Cost of Capital & Capital Structure: Weights, Trade-offs & Optimal Mix

Core Concepts

1. Cost of Capital: The Price of Funds

The cost of capital is the minimum return a firm must earn on its investments to satisfy all its investors (debt holders, equity shareholders, and retained earnings). It represents the opportunity cost of using funds.

Types of Cost of Capital

Why does this matter?

• Firms must earn more than their cost of capital to create value.
• Debt is cheaper than equity (due to tax shields), but too much debt increases risk.

2. Weighted Average Cost of Capital (WACC)

WACC is the average cost of all financing sources, weighted by their proportion in the capital structure.

Formula

$$WACC=\left(\frac{E}{V}\times k_e\right)+\left(\frac{D}{V}\times k_d\times (1-T)\right)+\left(\frac{P}{V}\times k_p\right)$$ Where:

• $E$ = Market value of equity
• $D$ = Market value of debt
• $P$ = Market value of preferred stock
• $V=E+D+P$ = Total capital
• $T$ = Corporate tax rate

Worked Example: Kathmandu Hotel’s WACC

Given:

• Equity ($E$) = Rs 5,000,000; $k_e=15\%$
• Debt ($D$) = Rs 3,000,000; $k_d=10\%$; Tax rate ($T$) = 25%
• Preferred stock ($P$) = Rs 500,000; $k_p=12\%$

Step 1: Calculate weights $$\frac{E}{V}=\frac{5,000,000}{8,500,000}=58.82\%$$ $$\frac{D}{V}=\frac{3,000,000}{8,500,000}=35.29\%$$ $$\frac{P}{V}=\frac{500,000}{8,500,000}=5.88\%$$

Step 2: Plug into WACC formula $$WACC=(0.5882\times 15\%)+(0.3529\times 10\%\times 0.75)+(0.0588\times 12\%)$$ $$WACC=8.82\%+2.65\%+0.71\%=\ast \ast 12.18\%\ast \ast$$

Interpretation: Kathmandu Hotel must earn at least 12.18% on its projects to satisfy all investors.

In the Real World

1. Nepal Investment Bank’s Loan Decisions

   • Banks like NIBL use WACC to decide whether to lend to hotels (e.g., Hotel Yak & Yeti).
   • If a hotel’s expected return > WACC, the bank approves the loan.
   • Example: If a hotel’s expansion project yields 14%, but its WACC is 12%, the bank sees it as a safe investment.

2. Daraz’s Inventory Financing

   • E-commerce firms like Daraz use short-term debt (trade credit) to fund inventory.
   • Their capital structure balances cheap debt (supplier credit) with equity to avoid over-leveraging.
   • Trade-off: Too much debt risks insolvency if sales drop (like in the 2020 COVID-19 slowdown).

3. Ncell’s Dividend Policy

   • Telecom firms like Ncell pay dividends to shareholders but must ensure their cost of equity ($k_e$) is covered.
   • If they pay too much, their stock price may fall (as seen in 2023 when Ncell cut dividends due to high debt costs).

Capital Structure: The Optimal Mix

Capital structure refers to the proportion of debt, equity, and retained earnings a firm uses to finance operations.

Key Theories

Factors Affecting Capital Structure

mindmap
  root((Factors Affecting Capital Structure))
    Business Risk
      Industry volatility
      Operating leverage
    Financial Flexibility
      Ability to borrow
      Covenants (debt restrictions)
    Growth Opportunities
      High growth → More equity
      Low growth → More debt
    Tax Considerations
      Interest tax shield (debt is cheaper)
    Cost of Capital
      Cheaper debt → More leverage
    Control
      Equity issuance dilutes ownership
    Market Conditions
      Low interest rates → More debt
      High stock prices → More equity

Real-World Application: NEPSE-Listed Hotels

Optimal Capital Structure: The Trade-off Theory

The trade-off theory suggests firms balance:

1. Tax benefits of debt (cheaper cost of capital).
2. Bankruptcy costs (too much debt increases risk).

Worked Example: Should Hotel Everest Use More Debt?

Given:

• Current capital structure: 70% Equity, 30% Debt
• Current WACC = 14%
• If debt increases to 50%, WACC drops to 12% (due to tax shield).
• But bankruptcy risk rises, increasing $k_e$ to 18%.

Analysis:

Decision:

• If bankruptcy costs < tax savings, increase debt.
• If bankruptcy risk is too high, stick with current mix.

Exam Tip

What Examiners Want to See

1. WACC Calculation

   • Always use market values, not book values.
   • Remember: Debt cost is after-tax ($k_d\times (1-T)$).
   • Common mistake: Forgetting preferred stock in the formula.

2. Capital Structure Trade-offs

   • Explain why firms choose debt vs. equity (taxes, risk, control).
   • Use real examples (e.g., "Nepal Investment Bank prefers debt for tax shields").

3. Numerical Problems

   • Break down steps (weights → WACC → interpretation).
   • Label all variables clearly (e.g., $E,D,k_e,k_d$).

4. Theories

   • MM Proposition II is often tested—know how $k_e$ changes with debt.
   • Trade-off theory is key for optimal capital structure questions.

Past Exam Pitfalls

• ❌ Using book values instead of market values in WACC.
• ❌ Ignoring tax effects on debt cost.
• ❌ Assuming all debt is good (forget bankruptcy risk!).

Summary Table: Key Formulas