More Capital Structure Tutorials
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Corporations need money daily to
finance their operating activities, embark on investment
activities and pay taxes, interest expense, etc. If you
recall the chapter on valuing
stocks, we said corporations can raise capital in
2 ways:
1) Bonds (debt financing)
2) Issue common and preferred shares
What if a corporation does both of
these? It can issue bonds (which are a source of debt)
and more common shares (which is a source of equity).
But what's the right mix between the two? How much debt
and how much equity should a company
carry? We answer this question next:
Note: The mix of bonds (debt) and common shares of a corporation
is known as its Capital
Structure.
The amount of debt and equity that
a company must maintain can be calculated via the WACC.
Weighted Average Cost of
Capital (WACC) is therefore an overall
return that a corporation MUST earn on its existing
assets and business operations
in order to increase or maintain the current value
of the current stock. For example, if Microsoft's
WACC is 15% and current stock price is 28$, then the company
must earn a 15% return on its existing assets and business
operations (net income) in order to MAINTAIN the stock
price at $28. The last thing that corporations would wish
to happen is their stock price falling down!
Weighted
Average Cost of Capital (WACC) Formula
The formula for WACC is:
[Rd
x D/V x (1-5)] + [Re x E/V]
Rd = Bond's yield
to Maturity (I/Y in Calculator)
D = Market Value (Present Value) of Bonds
(1 - t) = 1 - tax rate = Interest tax
shield deductibility of interest expense
Re = Shareholder's return requirement
V = Total value of all capital (Debt
+ Equity)
Weighted
Average Cost of Capital (WACC) Example
Coco Corp. has issued 10,000 units
of bonds that are currently selling at 98.5. The coupon
rate on these bonds is 6% per annum with interest paid
semi-annually. The maturity left on these bonds is 3 years.
The company has 2,000,000 common
shares outstanding with the current stock price at $10
/ share. The stock beta is 1.5, risk free rate for government
bonds is 4.5% and the Expected Return on the Stock Market
is 14.5%.
The tax rate for the corporation
is 30%
Bond
Calculations |
Stock
Calculations |
N = 3 x 2 = 6
I/Y = ? (Rd)
PV = 0.985 x 10,000 x $1000 = $9,850,000 (D)
PMT = (-10,000,000 x 0.06) / 2 = $-300,000
FV = $-10,000,000
P/Y = 2
C/Y = 2
Solution: I/Y = 6.56%
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Re = Rf + B[Rm - Rf]
Re = 0.045 + 1.5 [0.145 - 0.045]
Re = 0.045 + 0.15
= 0.195 (19.5%)
Market Value of Equity = E
Stock price x common shares O/S
$10 x 2,000,000 = $20,000,000 |
V = Total Capital Structure
V = 9,850,000 (bonds debt) + 20,000,000 (equity of common
shares)
V = 29,850,000
Summary of Important Terms
Rd = 6.56% = 0.0656
D = 9,850,000
V = 29,850,000
D/V = 9,850,000 / 29,850,000
Re = 0.195
E = 20,000,000
E/V = 20,000,000 / 29,850,000 = 0.67
(1-T) = (1 - 0.3) = 0.7
WACC
= [Rd x D/V x (1-5)] + [Re x E/V]
[(0.0656) (0.33) (0.7)] + [(0.195)
(0.67)]
= 0.01515 + 0.1307 = 0.1458
-> 14.58%
Interpretation of WACC
A WACC of 14.58% means Coco Corp.
must earn a return of 14.58% on all its assets and business
operations in order to MAINTAIN the current stock price
at $10 per share. If Coco Corp. wants its stock price
to go higher, it must achieve a return rate greater than
14.58%
