Cost of Capital & Capital
Structure
9-1
,Learning Objectives
At the end of this session you should be able to:
▪ Calculate the required returns on equity, preference shares
and debt
▪ Calculate the WACC and explain when it is appropriate to use
it
▪ Explain the theories of Modigliani and Miller
▪ Understand the impact of corporation tax and costs of financial
distress
▪ Discuss the trade-off and pecking order theories of capital
structure
9-2
,Positive NPV?
Consider the following project:
Year 0 1 2 3
Cash flow (£m) -13 3 4 9
At r = 5% NPV = +£1.3m
At r = 15% NPV = -£1.5m
Which r should we use?
9-3
, The Providers of Capital
▪ The overall cost of capital for the firm depends on
the rate of return investors require, to be willing to
provide capital in the first place
▪ The return investors will demand will depend on the
risk they are exposed to:
▪ Ordinary shareholders – Highest Risk, Highest Return
▪ Preference shareholders – Medium Risk, Medium Return
▪ Bondholders – Lowest Risk, Lowest Return
9-4
Structure
9-1
,Learning Objectives
At the end of this session you should be able to:
▪ Calculate the required returns on equity, preference shares
and debt
▪ Calculate the WACC and explain when it is appropriate to use
it
▪ Explain the theories of Modigliani and Miller
▪ Understand the impact of corporation tax and costs of financial
distress
▪ Discuss the trade-off and pecking order theories of capital
structure
9-2
,Positive NPV?
Consider the following project:
Year 0 1 2 3
Cash flow (£m) -13 3 4 9
At r = 5% NPV = +£1.3m
At r = 15% NPV = -£1.5m
Which r should we use?
9-3
, The Providers of Capital
▪ The overall cost of capital for the firm depends on
the rate of return investors require, to be willing to
provide capital in the first place
▪ The return investors will demand will depend on the
risk they are exposed to:
▪ Ordinary shareholders – Highest Risk, Highest Return
▪ Preference shareholders – Medium Risk, Medium Return
▪ Bondholders – Lowest Risk, Lowest Return
9-4
