Question

1. Explain component costs of capital and weighted cost of capital (WACC), using an example relevant to you.)
2. Compare and contrast WACC and Required Rate of Return (RRR) of investors. Discuss how costs of capital learned in this module relate to Capital Asset Pricing Model (CAPM) learned in an earlier module.
3. Evaluate the impact of business risks and market risks on corporate capital structure. Discuss the importance of maintaining an optimal corporate capital structure.

Answer 1

Consider a capital structure with $30M debt, $20M preferred share capital and $50M common share capital. The weighted cost of capital is calculated as below-

Amount of debt	30,000,000
Amount of common shares	50,000,000
Amount of preferred shares	20,000,000
Weight of debt	30%
Weight of common shares	50%
Weight of preferred shares	20%
debt interest rate	7.90%
tax rate	35.00%
cost of debt	5.14%	=7.9%*(1-35%)
Risk free rate	3.00%
Market risk premium	8.00%
Beta	1.5
Cost of equity	15.00%	=Rf+ beta*(market risk premium) =3%+1.5*8% (As per CAPM)
Divident payment on preferred shares	11.00%
WACC	11.2405%	=30%*5.14%+50%*15%+20%*11%

The capital structure has 3 components- debt, preferred shares and common shares. Cost of each component is basically the required rate of return by providers of each type of capital providers. For example, the preferred shares capital providers require a 11% fixed dividend on their capital. The cost of individual types of capital is also called as the component cost of capital. It should be noted that the interest payment has a tax benefit to the company, as the interest amount is tax deductible. This is also called as the tax shield. Hence, the cost of debt is usually lower than interest payment made on debt.

In this example, we have calculated the cost of equity or common shares by CAPM. CAPM requires a market risk premium for equity capital providers over and above the risk free rate. The beta is the indicator of systematic risk for the company. It is the multiple for market risk premium for calculating cost of capital through CAPM. The general formula for CAPM is-

Cost of equity = Risk free rate + beta * (Market return- risk free rate)

Market return- risk free rate is called as equity premium. Therefore-

Cost of equity = Risk free rate + beta * (Market risk premium)

Impact of business risk and market risk on capital structure-

When a firm takes up debt, it is adding leverage. He leverage magnifies the returns from the business for the equity providers. In good markets, when the business is profitable, the debt providers will be eligible for a fixed interest payout. The effective interest payout is even lower for the firm due to tax shield. Hence, return for equity providers is increases more than the PAT. On the other hand, when the business is bad and the profits are low, the interest payout for debt providers is still fixed. The payout for equity providers is even lower. Even in the period of loss, the debt holders still need to be paid and the equity capital is depleted.

During a recession or during low point of business cycle, the market risk increases disproportionately. The equity risk premium is increased further by the multiple beta. Hence, the cost of equity capital I higher. At the same time, the debt providers perceive higher risk in the market. They demand higher returns on their capital. The cost of debt increases too. As a result, the WACC becomes higher. Any projects which have higher risk or lower payout become infeasible as the cost of capital for the firm increases.

A business with too high debt will become unsustainable during the time of recession or slow growth. As the amount and proportion of debt on the balance sheet increases, the cost of debt increases, as the lenders perceive the company to be more risky. The credit rating of the company goes down. At the same time, a business with too low debt will have a higher cost of capital and will have difficulties in finding sufficiently profitable projects to grow. The returns to equity holders will be lower as it will not be able to utilize its debt shield effectively.