking firms, insurance companies, corporations, and government-backed Small Business Investment Corporation (SBIC).

There are two main methods that small businesses use to obtain equity finance: the private equity investors or venture capital firms, public stock issues. The private placement is easier and more common for young companies or start-ups. Even if the stock still closed with a number of federal and state securities laws, does not require formal registration with the Securities and Exchange Commission. The main requirements for private equity that the company did not advertise the offer, and you have to do the transaction directly to the customer.

However, the public stock offering includes a lengthy and costly registration process. Indeed, it charges, the public stock offering in more than 20 percent of the capital. As a result, public stock offerings are generally a better choice for mature companies, as a starter. Bids may benefit from intervention maintaining control of a small company, but also expand the participation of different groups of investors, but by concentrating it in the hands of a venture capital company.

2.2.1 Cost of Equity

Cost of equity = Risk free rate of return + Premium expected for risk

Expected Return

The expected return (or required rate of return for investors) can be calculated with the “dividend capitalization model”, which is:

That equation is also seen as: Expected Return = dividend yield + growth rate of dividends.


“The capital required for a productive, as with any other factor is that there is a cost” by Eugene F. Brigham’s book Fundamentals of Financial Management. In this case, the cost of debt capital the interest which the company must pay to borrow. In the capital cost shall be repaid to investors in dividends and capital gains. Since the amount of available capital is often limited, it is distributed in various companies on the basis of price. “Business is the most profitable investment opportunities are willing and able to pay most of the capital and thus attract out inefficient firms, or those for which such goods are not in demand,” Brigham explained. The good thing is that in most industrialized countries (eg USA, Germany, Japan, Britain, etc.), there are agencies that help individuals or groups of loans on favorable terms. Among those eligible for such assistance to small businesses, certain minorities, and the company is willing to build plants in areas with high unemployment.

As usual, the cost of capital for small businesses tend to be higher than the big, established companies. Because of the higher risk for both service providers and charge a higher price for equity funds. Several researchers found that small stock portfolios have consistently achieved the higher average returns than large company stocks, it is called the small business impact. In fact, it’s bad news for small firms, where small companies effect means that the market requires a higher return on capital stocks of small companies than otherwise similar stocks of large companies. Therefore, the cost of equity is higher for small businesses. The weighted average cost of capital of the company’s return that investors expect the various debt and equity issued by the company, according to Richard A. Brealey and Stewart C. Myers, in his book, “Principles of Corporate Finance.”

Table 1 – Cost of Capital

3.1 Capital Asset Pricing Model

Capital Asset Pricing Model (CAPM) is used to determine the economics of the theoretically appropriate price of the asset as security.

3.1.1 The Expected Return on Equity According to the Capital Asset Pricing Model

Market risk is generally characterized by β-parameter. Thus, investors would expect (or demand) that:


Es: The expected return of security

RF: The expected risk-free rate in this market (bonds)

Î’s: Sensitivity to market risk to the safety

RM: The historical performance of the stock market / stock market

(Rm-rf): The risk premium in the market risk-free assets in the assets.


The expected yield (%) = risk-free interest rate (%) * + sensitivity to market risk (the historical performance (%) – risk-free interest rate (%))

Other expected yield (%) = yield of the bonds closest to the concept of the project or the project’s safety + beta * (market risk premium)

historically the market risk premium of 3-5%


The models show that investors expect a return on risk-free rate plus a market risk sensitivity of the security times the market risk premium.

A truly risk-free rate is the lowest offer price for the bonds market, such as government bonds.

The risk premium varies over time and space, but some developed countries in the twentieth century, an average of around 5%. The real stock market returns are roughly the same as the annual real GDP growth. The gains in the Dow Jones Industrial Average is 1.6% per year over the period 1910-2005. The dividend increased by all the “real” return on average equity in the double, about 3.2%.

Sensitivity to market risk (β) is unique to each company and depends on the management to every business and capital structure. This value is not known “ex ante” (beforehand), but may not be retrospective (past) experience with similar guarantees and undertakings.

3.2 Cost of Retained Earnings/Cost of Internal Equity

We must remember that the profits from the component of equity, and thus the cost of retained earnings (internal equity) equal to the cost of equity capital as described above. The dividends (income paid to investors, and should not be) part of the return on capital to shareholders, and to influence the capital cost of the mechanism.

3.3 Weighted Average Cost of Capital

What makes the weighted average cost of capital – WACC does this mean? This estimate is the company’s cost of capital, which is weighted in proportion to their capital. Each source of capital – ordinary shares, preference shares, debentures and other long-term debt – include the WACC calculation. Each equal to the WACC of a company increases the return on equity beta and the woman, and notes a reduction in the WACC increases and a higher level of risk.

The total value of equity (for a company that no outstanding warrants and is the same as the company’s market capitalization) plus the cost of debt (the cost of debt should be continually updated as a result of changes in the cost of debt interest rate changes). It should also be noted that “justice” in the debt-equity ratio of the total market value of equity, no equity on the balance sheet. To calculate the weighted cost of capital, we must first calculate the cost of some funding sources, namely:

cost of debt

Cost of Preference Capital

cost of capital.

WACC is calculated by an iterative procedure that requires an estimate of market value of equity.

WACC formula is:

[Rd x D / V x (1-5)] [Re x E / V]

Rd = Bond yield to maturity (Y / Y Calculator)

D = Market value (NPV) of debt

(1 – T) = 1 – tax shield on interest deduction for interest expense =

Re = shareholder return requirements

V = value of total capital (debt equity)

Generally, a company or assets financed by debt or equity securities. WACC is the average cost of financing sources, each weighted by its use in a given situation. By taking a weighted average, we see that much interest the company must pay for every dollar it finances.

Since a company’s WACC is the overall expected return on the company as a whole, and as such are often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. This is the appropriate discount rate to use the cash flow risk similar to the entire company.

3.3.1 Example of Weighted Average Cost of Capital (WACC)

“A” Corporation issued 10,000 units of the bonds, which currently sells for 98.5. The coupon rate of 6% this year bonds, the interest semi-annually. The remaining period of these bonds is 3 years.

The company’s current share price of two million common shares for $ 10 a share. The stock beta 1.5, a 4.5% risk-free rate on government bonds and the expected return on equity of 14.5%.

The tax rate is 30%

Table – 2 Bond and Stock Calculations

Bond Calculations

Stock Calculations

N = 3 x 2 = 6

I/Y = ? (Rd)

PV = 0.985 x 10,000 x $1000 = $9,850,000 (D)

PMT = (-10,000,000 x 0.06) / 2 = $-300,000

FV = $-10,000,000

P/Y = 2

C/Y = 2

Solution: I/Y = 6.56%

Re = Rf + B[Rm – Rf]

Re = 0.045 + 1.5 [0.145 – 0.045]

Re = 0.045 + 0.15 = 0.195 (19.5%)

Market Value of Equity = E

Stock price x common shares O/S

$10 x 2,000,000 = $20,000,000

V = Total Capital Structure

V = 9,850,000 (bonds debt) + 20,000,000 (equity of common shares)

V = 29,850,000

3.4 Cost of Capital in Islamic Banking

Proper use of investment criteria is important for industry and agriculture as well. Although the assessment can be used for both public and private sectors of the economy, should the public sector in its own special problems considered complementary, because the social costs and benefits. Therefore, we will participate in the private sector and the problems of evaluating investments in various industrial projects.

Contradictions abound in the relative merits of different methods of investment valuation. But the most important points with different match.

It is worth noting that almost every economist in the treatment “discounting” as a method of evaluation, as the only possible way to choose between different investments. Essentially two methods frequently used economists, namely the net present value (NPV) and the enlarged internal rate of return (IRR). The concept of internal rate of return (IRR) was JM Keynes (perhaps better known as the marginal efficiency of capital MEC) schedule, called the marginal efficiency of investment (MEI). It is defined as the rate at which the present value of future income exactly equal to the market price for the project. In other words, this is Return on capital employed. It is, committed while the return of the project. NPV of the project is formally defined as the value today of the surplus that the company can do in addition to the investor’s own marginal.

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IRR on the basis of the extended to the negative cash flows are discounted back to the company’s cost of capital as long as it does not outweigh the positive cash flow. Both methods (the extended NVP and IRR) on its own common deficiencies, such as non-IRR NVP can be used either in the usual way that the correct ranking of projects in situations where the entrance is a rationing system. But there are ways to eliminate gaps and allow them to appropriate methods of investment evaluation.

We will have a higher degree of internal rate of return, which is simply called the internal rate of return. A simple rule of decision in cases where the decision is “all or nothing” about which projects should be chosen from the various investment options, to implement all the projects whose IRR exceeds the cost of capital.

Cost of capital, the capitalist system, the rate that a loan company and the investment is likely to be, which is simply the “interest”. In other words, that “cut – off rate”, in relation to the internal rate of return regulation, which are also found in the literature as a “barrier percentage”. Note that the NPV approach to investment decisions, it is essential that decision-making, that there is no explicit prior discount rate, which, as already mentioned, is nothing more than to get money market rates. But they did not have a pre-determined percentage of the IRR method, except when it’s time, where debt capital is rationed in the various projects. This makes it completely independent of the IRR method is very appropriate rate and can be used for investments in the Islamic interest-free option and follow the debate.

In the case of capitalism, is the internal greater than or equal to the market, the project will be implemented. The project also encourages companies to maximize profits, which last carried out the project’s internal rate of return equal to interest. Apparently, the internal time of a declining function of investment, more projects, which would reduce the internal rate of return (in the same trade, of course).

Already adopted (the Western economists) that the interest rate plays a decisive role in determining which projects will be implemented and also how much capital to be invested in various projects. Roll the relationship between these two terms seem to be exaggerated. Since only one project, the established criteria are quite valid and applicable as the optimal size of equity should be considered. As the number of projects increases, the IRR should be calculated for each project will increase so much. Moreover, it happens to all nodes in the two IRR’s. This complicates the problem, and this will reduce the importance of interest, especially if interest rates happen to be far from the IRR to the last possible projects.

Given that an investor’s risk-taking entrepreneurs, he is usually in front of the chains of investment options from which to choose allegedly, the first of the highest IRR. Assuming that you know, a lot of project finance, there may be dozens of projects whose IRR is higher than the going rate. There is no doubt that these projects are attractive, but to varying degrees, the contractor and will be selected in descending order rate. This is the case in the real economy, the role of interest rates is rather passive, even useless. This is because in such circumstances, the project IRR rate range. This is beyond that point to the role that a reasonable interest rate, and the role of the cut-off ratio. In other words, it is a long process before the existence of the interest rate becomes irrelevant, because the IRR for a couple of projects related to each other because of the interdependence refers to the ratio of investment is not at all.

Exogenous real interest rate in the sector (especially investment), it is ironically suggested the capitalist system and then used to determine the optimal level of investment. In addition, the speculators, who needs money market interest in the products, allowing decisions to lead the business, whose activities are so important to the economy. It seems reasonable to link the contrary, ie, because of the interest, but we assume it to be the real sector, led by the monetary sector, if any.

The abolition of an Islamic state, it would not be an external variable such as interest, what type and level of investment. Investment projects, in this framework are competing with each other, and the investment will be needed to achieve full employment, that is, until there are idle production factors in the economy.

This is particularly true of human resources make it necessary and inherent meaning, as we see in Islam, the authorities should not keep the unemployed, for the sake of the interests of capitalists.

Can easily be shown that in an Islamic context, for each part of the money (ie, the potential capital) that comes out of the interest-free banks to finance various projects under various types of contracts, it becomes possible to go directly to the products and / or services.

Is a term, and it is: a prerequisite for an Islamic state is strictly prohibited, and appear to prevent speculation in any market (be it either money or goods). It has long been a misunderstanding among some Islamic scholars in the financial support that speculation can take place, and the abolition of interest is permitted. Easy to show that one-to-one correspondence between the interest (rate), and speculation. Interest rate (rate) is necessary and sufficient condition for the speculation that takes place. Although the lack of clearly illegal-frame-rate, if speculation is allowed in any market, you will definitely be of interest in its own nature. Therefore, the prohibition of interest leads logically to a ban on speculation. This interdependence between interest and speculation is not only very rarely in the economic literature, but also its negligence was the source of serious misunderstandings. Economic relations are rarely a single direction.

A collection of the IRR can be measured both by an Islamic bank, Islamic banking sector, an independent agency authorized to appropriate guidance on the nature and viability of the project. This measure is to be used so that the expected profits can be divided into an Islamic bank and finance company demanding. The matrix is very useful for determining how much funding should be allocated to projects that are in the priority list for economic development. To determine the company’s share of the profits, various factors, such as the following may be considered: the risk premium, the rate of poverty in different parts of the country’s priorities for economic development plans, the degree of capital intensity, taxes, employment considerations of the burden of rates and the like. All of these factors, or a combination thereof may affect the company’s demanding (my fiancee) share of the profits that can be safely manipulated without interfering with the market mechanism. It gives interest-free banking system, the IRR method, the absolute advantage of the artificial manipulation of interest rates, which is quite often the case in capitalist countries, and an obvious interference with market mechanisms. This contrasts with the situation are often held in the Western economists who argue that market mechanisms should be avoided. Add to this the expected negative correlation between interest and investment as both a classical and Keynesian economists have empirically demonstrated that infertile. This is so, while the bill may be taken into account the positive correlation between the rate of profit and investment. This bill provides not only the interest cost of the capitalist system, but also that profit maximization is consistent with the aims of each company. Surprisingly, however, this goal is at the micro level, the capitalist will change textbooks without a logical explanation for the negative correlation between interest investment at the macro level.

Using the IRR method of an Islamic state is not only compatible with the goal of maximizing profits (if proof was not suitable for such a system) – and to avoid interfering with market mechanisms – but it is an absolute advantage in another, so the opportunity cost of capital to zero. The logic is simple. This lack of interest, all projects compete with each other (with due regard to their own priorities), internal rate of return. Also, the fact that the investment projects against each other at each other and there is no reason to ensure that any external factors to determine the same extent as the cost of capital for each project. The capitalist system, the current interest rate to be logically “the next best alternative”, or the cost of capital for each project. The logic of the independence of the IRR for the project.

The second best option “not to report to the IRR for a project according to an account must be seen as the opportunity cost of capital. This is because of the interdependence of all projects do not meet any of the BMR in another appropriate opportunity cost of the project, otherwise it would cost hundreds of alternatives to the capitalist framework, while the interest rate will be to measure the opportunity cost of all capital investment. In other words, to allow costs to be met independent state. Failure to consider the interdependencies between projects and independent degree of internal rate of investment has led to that many writers to form the misconception about the opportunity cost of capital.

This lack of interest, there is nothing to compare the IRR of the various projects (with the exception of the IRR of the project by themselves). Interdependent and common to the Islamic banks, these proje


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