CapitalStructureandtheCostofCapitalL.ppt

Dr. Evarist Stoja Financial Management Capital Structure and the Cost of Capital Capital Structure and the Cost of Capital Learning Outcomes By the end of this session you should: Understand the characteristics of debt finance. Discuss the traditional view of gearing and the cost of capital. Discuss Miller Modigliani propositions The ‘Traditional’ View The ‘traditional’ view emphasizes the benefits of using relatively cheap debt capital. Debt is usually cheaper than equity because: The pre-tax rate of interest is lower than the return required by shareholders – top of creditor hierarchy. Debt interest can also be set against profits for tax purposes. The administrative and issuing costs are normally lower. Cost of equity A company’s cost of capital is a fundamental determinant of its market value, since its cost of capital is used as the discount rate in investment appraisal methods such as net present value and internal rate of return. A major determinant of a company’s cost of capital is its cost of equity, which can be found using either the Gordon model or the capital asset pricing model Determining the Cost of equity The level of return required by shareholders and debt holders will reflect the risk they face. Summary of the factors determining shareholders’ required rate of return. Optimal capital structure? The optimal capital structure debate addresses the question of whether or not a company can minimise its cost of capital by adopting a particular combination of debt and equity finance. Optimal capital structure Modigliani-Miller (1958) (MM) Miller and Modigliani’s first paper argued that a companys value was determined solely by its ‘investment decisions’ and so was independent of its financing policy. MM contended that, in a ‘perfect capital market’ the value of a company depended simply on its operating income stream and the degree of business risk attaching to this, regardless of the actual capital structure. Cont’d… The assumption that capital m