Capital Structure

By M. Isi Eromosele

There is a cost of doing business that must serve as your benchmark for how you invest in long-term assets. This cost is called Cost of Capital. Cost of Capital is the rate you pay who invests money in your business.

You can think of Cost of Capital as the rate of return investors require for incurring risk whenever they invest in your company. Cost of Capital applies to long-term funding of assets as opposed to short-term funding of working capital.

Why is Cost of Capital so important? It is so because you have to earn an overall rate of return on your assets that is higher than your cost of capital. If not, you end-up destroying

value. So how do you calculate Cost of Capital?

The most popular approach is called the Capital Asset Pricing Model or CAPM. CAPM estimates your cost of equity by taking a risk free rate and adjusting it by risks that are unique to your company or industry. Long-term government bonds are often used to estimate risk free rates while overall market premiums run around 6%.

CAPM is not perfect since it has many unrealistic assumptions and variations in estimates. For example, sources (Bloomberg, S & P, etc.) for reporting market risks of specific companies provide very different estimates. Additionally you might find simple estimates are just as accurate as CAPM.

For example, simply adding 3% to your cost of debt may provide a reasonably accurate estimate of your cost of capital. You can also look at companies that are very similar to your company. In any event, you need to calculate your cost of capital since it is an extremely important component in your financial management decision making.

Calculating Weighted Average Cost of Capital

Weighted Average Cost of Capital (WACC) is the overall costs of capital. WACC is

based on your current capital structure. Market values are used to assign weights to

different components of capital.

It should be noted that market weights are preferred over book value weights since market values more closely reflect how you raise your capital. Market weights are calculated by simply dividing the market value for each component by the sum of market values for all components.

Capital Structure Theory

The theory behind capital structure is to find the right mix of long-term funds that minimizes the costs of capital and maximizes the value of the organization. This ideal mix is called the optimal capital structure. It can be argued that an optimal capital structure really doesn't exist since changing the mix of capital will not change values.

However, four approaches can be used to find the optimal capital structure. They are Net Operating Income (NOI), Net Income (NI), Traditional, and Modigliani-Miller.

The NOI approach holds that costs of capital is relatively the same regardless of the degree of leverage. The NI approach takes the opposite view; costs of capital and market values of companies are affected by the use of leverage.

The Traditional Approach is a mix of both the NOI approach and the NI approach. Finally, the Modigliani-Miller view is that costs of capital and market values are independent of your capital structure.

In practice, there are lots of factors that influence capital structure. They include growth in sales, asset composition, risk attitudes within the organization, etc. The best approach seems to be to focus on a range of capital structures in managing the organization.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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