There are a number of different ways in which a company can finance its operational asset requirements and its growth. Publicly listed companies acquire owners’ equity through ordinary share issues and by retaining profits. Whereas, debt financing is obtained via bank loans, bonds and debentures.
The best capital structure for a business usually consists of both equity and debt, which optimises the business’s market value and finances the operational assets, while minimising the cost of capital. Lowering the cost of capital helps to maximise the shareholders' wealth and increase the share value in the shares market.
Welcome to Topic 7: Capital Structure and Cost of Capital. In this topic, you will learn about:
- Capital structure
- Cost of capital
- Growth rate.
These relate to the Subject Learning Outcomes:
- Understand the role of the finance and accounting functions in an organisation.
- Identify the terminology and concepts that underlie the preparation of general-purpose financial reports.
- Apply mathematics of finance to determine risk, return, evaluation of investment, financing, working capital and distribution decisions.
- Develop analytical skills drawing from key finance theories, concepts and techniques.
Welcome to your pre-seminar learning tasks for this week. Please ensure you complete these prior to attending your scheduled seminar with your lecturer.
Click on each of the following headings to read more about what is required for each of your pre-seminar learning tasks.
Read Chapter 18 of the prescribed text - Melicher, RW & Norton, EA 2017, Introduction to finance: Markets, investments, and financial management, 16th edn., John Wiley & Sons, Inc.
Read the following journal articles:
- Arabzadeh, M 2012, 'A study on effects of cost-of-equity models on cost-of-capital and capital structure', Management Science Letters, 2(6):1855-1864.
- Barges, A 1962, 'The Effect of Capital Structure on the Cost of Capital', The Journal of Finance, 17(3):548.
- Myers, SC 2001, 'Capital structure', Journal of Economic Perspectives, 15(2):81-102.
Identify the key takeouts and add these to your reflective journal. You can access the reflective journal by clicking on ‘Journal’ in the navigation bar for this subject. If you are unsure of any concepts, reach out to your lecturer.
Read the following web articles:
- Tatum, M n.d., 'What Is the Relationship between Capital Structure and Cost of Capital?', Smart Capital Mind
- CFI, n.d., 'Cost of Capital', Corporate Finance Institute
Identify the key takeouts and add these to your reflective journal. If you are unsure of any concepts, reach out to your lecturer.
Read Section 18.8 on p. 565 of the prescribed text then consider Discussion question 3:
- Since its founding, Facebook has had very little long-term debt on its balance sheet. You have been hired as a consultant to Facebook's board. Explain if you would recommend a change in Facebook's capital structure policy—and why?
Make note of your answers in your reflective journal and be ready to share your reflections with the class during the scheduled seminar.
This topic has discussion forum activities, which will enhance your knowledge and give you the opportunity to interact with your peers. You can access the activities by clicking on the following links. You can also navigate to the forum by clicking on 'FIN100 Subject Forum' in the navigation bar for this subject.
Read and watch the following content.
Capital structure
The capital structure of a company is needed to determine the ideal value of the cost of capital of a company. Fundamentally, businesses commence with owners’ equity by financing their business assets. As time passes, when the business requires additional capital, management can choose whether to finance it with equity or with debt. Many factors must be considered before that decision can be made, such as:
- Cost of capital
- Control
- Government.
The following table provides details of each of these factors.
| Cost of capital | The expected return requirement of the acquired capital that can be satisfied with the generated revenue stream of the business. |
|---|---|
| Control | Whoever finances most of the company’s operating assets will have an advantage of influencing its decision-making process. Even though ordinary shareholders have more voting rights, preferred shareholders and debenture holders can convince the board of directors of particular decisions, if they finance a major part of the capital structure. |
| Government | Intervening government regulations and policies may cause companies to arrange their capital structures accordingly. |
The following figure summarises the financial position of a business, showing how the total assets of a business are financed by owners’ equity and liabilities (debt).
Financing with equity or liability
High-risk businesses, such as innovative, high-tech, mining and excavation industries, are usually predominantly financed by equity. In contrast, low-risk businesses with a stable revenue flow, tend to use debt financing. The reason being, high-risk industry businesses do not have guaranteed success for their investment, which is alarming for debt financing because it expects a low but steady periodic return on their investment, unlike owners’ equity.
Cost of capital
The cost of capital is dependent on the financial leverage of a business. As the norm, the required rate of return for equity is always higher than the required rate for debt financing, due to the risk absorbed by the owners.
The following formulas are used to calculate the required rate of return:
$$\begin{aligned}\mathsf{Required\;rate\;of\;return}&=\mathsf{minimum\;expected\;cash\;flow} \\ \mathsf{Minimum\;expected\;cash\;flow} &=\mathsf{owners’\;equity\;expected\;rate\;of\;return} + \mathsf{debt\;financing\;interest}\end{aligned}$$
Example:
A project with $1 000 capital requirement is financed by:
- $550 equity with a 15 % expected rate of return
- $450 debt with 8 % interest.
The cost of capital is calculated as follows:
$$\begin{aligned}\mathsf{Owners’\;equity\;expected\;rate\;of\;return}&=550\times15\,\%\\&=$82.50\\\\\ \mathsf{Debt\;financing\;interest}&=450\times8\,\%\\&=$36.00\\\\\ \mathsf{Minumum\;expected\;cash\;flow}&=82.50+36.00\\&=$118.50\\\\\ \mathsf{Required\;rate\;of\;return}&=\frac{118.50}{1\,000}\times100\\&=11.85\,\%\end{aligned}$$
As you can see, the total required rate of return (11.85 %) is in between the debt financing interest (8 %) and the owners’ equity expected rate of return (15 %).
Growth rate
The growth of a business can be measured in many ways, including:
- Revenue growth rate
- Seasonal growth rate
- Acquisition growth
- Earnings before interest and taxes (EBIT) growth rate.
With each of the previous measures, two (2) points in time are compared to determine any change in value. For example, comparing the current month with the previous month or by looking at the current month versus the same month last year.
As such, all of these measures are calculated using the following generalised formula:
$$\mathsf{Growth\;rate}=\frac{(\mathsf{current\;value}\,-\,\mathsf{previous\;value})}{\mathsf{previous\;value}}$$
Internal growth rate
The internal growth rate of a business measures how quickly a business can increase its asset base over the next year without raising outside funds. It does not measure divisional growth or break down total growth into domestic or international components. The internal growth rate gives a general, company-wide value (Melicher & Norton 2017, p. 579).
Internal growth rate can be calculated using either of the following formulas:
$$\begin{aligned}\mathsf{Internal\;growth\;rate}&=\frac{\mathsf{expected\;changed\;in\;retained\;earnings}}{\mathsf{total\;assets}}\\&\mathsf{or}\\\mathsf{Internal\;growth\;rate}&=\frac{\mathsf{RR}\times\mathsf{ROA}}{1-(\mathsf{RR}\times\mathsf{ROA})}\end{aligned}$$
Where:
- RR = retained rate
- ROA = return on assets.
Sustainable growth rate
Sustainable growth rate measures how quickly the business can grow when it uses internal equity and debt financing to keep its capital structure constant over time (Melicher & Norton 2017, p. 580). As the owners’ equity increases with retained earnings of a business, management raise debt financing to maintain the business’s debt-to-equity ratio at a continuous rate.
Sustainable growth rate can be calculated using the following formula:
$$\mathsf{Sustainable\;growth\;rate}=\frac{(\mathsf{RR})\times(\mathsf{ROE})}{1-(\mathsf{RR}\times\mathsf{ROE})}$$
Where:
- RR = retained rate
- ROE = return on equity.
Key takeouts
Congratulations, we made it to the end of the seventh topic! Some key takeouts from Topic 7:
- The capital structure of a business is determined by its cost of capital requirement.
- Cost of capital consists of the expected rate of return of owners’ equity and debt interest.
- Growth rate can be calculated by the general formula:
$$\mathsf{Growth\;rate}=\frac{(\mathsf{current\;value}\,-\,\mathsf{previous\;value})}{\mathsf{previous\;value}}$$
Welcome to your seminar for this topic. Your lecturer will start a video stream during your scheduled class time. You can access your scheduled class by clicking on ‘Live Sessions’ found within your navigation bar and locating the relevant day/class or by clicking on the following link and then clicking 'Join' to enter the class.
Click here to access your seminar.
The learning tasks are listed below. These will be completed during the seminar with your lecturer. Should you be unable to attend, you will be able to watch the recording, which can be found via the following link or by navigating to the class through ‘Live Sessions’ via your navigation bar.
Click here to access the recording. (Please note: this will be available shortly after the live session has ended.)
In-seminar learning tasks
The in-seminar learning tasks identified below will be completed during the scheduled seminar. Your lecturer will guide you through these tasks. Click on each of the following headings to read more about the requirements for each of your in-seminar learning tasks.
Watch the video, The Cost of Capital (Deric Business Class), which explains the concept of cost of capital and its implications to a business and to an investor.
Working in a breakout room team assigned by your lecturer during the scheduled seminar, discuss the following questions with your teammates. Your lecturer will request that you present the findings back to the class.
- How cost of capital increase or decrease a business's market value?
- Why debt capital is less expensive when compared to equity?
Read the following two (2) articles about Tesla and Toyota by Investopedia and Macroaxis.
- McDonald, TK 2021, Tesla Stock: Capital Structure Analysis, Investopedia
- Macroaxis 2022, Toyota Current Financial Leverage, Macroaxis
Share and discuss your findings with your teammates. Use the following questions to guide your discussion:
- Is Tesla’s capital structure different from Toyota? If so, how and why?
- As a investor what company would you choose to invest in, and why?
Welcome to your post-seminar learning tasks for this week. Please ensure you complete these after attending your scheduled seminar with your lecturer. Your lecturer will advise you if any of these are to be completed during your consultation session. Click on each of the following headings to read more about the requirements for each of your post-seminar learning tasks.
Knowledge check
Complete the following four (4) tasks. The following questions have been adapted from p. 574 of Melicher, RW & Norton, EA 2017, Introduction to finance: Markets, investments, and financial management, 16th edn., John Wiley & Sons, Inc.
Click the arrows to navigate between the tasks.
Knowledge check
Complete the following five (5) tasks. The following questions have been adapted from p. 581 of Melicher, RW & Norton, EA 2017, Introduction to finance: Markets, investments, and financial management, 16th edn., John Wiley & Sons, Inc.
Click the arrows to navigate between the tasks.
Read the instructions and requirements for Assessment 3 and familiarise yourselves with the client’s case. You can access the instructions by clicking “Assessment 3” in the navigation bar for this subject.
Each week you will have a consultation session, which will be facilitated by your lecturer. You can join in and work with your peers on activities relating to this subject. These session times and activities will be communicated to you by your lecturer each week. Your lecturer will start a video stream during your scheduled class time. You can access your scheduled class by clicking on ‘Live Sessions’ found within your navigation bar and locating the relevant day/class or by clicking on the following link and then clicking 'Join' to enter the class.
Click here to access your consultation session.
Should you be unable to attend, you will be able to watch the recording, which can be found via the following link or by navigating to the class through ‘Live Sessions’ via your navigation bar.
Click here to access the recording. (Please note: this will be available shortly after the live session has ended.)
- Fama, EF & MacBeth, J 1973, Risk, return and equilibrium: Empirical tests, Journal of Political Economy, 81:607-636.
- Pettengill, G, Sundaram, S & Mathur, I 1995, The Conditional Relation Beta and Returns, Journal of Financial Quantitative Analysis, 30:101-116.
References
- Arabzadeh, M 2012, A study on effects of cost-of-equity models on cost-of-capital and capital structure, Management Science Letters, 2(6):1855-1864.
- Barges, A 1962, The Effect of Capital Structure on the Cost of Capital, The Journal of Finance, 17(3):548
- CFI, n.d., Risk and Return, Corporate Finance Institute, https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/risk-and-return/
- Melicher, RW & Norton, EA 2017, Introduction to finance: Markets, investments, and financial management, 16th edn., John Wiley & Sons, Inc.
- Myers, SC 2001, 'Capital structure', Journal of Economic Perspectives, 15(2):81-102.
- Thakur, M n.d, Systematic Risk vs Unsystematic Risk, EDUCBA, https://www.educba.com/systematic-risk-vs-unsystematic-risk
