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Measuring Capital Structure

We have explained the formula for calculating the weighted-average cost of capital. We will now look at some of the practical problems in applying that formula. Suppose that the financial manager of Big Oil has asked you to estimate the firm`s weighted-average cost of capital. Your first step is to work out Big Oil`s capital structure. But where do you get the data?

Financial managers usually start with the company`s accounts, which show the book value of debt and equity, whereas the weighted- average cost of capital formula calls for their market values. A little work and a dash of judgment are needed to go from one to the other.

Table 4.11 shows the debt and equity issued by Big Oil. The firm has borrowed $200 million from banks and has issued a further $200 million of long-term bonds. These bonds have a coupon rate of 8 percent and mature at the end of 12 years. Finally, there are 100 million shares of common stock outstanding, each with a par value of $1.00. But the accounts also recognize that Big Oil has in past years plowed back into the firm $300 million of retained earnings. The total book value of the equity shown in the accounts is $100 million + $300 million = $400 million.

The figures shown in Table 4.11 are taken from Big Oil`s annual accounts and are therefore book values. Sometimes the differences between book values and market values are negligible. For example, consider the $200 million that Big Oil owes the bank. The interest rate on bank loans is usually linked to the general level of interest rates. Thus if interest rates rise, the rate charged on Big Oil`s loan also rises to maintain the loan`s value. As long as Big Oil is reasonably sure to repay the loan, the loan is worth close to $200 million. Most financial managers most of the time are willing to accept the book value of bank debt as a fair approximation of its market value.

What about Big Oil`s long-term bonds? Since the bonds were originally issued, longterm interest rates have risen to 9 percent.4 We can calculate the value today of each bond as follows.5 There are 12 coupon payments of .08 ГЧ 200 = $16 million, and then repayment of face value 12 years out. Thus the final cash payment to the bondholders is $216 million. All the bond`s cash flows are discounted back at the current interest rate of 9 percent.

Therefore, the bonds are worth only $185.7 million, 92.8 percent of their face value. If you used the book value of Big Oil`s long-term debt rather than its market value, you would be a little bit off in your calculation of the weighted-average cost of capital, but probably not seriously so.

The really big errors are likely to arise if you use the book value of equity rather than its market value. The $400 million book value of Big Oil`s equity measures the total amount of cash that the firm has raised from shareholders in the past or has retained and invested on their behalf. But perhaps Big Oil has been able to find projects that were worth more than they originally cost or perhaps the value of the assets has increased with inflation. Perhaps investors see great future investment opportunities for the company. All these considerations determine what investors are willing to pay for Big Oil`s common stock. In September 2001 Big Oil stock was $12 a share. Thus the total market value of the stock was

Number of shares ГЧ share price = 100 million ГЧ $12 = $1,200 million In Table 4.12 we show the market value of Big Oil`s debt and equity. You can see that debt accounts for 24.3 percent of company value (D/V = .243) and equity accounts for 75.7 percent (E/V = .757). These are the proportions to use when calculating the weighted-average cost of capital. Notice that if you looked only at the book values shown in the company accounts, you would mistakenly conclude that debt and equity each accounted for 50 percent of value.