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Capm The Cost Of Capital And Capital Structure Finance Essay

This essay intends to explain the meaning of companies capital structure, the cost of capital which is the opportunity cost of the different types of a company’s capital structure and the capital asset pricing model (CAPM) used in the calculation of the expected return of a company. Six (6) companies from the Non-Cyclical Consumer Goods and Services sector, were selected from the US stock market (S&P 500), they include; Unilever PLC, and Nestle India Limited from the Food Processing industry, United Breweries Limited, Molson Coors Brewing Company and the Millennium Beer Industries Ltd from the Beverage-Brewers industry and finally, R.E.A Holdings Plc from the Fishing/Farming industry. The beta, total debt and equity of these selected companies would be analyzed to determine their financial structure.

The essay is divided into two parts; Capital Structure Appraisal and the Academic Commentary. The first part discusses capitalization choices made by these companies and the cost of their options. In the Academic Commentary, the Modigliani-Miller Theorem will be discussed.

Capital Structure Appraisal

The capital structure of a firm contains the various financing methods a company intends to utilize to finance its various projects and operations, this could be inform of debt, equity or the combination of both, including all other forms of capital. Some factors considered in the process of selecting the appropriate capital structure of a company are; the cost of capital, the expected return and risk involved.

Cost of capital as defined by Brealey and Meyers (2003) is the opportunity cost of capital for a firm’s existing assets; used to value new assets that have the same risk as the old ones. He further explained, that the cost of capital can be thought as the expected return on an hypothetical portfolio and, can be calculated by taking the weighted average of the expected return on debt and equity.

However, the CAPM theory provides explicit hypotheses about the relative structure of security prices, based on the expectations about the returns to investors in securities and is now regarded as the dominant valuation model (Cragg and Malkiel, 2009). In addition, Pratt et al (2000) defines The CAPM as a conceptual cornerstone of modern capital market theory. Its relevance to business valuations is that businesses and business interests are a subset of the investment opportunities available in the total capital market; thus, the determination of the prices of businesses theoretically should be subject to the same economic forces and relationships that determine the prices of other investment assets.

In order to further understand the concept behind the CAPM, cost of capital and capital structure as a whole, a group of seven companies from the US Stock market (S&P 500) were selected, considering their beta, total debt and equity. These selected companies are from the Non-Cyclical Consumer Goods and Services industry. They are presented in the Table 1 below:

Table 1: Showing the Beta and Total Debt to Equity of Selected Companies from the US Stock Market

Company

Beta

Total Debt to Equity

Unilever PLC

0.64

78.06

Nestle India Limited

0.45

-

United Breweries Limited

1.15

-

Molson Coors Brewing Company

0.77

19.03

Millennium Beer Industries Company

1.36

-

R.E.A Holdings PLC

1.11

55.52

Data culled from http://uk.reuters.com/business

To discuss the capital structure and financing via debt and equity issuance of the above companies, one has to understand the intent behind the choices made by a company managers. Hubbard (2009) presumes that the manager seeks to maximize firms’ value; he further explains that the funds can be obtained from several sources, each potentially having different effects on firm value. Choices are distinguished by the type of contingent financial claim (debt or equity) and by the provider of funds (private or publicly marketed sources). He estimated both choice models, with the two different variance restrictions.

These two models are illustrated in Figure 1, as choice tree 1 and choice tree 2. Hubbard (2009) explains the model; “The first model, tree 1, has the interpretation that firms choose whether to use public or private sources, and then from one of those branches choose either debt or equity. The second model has the firm choosing debt or equity first, then deciding from what provider to obtain the funds”.

Figure 1: Financial decision trees (Hubbard, 2009)

In Table 1 it can be denoted from the presented data, that Unilever PLC, Molson Coors Brewing Company and R.E.A Holdings PLC have a capitalization structure of debt and equity, while Nestle India Limited, United Breweries Limited and Millennium Beer Industries Ltd can be said to be equity-financed and, this is reflected in their individual betas.

Pratt and Niculita (2007) explain “The beta is a function of the excess expected return on an individual security relative to the excess expected return on the market index. By “excess return,” we mean the return over and above the return available on a risk-free investment (e.g., U.S. Treasuries). In fact, practitioners and many published data sources estimate this forward-looking risk measure (beta) by calculating the historical relationship observed between the return on an individual security and the return on the market as measured by a broad market index such as the Standard & Poor’s 500 Stock Composite Index. For the market index as a whole, the average beta, by definition, is 1.0. If a stock tends to have a positive excess return greater than that of the market when the market return is greater than the risk-free return and, a more negative excess return than that of the market when the market return is less than the risk-free return, then the stock’s beta is greater than 1.0”.

This can therefore, indicates the relationship between beta of a company and the industry as a whole. Table 2 below presents the individual industry betas and total debt to equity of the selected companies.

Table 2: Showing the Beta and Debt to Equity for the Industries.

INDUSTRY

BETA

TOTAL DEBT/EQUITY

Food Processing Industry

0.64

37.27

Beverage-Brewers

0.79

58.02

Fishing/Farming

0.92

80.41

Source: http://uk.reuters.com/business

Stocks with betas greater than 1.0 tend to amplify the overall movements of the market. Stocks with betas between 0 and 1.0 tend to move in the same direction as the market, but not as far. (Brealey and Meyers, 2003)

According to Pratt and Grabowski (2008), published and calculated betas for public stocks typically reflect the capital structure of each respective company at market values. These betas sometimes are referred to as levered betas, betas reflecting the leverage in the company’s capital structure. Levered betas incorporate two risk factors that bear on systematic risk: business (or operating) risk and financial (or capital structure) risk. Removing the effect of financial leverage leaves the effect of business risk only. The unlevered beta is often called an asset beta. Asset beta is the beta that would be expected were the company financed only with equity capital. When a firm’s beta estimate is measured based on observed historical total returns (as most beta estimates are), its measurement necessarily includes volatility related to the company’s financial risk. In particular, the equity of companies with higher levels of debt is riskier than the equity of companies with less leverage (all else being equal).

Furthermore, in order for an investor to select the most efficient portfolio, different valuation ratios are used to evaluate the prospective companies in regarding their various financial parameters, such as risk, price size, growth, etc. These ratios include Price-to-Earnings (P/E) Ratio, Price-to-Book (P/B) Ratio, Price-to-Sales (P/S) Ratio, etc. For the sake of evaluating the selected companies in this essay, the Price-to-Earnings (P/E) would be used, although, it has its limitations. Below is Table 3, which contains the selected companies and their Price-to-Earnings Ratio.

Table 3: Showing the Price-to-Earnings Ratio of Selected Companies from the US Stock Market

Company

Beta

Price-to-Earnings Ratio (P/E)

Unilever PLC

0.64

15.35

Nestle India Limited

0.45

50.57

United Breweries Limited

1.15

-

Molson Coors Brewing Company

0.77

11.84

Millennium Beer Industries Company

1.36

-

R.E.A Holdings PLC

1.11

12.33

Source: http://uk.reuters.com/business

Walton and Aerts (2009) points out that P/E involves an amount not directly controlled by the company, that is, the current market price of an ordinary share. They explain, that it reflects how the market judges the company’s performance. Basically, a high P/E ratio indicates that investors expect that the company’s earnings will grow rapidly. Growth expectations will be linked to the industry to which the company belongs.

Academic Commentary

An investor desire is to increase return from investing in a company’s security. A well diversified portfolio can be said to be a combination of securities with risk that offset each other. The Modigliani and Miller Theorem propose two scenarios that explain this;

Proposition I state that in a perfect market any combination of securities is as good as another. The value of the firm is unaffected by its choice of capital structure. Brealey and Meyers (2003) further explains that this can be seen by imagining two firms that generate the same stream of operating income and differ only in their capital structure. Firm U is unlevered. Therefore the total value of its equity is the same as the total value of the firm. Firm, L, on the other hand, is levered. The value of its stock is, therefore, equal to the value of the firm less the value of the debt: EL=VL-DL.

Considering the data in Table 1, it can be said that if the companies that are all equity financed decides to issue debt to repurchase equity, their value of debt will increase from zero and subsequently will lead to the value of equity decreasing. Notice how these changes complement each other, in such a way that the financial structure of the company remains the same.

Preposition II states that the expected rate of return on the common stock of a levered firm increases in proportion to the debt–equity ratio (D/E), expressed in market values; the rate of increase depends on the spread between rA , the expected rate of return on a portfolio of all the firm’s securities, and rD , the expected return on the debt. Here rE=rA if the firm has no debt (Brealey & Meyers, 2003). This can be expressed in the formula:

rE = rA + D (rA-rD)

E

Relating this to the selected companies presented in Table 1, one can say that the return on Unilever Plc, Molson Coors Brewing Company and R.E.A Holdings PLC increases in proportion to the debt-equity ratio in the security market values.

In addition, Friedman (2009) says that the Modigliani-Miller (without agency costs) models, causes the supply curve to be perfectly elastic in the market and hence firms are willing to substitute debt and equity financing indefinitely on the same terms. Asset characteristics are incapable of altering this terms of trade, and no firm is unique in the terms it is willing to offer to substitute one form of financing for another. Hence, firm-specific factors play no role in capital structure determination.

Brealey and Meyers (2003) says “Modigliani-Miller opponents, the “traditionalists,” argue that market imperfections make personal borrowing excessively costly, risky, and inconvenient for some investors. This creates a natural clientele willing to pay a premium for shares of levered firms. The traditionalists say that firms should borrow to realize the premium. But this argument is incomplete. There may be a clientele for levered equity, but that is not enough; the clientele has to be unsatisfied. There are already thousands of levered firms available for investment...Proposition I is violated when financial managers find an untapped demand and satisfy it by issuing something new and different. The argument between Modigliani-Miller and the traditionalists finally boils down to whether this is difficult or easy. We lean toward Modigliani-Miller’s view: Finding unsatisfied clienteles and designing exotic securities to meet their needs is a game that’s fun to play but hard to win”

In conclusion, the reason why firm’s still raise capital by equity issuance when debt is cheaper, can be said to be as a result of different factors, one of which is the risk (beta on debt) associated with debt, as it has been explained in this essay that, the capital structure of a company financed with the combination of debt and equity, increases the risk of the company, although it should be noted that at the same time it increases the expected rate of return, which is the main desire of any given firm, to increase return from investments.

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