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. Compute overall cost of capital (WACC)
6. Compute marginal cost of capital (MCC)
7. Understand the concept of capital structure
4.1. Introduction about bond and stock
A bond is a long term contractual agreement between the issuer of the bond and the holder of the
bond to pay a stated sum of money on a stated period of time. It 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.
Features of a bond (Characteristics of a bond);
- Par or Face Value: The amount of money that is paid to the bondholders at maturity. 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.
- Maturity Date: The maturity date represents the date on which the bond matures, i.e., the
date on which the face value is repaid.
- 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.

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Types of bond based on issuer
i. Treasury bonds/Government bond/, sometimes referred to as government bonds, are
issued by the federal government. It is reasonable to assume that the federal government
will make good on its promised payments, so these bonds have no default risk.
ii. Corporate bonds 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.
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:
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.
Types of bond based on interest
i) Coupon (interest bearing bond):- A bond is having coupon (interest) payment.
ii) Zero coupons (non interest bearing bond):- bonds have not coupon (interest) payment.
Other types of bonds;
i) Callable bond; is a bond with an embedded that allows the issuer to redeem the
bond before maturity at cost.
ii) Putable bond: is a bond with an embedded that allows the investor to redeem the bond
before maturity.
iii) 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.
iv) Non-convertible bond; a bond that are not converted into stocks.
v) Income bond; is a type of debt security in which only the face value of the bond is
promised to be paid to the investor, with any coupon payments paid only if the issuing
company has enough earnings to pay for the coupon payment.
vi) Eurobond; is a debt instrument that is denominated in a currency other than the home
currency of the country or market in which it is issued.
vii) Floating-rate note (FRN):- is a debt instrument with a variable interest rate. The interest
rate for an FRN is tied to a benchmark rate.
viii) Indexed bond is a type of bond in which the payment of interest income on the principal
is related to a specific price index, typically the Consumer Price Index (CPI).
ix) Purchasing power bonds; are bonds that adjust their terms to maintain the purchasing
power of the contract rather than paying a fixed-dollar sum.
x) Junk bonds; are high-yield bonds issued by companies with poor credit quality and high
risk of default.

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Definition of stock
Stock is a document that shows ownership right. A stock, also known as equity, is a security that
represents the ownership of a fraction of the issuing corporation. Units of stock are called shares,
which entitle the owner to a proportion of the corporation’s assets and profits equal to how much
stock they own.
Stocks are bought and sold predominantly on stock exchanges and are the foundation of many
individual investors’ portfolios. Stock trades have to conform to government regulations meant
to protect investors from fraudulent practices.
Types of stock
i) Common stock; is a security that represents ownership in a corporation, with voting rights
and dividend potential.
ii) Preferred stock; is a type of equity that pays fixed or adjustable dividends and has priority
over common stock in distributions and liquidation.
Difference between common stock and preferred stock
Common stock Preferred stock
Having dividend right Having dividend right
Having asset right on liquidation Having asset right on liquidation
Preemptive right (right to acquire additional No preemptive right
share on issuance)
No preferential right on dividend Preferential right on dividend
No cumulative right Cumulative right (The right to ask dividend in
arrears)

4.2. Valuation of bond

Definition of valuation
Valuation is the process of determining the worth of an asset based on its future cash flow
(economic benefit). 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.
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.
Valuation of bond with finite maturity
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 + (1+Kd) 2 +---+ (1+Kd) n + (1+Kd) n
= I (1- 1 ) MV
n
(1+Kd) + (1+Kd) n
or VB = INT(PVIFAkd,n) + M(PVIFkd,n)
Where: VB= bond value
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 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
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
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?
Answer: VB = I
Kd
= 50
0.12
= Birr 416.67
The relationship between required rate of return and coupon rate
 If YTM > CR the bond sells at discount below par value.
 If YTM < CR the bond sells at premium above par value.
 If YTM = CR the bond sells at par value.
4.3. Valuation of stocks
Preferred Stock Valuation
The value of preferred stock is the present value of all future preferred dividends it is expected to
provide over an infinite time horizon. Most preferred stocks entitle their owners to regular and

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fixed dividend payments. If the payment last forever, the issuer is perpetuity. Therefore, the
value of a preferred stock is found by the following formula;
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. 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
Common Stock Valuation
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. The common stock valuation equation can be
simplified by redefining each year’s dividend. The dividends are defined interns of anticipated
dividend growth. Generally there are three cases accordingly; these are;
1. Zero growth common stock
2. Constant growth common stock (The Gordon constant Growth model)
3. Variable growth common stock (supernormal growth)
1) Zero growth stock
It is a common stock whose future dividends are not expected to grow at all. The expected
growth rate (g) is zero. This is the simplest model to common stock valuation. It assumes a
constant, non growing annual dividend. So here the annual dividend is all equal. That is
D1=D2=Dn their fore the value of common stock is;
VC = Div/Ks
Where VC= Value of common stock
Div = Dividend
Ks = Cost of common stock (required rate of return)
Example: - The most recent common stock dividend of X company was birr 3.60 per share. Due
to the firm’s maturity as well as stable sales and earnings. The dividend is expected to remain at
the current level of the foreseeable future.
VC = Div/Ks = 3.60/0.12 = birr 30
The maximum price the investor would be willing to pay for a share of common stock is birr 30
for to receive a birr 3.60 annual dividend for an indefinite years.
2) Constant growth common stock
Constant growth stock is a common stock whose future dividends are expected to grow at a
constant dividend growth rate (g). It is sometimes called normal growth stock. The constant

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(normal) growth common stock valuation model is the most widely cited approach to common
stock valuation. Based on this model the value of common stock is calculated as;
VC = Div(1+g) /Ks – g or VC = Div1/Ks – g
Where Div1 = Dividend in period 1
Ks = The expected rate of return on a constant growth stock
g = expected growth rate/capital gain yield
Example:- XYZ co common stock currently pays an annual dividend of birr 5.40 per share. The
dividends are expected to grow at a constant annual rate of 5% to infinitely. Estimate the value of
common stock if the required rate of return is 12%
VC = Div1/Ks – g =5.4(1.05)/0.12-0.05 = birr 81
3) Variable growth common stock
Variable growth stock is a stock whose dividends are expected to grow at variable or non
constant rates. The model of common stock valuation that allows for a change in the dividend
growth rate is called variable growth model. The value of a stock of variable growth common
stock is determined as;
Vc= Div1 Div2 Divn P0
(1+Ks) + (1+Ks) +---+ (1+Ks) + (1+Ks) n
1 2 n

Example:- CDF company most recent annual dividend, which was paid dividend birr 30 in year
1, 25 in year 2 and 45 in year 3. Were sold for birr 1200 at the end of year 3. What is the value of
common stock with a required rate of return of 12%.
Vc= Div1 Div2 Divn P0
(1+Ks) + (1+Ks) +---+ (1+Ks) + (1+Ks) n
1 2 n

Vc = 30/1.121 + 25/1.122 +45/1.123 +1200/1.123 =

4.4. Cost of capital

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. It is also defined as the minimum rate of return a firm must earn on its invested capital
to maintain the value of the firm unchanged. We can say that the cost of capital is the rate of
return at which the market value of the firm will remain unchanged.
If a firm’s actual rate of return exceeds its cost of capital, the value of the firm would increase. If
on the other hand, the cost of capital is not earned, the firm’s market value will decrease. So, the
cost of capital is the rate of return that is just sufficient to leave the price of the firms common
stock unchanged.
Specific components of cost of capital
A). Cost of Debt.
B). Cost Of Preferred Stock.
C). Cost Of Common Stock.
D). Cost Of Retained Earnings.
Cost of debt

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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.
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.

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 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
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.

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(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%
(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
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;
dividendpers h are Dp
Kp = =
netproceed(NP ) NP
Example: A preferred stock selling for Br.500 with an annual stated dividend per share of Br.50

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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.

Cost of Common Stock

Cost of common stock is a minimum rate of return that the corporation must earn for its common
stock holders 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.
The Dividend–Growth Model
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-price (E/P)
NP NP
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
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 NP = Net Proceed
Do = current dividend per share g = dividend growth rate

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 D1 = dividend at the end of 1st year

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 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?
¿(1+ g) 12(1+ 6 %)
Kc = + g= + 6% = 0.1383 + 0.06 = 19.83%
NP 92
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?
¿(1+ g) 12(1+0.06)
KRE¿ +g = + 0.06 = 18.72%
NP 100
4.5. The overall cost of capital (Weighted average cost of capital)
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 is the weighted average of the individual cost of debt, preferred
stock and common equity. It is also called the composite cost of capital. If the weight of the
component capital sources are all given, the weighted average cost of capital can be computed as;

WACC= WdKd (1-t) + WpKp+WcKc+WrKr

Where
WACC = weighted average cost of capital
Wd =Weight of debt
Kd (1-t) = After tax cost of debt
Wp = Weight of preferred stock
Kp = Cost of preferred stock
Wc = Weight of common stock
Kc = Cost of common stock

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 Wr = Weight of retained earning
Kr =Cost of retained earning
Example:- ABC company capital structure shows 30% debt, 40% common stock, 20% preferred stock
and 10% retained earnings. The cost of capital for debt is 12%, common stock 10%, preferred stock
6% and retained earnings 5%. What is the weighted average cost of capital of the company? If the tax
rate is 30%
WACC= WdKd (1-t) + WpKp+WcKc+WrKr
= 0.3*0.12(1-0.3)+0.2*0.06+0.4*0.1+0.1*0.05 =
4.6. Marginal cost of capital (MCC)
Marginal cost of capital is the cost of obtaining additional capital. It 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 WACC.
As a firm raises larger and larger amount of capital, the WACC also rises. MCC determines the
breaking point where the cost of capital will increase.
Example:- The target capital structure of DEF company is 40% debt, 10% preferred stock and 50%
common stock with a cost of preferred stock of 12.06%, cost of retained earnings of 14% and cost of
common stock of 15%. The company has birr 900,000 available retained earnings. But when the firm
fully utilizes its retained earnings, it must use the use the more expensive new common stock
financing to meet its equity needs. In addition, the firm expects that it can borrow up to birr 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 (a) exhausting of retained earnings (b) increment of
debt between 0-1,200,000
2) Determine the range of total new financing where the WACC will rise
3) Calculate the WACC for each range of finance
Solution
1. Breakeven point common equity = Available retained earnings/Weight of common stock
= 900,000/0.5 = 1,800,000
Breakeven point of long term debt = New borrowing/Weight of debt
= 1,200,000/0.4 = 3,000,000
2. There are three ranges of finance that could be identified on the basis of breakeven points;
1st range 0-1,800,000
2nd range 1,800,00-3,000,000
3rd range 3,000,000 above
3. WACC (1st range) = 0.4*0.073+0.1*0.1206+0.5*0.14 = 11.132%
WACC (2nd range) = 0.4*0.073+0.1*0.1206+0.5*0.15 =11.63%
WACC (3nd range) = 0.4*0.091+0.1*0.1206+0.5*0.15 = 12.35%
4.7. Capital 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

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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
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.
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.

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 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.
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.
Capital structure theories
Modigliani-Miller (MM) Theory
The Modigliani-Miller (M&M) theory is a capital structure approach named after Franco Modigliani
and Merton Miller. Modigliani and Miller were two economics professors who studied capital
structure theory and collaborated to develop the capital structure irrelevance proposition in 1958. They
proposed the relationship between capital structure, firm value and WACC.
This proposition states that in perfect markets the capital structure a company uses doesn't matter
because the market value of a firm is determined by its earning power and the risk of its underlying
assets. According to Modigliani and Miller, value is independent of the method of financing used and
a company's investments. The M&M theorem made the two following propositions:
 Modigliani and Miller (M&M) Propositions I and II with no taxes
 Modigliani and Miller (M&M) Propositions I and II with taxes
Debt has two distinguishing features that we have not taken into proper account.
 First, as we have mentioned in a number of places, interest paid on debt is tax deductible. This is
good for the firm, and it may be an added benefit of debt financing.
 Second, failure to meet debt obligations can result in bankruptcy. This is not good for the firm, and
it may be an added cost of debt financing.
We can start by considering what happens to M&M Propositions I and II when we consider the effect
of corporate taxes. To do this, we will examine two firms: Firm U (unlevered) and Firm L (levered).
These two firms are identical on the left side of the balance sheet, so their assets and operations are the
same.
Proposition I
This proposition says that the capital structure is irrelevant to the value of a firm. The value of two
identical firms would remain the same and value would not be affected by the choice of financing
adopted to finance the assets. The value of a firm is dependent on the expected future earnings. It is
when there are no taxes.
MM proposition I with no tax
 The value of a firm is independent of its capital structure. The value of the firm do not change due
to the change in capital structure
 The value of unlevered firm equals to the value of levered firm.

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  Unlevered firm is a firm that has no debt.
 Share price is constant
Example: assume an all equity firm has a market value of Br. 300,000 and 50,000 shares outstanding.
It is thinking of changing its capital structure by borrowing Br. 120,000 in debt and repurchasing
shares. Ignore tax.
A. Proposition I: The value of the firm levered (V L) is equal to the value of the firm unlevered (V U):
VL = VU
Implications of Proposition I:
1. A firm’s capital structure is irrelevant.
2. A firm’s weighted average cost of capital (WACC) is the same no matter what mixture of debt and
equity is used to finance the firm.
MM proposition I with tax
 The value of unlevered firm different from the value of levered firm
 More debt = larger interest tax shield = less taxes = larger firm value
 The value of unlevered firm + present value of interest tax shield = value of levered firm
 Interest tax shields are the tax saving attained by a firm from interest expense.
A. Proposition I with taxes: The value of the firm levered (V L) is equal to the value of the firm
unlevered (VU) plus the present value of the interest tax shield:
VL = V U + TC * D
Where TC is the corporate tax rate and D is the amount of debt.
Implications of Proposition I:
1. Debt financing is highly advantageous, and, in the extreme, a firm’s optimal capital structure is 100
percent debt.
2. A firm’s weighted average cost of capital (WACC) decreases as the firm relies more heavily on debt
financing.
MM proposition II with no tax
The WACC do not change due to the change in capital structure
 Share price is constant
 WACC is constant:
 Cost of equity raises as the firm increases its debt financing
WACC = (E/V) * Re + (D/V) * Rd
RA = (E/V) * Re + (D/V) * Rd
RE = RA + (RA- RD) * (D/E)
Where, WACC is weighted average cost of capital
E/V is rate of equity
Re is cost of equity
D/V is rate of debt
Rd is cost of debt
RA is required rate of return
D/E is debt equity ratio
Example:- XYZ CO. has a required rate of return of 12%. It can borrow at 8%. Assuming that, the firm
has a target capital structure of 80% equity and 20% debt. Calculate cost of equity and WACC?
Solution
RE = RA + (RA- RD) * (D/E)
= 0.12 + (0.12 – 0.08) * (0.2)
= 0.13 or 13%
WACC = (E/V) * Re + (D/V) * Rd
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 = 0.8 *0.13 + 0.2 *0.08
= 0.12 or 12%
What is the cost of equity and WACC if the firm’s capital structure is 50% debt and 50% equity?
MM proposition II with tax
 Cost of equity raises as the firm increases its debt financing and it is similar withMM proposition
II without tax.
 WACC decreases with increase in debt.
 VL> VU i.e. Value of a firm increases with increase in debt.
 VL = VU + D * tax rate
Here cost of equity is calculated as follows:
RE = RU+ (RU – RD) * (D/E) * (1-T)
WACC = (E/V) * Re + (D/V) * Rd* (1 –T)
Example: given RD= 8%
RU = 10%
Debt = 1,000
Leveraged firm value = 7,300
Tax rate = 30%
Calculate cost of equity and WACC?
Solution
VL = VU + D * tax rate
RE = RU+ (RU – RD) * (D/E) * (1-T)
= 0.1 + (0.1 – 0.08) * 1000/6300 * (1- 0.3)
= 0.1022 or 10.22%
WACC = (E/V) * Re + (D/V) * Rd* (1 –T)
= (6,300/7,300) * 0.1022 + (1,000/7,300) * 0.08(1-0.3)
= 0.96 or 9.6%
Increase in debt increases the value of the firm and decreases WACC
Example: VU = 500
Debt = 500
RU (cost of Unleveraged firm) = 20%
Cost of debt = 10%
Tax rate = 34%
Calculate cost equity and WACC?
Solution:
E = VL –D
VL= VU + D * tax rate
RE = RU+ (RU – RD) * (D/E) * (1-T)
= 0.2 + (0.2 -0.1) * (500/170) * (1 – 0.34)
= 0.39 or 39%
WACC = (E/V) * Re + (D/V) * Rd* (1 –T)
= (170/670) * 0.39 + (500/670) *0.1(1-0.34)
= 14.92%
The static (tradeoff) theory of capital structure
It is also called tradeoff theory. The static theory of capital structure says that firms borrow up to the
point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the
increased probability of financial distress. The static theory assumes that the firm is fixed in terms of
its assets and operations and it considers only possible changes in the debt-equity ratio. According to

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static theory, the gain from tax shield on debt is offset by financial distress costs. An optimal capital
structure exists that just balances the additional gain from leverage against the added financial distress
cost (bankruptcy cost). According to static theory, the WACC falls initially because of the tax
advantage of debt. Beyond the point D/E; it begins to rise because of financial distress cost.
The Pecking-Order Theory
The pecking order theory focuses on asymmetrical information costs. Flotation costs and asymmetric
information leads to use this theory. This approach assumes that companies prioritize their financing
strategy based on the path of least resistance. Internal financing is the first preferred method, followed
by debt and external equity financing as a last resort.
The pecking-order theory is an alternative to the static theory. A key element in the pecking-order
theory is that firms prefer to use internal financing whenever possible. A simple reason is that selling
securities to raise cash can be expensive, so it makes sense to avoid doing so if possible. If a firm is
very profitable, it might never need external financing; so it would end up with little or no debt. This is
because internal funds are less costly than external funds, and debt is less costly than
equity. Therefore, companies will only issue new equity as a last resort.
Implications of the pecking order
The pecking-order theory has several significant implications, a couple of which are at odds with our
static theory:
No target capital structure: under the pecking-order theory, there is any target or optimal debt-equity
ratio. Instead, a firm’s capital structure is determined by its need for external financing, which dictates
the amount of debt the firm will have.
Profitable firms use less debt: Because profitable firms have greater internal cash flow, they will
need less external financing and will therefore have less debt.
Companies will want financial slack: To avoid selling new equity, companies will want to stockpile
internally generated cash. Such a cash reserve is known as financial slack. It gives management the
ability to finance projects as they appear and to move quickly if necessary.
Signaling theory
The signaling theory suggests that companies use their capital structure to signal information to
investors about their future prospects. For example, a company that issues new equity may be
signaling to investors that it has profitable investment opportunities that require additional
funding. Similarly, a company that issues new debt may be signaling that it is confident in its ability to
generate future cash flows to service its debt obligations.
While both theories provide insights into how companies choose their capital structure, they have
different implications for the cost of capital and the value of the firm. The pecking order theory
suggests that companies with a conservative capital structure may have a lower cost of capital and a
higher firm value, while the signaling theory suggests that companies with a leveraged capital
structure may have a lower cost of capital and a higher firm value.

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