LONG-TERM FINANCING DECISIONS

CONTENT CAPSULE:

Basic concepts, basic tools of capital structure management

Factors influencing capital structure decisions
Incorporating capital structure into capital budgeting
Weighted average cost of capital (WACC)
Miscellaneous topics: CAPM, levered and unlevered beta, special issues on non-constant growth stocks
Effects of operating leverage and financial leverage on capital structure

Basic Concepts of Capital Structure Management

Capital structure is the permanent financing of the assets of the firm. Capital structure defines how much of the resources of
the company is coming from external creditors, from preferred shareowners, from ordinary shareholders, and which part of
any asset change is supported from accumulated profits.
Factors Influencing Capital (or Financial) Structure
The following considerations are taken before an optimum capital structure is arrived at:
1. Growth rate and stability of future sales
2. Competition in the industry
3. Composition of assets
4. Risk averseness of owners and management
5. Control of owners and management
6. Impression of lenders about the industry and the entity
7. Tax effects
Incorporating Capital Structure into Capital Budgeting
Capital investment decisions do not only involve choosing from alternatives. Once selection is made, the management
should next think of how the capital project will be financed. At this point, the preferred capital structure set by the entitys
management and owners will be used.
We should remember that when management had optimized its capital structure, the firm shall register the highest possible
stocks value and had minimized its cost of financing.
Weighted Average Cost of Capital (WACC)
The cost of capital (COC) is the sacrifice of getting our financing act together. If we borrowed our capital funds, our cost
of having the funds to support the project is equal to the corresponding interest expense we have to pay. If we will rely on
equity financing, the amount of capital raised will definitely be given to us by our stockholders only with the hope of
dividends to be distributed to them in the future.
The weighted average cost of capital (WACC) weighs the percentage cost of each component by the percentage of that
component in the financial structure.
Things to remember when computing for WACC for capital investment decisions:
a. Use market values to determine the weights.*
b. Estimate the component costs of WACC on an after-tax, cash flow basis.
c. Expected or promised returns are compared with WACCs, which represent required return.

Common Terms used in the understanding of a Firms COC

Beta ()measures a stocks market risk. It shows a stocks volatility relative to the market. Beta shows how risky a stock is
if the stock is held in a well-diversified portfolio.
Security Market Line (SML) is the line that shows the relationship between risk as measured by beta and the required rate of
return for individual securities
Constant Growth Stock are stocks whose dividends are expected to grow forever at a constant rate, g.2
Flotation Cost is the cost to issue securities; hence this reduces the amount of proceeds from such selling of securities.
COC Component per Capital Source
Source of Financing

Model Name

QUANTITATIVE MODELS
Formula

Additional Considerations

When Expected returns exceed or at least equal required returns, investment proposals are acceptable.
The retention growth model estimates growth by the equation g = b(r). Here b = expected future retention ratio and r = expected future
return on equity (ROE). This model assumes (1) that the retention ratio, b, will remain constant over time, (2) that the expected return on
equity, r, will remain constant over time, (3) that the firm will not issue new common stock, or that any new stock issued will be priced at
book value, and (4) that the aggregate risk of future projects will be the same as the firm's current projects
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CRC-ACE: 14 Long-term Financing Decisions

Long-term Debt

kd AT

Preferred Stock

Common Stock

= kd BT(1 T)
kp= D1/P0

Capital Asset Pricing Model

ks = kRF + (kM kRF)

Discounted Cash Flow

Model/Dividend
Growth/Gordon Model

ks = [D1/(P0 F)]+ g

Own-Bond-Yield-Plus-Risk
Premium

ks = kd + RP

Retained Earnings

ks = D1/P0 + g

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Use effective rate.
May involve growth rate
when preference carries
floating rate.
BetaL may have to be
computed.
Risk premium may be given.
This is also used to
determine the stocks price
at a given time.
There are also non-constant
growth stocks.

Same as ks, when there is no

flotation costs consideration

Miscellaneous topics: CAPM, Beta Estimation

Capital Asset Pricing Model (CAPM)
The following are some important notes we need to remember when applying CAPM:
1. The ks is equal to the required rate of return.
2. kRF = Risk-free rate ; The preferred proxy for kRF is the Rate on long-term Treasury bonds. This is affected by inflation.
3. b = The stock's beta coefficient is used as the measure of risk.
4. kM = The required rate of return on the market, or an "average" stock. This is affected by inflation. The behavior of
investors affect this return value.
5. Key Assumptions under CAPM model:
a. Individuals diversify and hold portfolios
b. To test the CAPM, one has to observe and be able to measure this efficient market portfolio.
c. The risk of a security is the risk it adds to the portfolio
d. Everybody holds the market portfolio
e. The covariance between an asset "i" and the market portfolio (Covim) is a measure of this added risk. The
higher the covariance the higher the risk.
6. Limitations of the CAPM
a. The CAPM can never be tested because the market portfolio can never be observed, as deemed it is not as
efficient as the CAPM assumes.
b. The CAPM is difficult to test on individual assets.
Beta Estimation()
The beta coefficient () of an individual stock is the correlation between the volatility (price variation) of the stock market
and the volatility of the price of the individual stock. The beta is the measure of the undiversifiable, systematic market risk.
Security Market Line (SML) is the line on s graph that shows the relationship between risk as measured by beta and the
required rate of return for individual securities. The slope of the regression line is defined as the beta coefficient.
The SML commonly adopts the CAPM model:

SML: ki = kRF + (kM kRF) i .

The following interpretations are made when given a value of beta:

If = 1.0, then the Asset is an average asset.
If > 1.0, then the Asset is riskier than average.
If < 1.0, then the Asset is less risky than average.
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Most stocks have betas in the range of 0.5 to 1.5.

Beta is affected by an entitys capital structure. The beta we use in the CAPM is the levered one, in case the entity uses debt
financing. The Hamada equation below is used to compute for new beta shall there be changes in capital structure.
u=

Current, levered
.
[1 + {(1-tax rate)(Debt/Equity)}]

Effects of Operating Leverage and Financial Leverage on Capital Structure

Leverage is the relative amount of fixed cost of capital (i.e. supplied by debt) in an entitys capital structure. Some
important relationships that we need to understand about leverage follows:
1. EPS will ordinarily be higher if a company uses debt financing. *
2. Greater leverage maximizes EPS but also increases risk.
3. An optimal capital structure does not maximize EPS.
Can a beta be negative? Answer: Yes, if beta is negative. Then in a beta graph the regression line will slope downward. Though, a
negative beta is highly unlikely.
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4. As long as Return on Assets (ROA) > kd , leverage can still be increased.
5. A company with a high percentage of fixed costs is riskier than another which has more reliance on variable costs
of production.
Degree of Financial Leverage
This measures the percentage change of earnings available to ordinary shareholders per change in net operating income.
When DFL of companies are compared, the one which has a higher DFL is a riskier entity.
DFL = Percentage in Net Income Percentage in Net Operating Income
DFL = EBIT (EBIT Interest Preferred Dividends)
( 1 Tax Rate)
Degree of Operating Leverage
This determines the extent to which fixed costs are used in the production process.
DOL = Percentage in Net Operating Income Percentage in Sales
DOL = CM (CM Fixed Costs)
Degree of Total Leverage
This combines DFL and DOL as follows:
DTL = DFL x DOL
DTL = Percentage in Net Income Percentage in Sales

/jrm