BUS202 Study Guide

7a. Explain the components of a company's capital structure

• What is capital?
• What are the major sources of a firm's capital?
• What does the term "capital structure" mean?

Firms have two sources of capital (the funds or financial resources that companies use to finance their operations, investments, and growth): debt and equity, or some variation of those two. Firms finance all of their activities with capital. Capital is not free. There is a cost to obtain and use it, which is represented normally by the interest rate charged. If you recall, an interest rate is nothing more than a price paid for money.

The major components of a company's capital structure (the specific mix or combination of debt and equity financing that a company uses to fund its operations and growth) are common stock, preferred stock, long-term debt, and short-term debt. Common and preferred stock are equity. Long-term and short-term debts are liabilities. There are different costs to each form of capital. Each firm has different percentages of its capital financed by each source. It is possible that a firm is all-equity and has no cost for liability financing. The WACC aims to match the capital source with the cost.

Review

To review, see:

• Introducing Capital Structure
• Basic Capital Structure Differences
• Capital Structure Considerations
• Cost of Capital

7b. Explain the Modigliani-Miller theorem in finance

• What is the Modigliani-Miller theorem?
• What assumptions must hold for the theorem to apply?
• What are the two primary propositions of the M&M theorem, and how do they differ?

Even using the WACC computation within finance, capital structure is not the primary determinant of a firm's value. The Modigliani-Miller (MM) Theorem states that capital structure does not determine a firm's value. The MM Theorem states that the value of a firm is based on its earning power and that that value is not affected by how a firm finances itself with debt or equity. Essentially, financing decisions are irrelevant to firm value.

In addition, the theorem also states that a firm's cost of equity increases with its debt-equity ratio. The MM Theorem holds this as true given the following assumptions: no transactions costs for financial transactions, equal borrowing costs for companies and investors, the firm responsibly invests excess cash, debt financing does not affect earnings before interest and taxes (EBIT) (a measure of a company's operating profitability that shows how much profit the company generates from its core business operations before accounting for interest expenses and tax payments), and firms and investors have access to the same information (there is no asymmetric information).

While Proposition I states that "In a world without taxes, bankruptcy costs, or asymmetric information, the value of a firm is independent of how it is financed", Proposition II states that "As a firm increases its leverage (debt), the required return on equity increases linearly to compensate equity holders for additional financial risk". In summary, the propositions argue that debt financing can change the risk and return profile for investors but does not increase the firm's total value in a perfect market.

Review

To review, see:

• Introducing Capital Structure
• Capital Structure Considerations
• Cost of Capital

7c. Compute the market and book value of a company

• What is market value?
• What is book value?
• What are the pros and cons of each valuation method?

There are many ways to assess the value of a company. The most common methods are market value and book value. Market value is the value communicated by the information available in financial markets, such as stock price, the number of shares of stock a firm has in the market, and investor sentiment.

The market capitalization or market value of a publicly traded company equals the price of one share of the company's stock times the total number of shares of stock the company currently has in the stock market. It is presumed that market value can be less stable and more reactionary depending on economic conditions and investor expectations; however, it is a more immediate and readily available indicator of the value of a firm. There is also an alternate way to compute a firm's market value using a firm's assets as the basis.

In contrast, a company's book value is primarily derived from an analysis of a company's financial statements. The balance sheet is the guiding financial statement used to assess book value. The value of the assets is used as the company's book value.

The biggest criticism of a company's book value is that it is said to represent the historical value of a company because balance sheet assets are recorded at the prices paid when the asset is acquired. Over time, the value of an asset can increase or decrease, and this change in value is not always captured on the balance sheet unless the asset is sold for a gain or loss. For example, if a firm owns land (an asset that normally appreciates), the purchase price of the land appears on the balance sheet, not any gains in that land's value unless the land is sold and the cash from the sale of the land is recorded. Fixed assets like a plant, property, and equipment will age.

Although depreciation is recorded on the balance sheet, the value attributed to depreciation might not be sufficient to cover the replacement cost of acquiring a new asset to replace one that has aged beyond use. It is also possible that the book value of the equipment underestimates the true value of the equipment because it doesn't account for the salvage value. An asset's salvage value is the amount realized from the sale of the used equipment when the firm has no further use for the equipment. To attempt to account for the intricacies of interpreting book value, some assets may be valued using a separate analysis and then added back to the firm's book value, or a premium on the existing book value can be added to or subtracted from the firm's total asset value on the balance sheet.

Review

To review, see:

• Introducing Capital Structure
• Market Capitalization
• Market Value of Assets
• Capital Structure Considerations
• Cost of Capital

7d. Apply the WACC formula for estimating a company's cost of capital

• What is capital?
• What is the weighted average cost of capital (WACC)?
• What is the basic formula for calculating WACC?

Capital refers to the financial resources a company uses to fund its operations and growth. This includes equity capital (money raised from shareholders via ownership) and debt capital (money borrowed through loans or bonds).

Often used to invest in assets, pay for day-to-day operations, or expand the business, the weighted average cost of capital (WACC) is a concept and formula designed to identify a firm's sources of capital and its cost for each form of capital to determine the overall average cost of capital a firm pays across all sources.

Use this problem to practice computing the WACC.

The formula to compute the weighted average cost of capital is given by WACC = (% of debt)(Before-tax cost of debt)(1−T) + (% of preferred stock)(cost of preferred stock) + (% of common stock)(cost of common stock)

Use this formula to compute the WACC for this example:

A firm has $1,500,000 in debt and $1,000,000 in equity, for a total value of $2,500,000. Its cost of debt is 10%, and its cost of equity is 2%. Its tax rate is 35%. What is this firm's WACC? Remember that in this problem, the firm has no preferred stock.

w_dr_d(1 − T): (1,500,000/2,500,000)(.10)(1 - .35) = 0.039
w_psr_ps:    (0/2,500,000) (0) = 0
w_sr_s: (1,000,000/2,500,000) (.02) = 0.008

WACC = .039 + 0 + .008 = 0.055 or 5.5%

Review

To review, see:

• Cost of Capital
• Calculating the Costs of Capital

Unit 7 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

• book value
• capital
• capital structure
• earnings before interest and taxes (EBIT)
• market capitalization
• market value
• Modigliani-Miller (MM) Theorem
• salvage value
• weighted average cost of capital (WACC)