[MUSIC PLAYING] This is Dr. Bob Nolley. And today, we start to examine the nature of the capital structure of the firm. Capital structure is the way a business has elected to finance the assets it needs for operations. The two ways. It can do that are through issuing equity, such as common stock shares, and taking on debt, like bonds or other long-term debt.
Let's take a look at a simple example. Let's say a firm has sold $40 billion in equity and $120 billion in debt. We would say that the firm is 25% equity financed and 75% debt financed. This ratio, debt to total financing, 75% in this example, is also referred to as the firm's leverage. A note-- there could also be hybrid securities in the capitalization which have characteristics of equity and debt, such as preferred stock.
Now for an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. The cost of capital is the rate of return that the capital could be expected to earn on another investment of the same risk. For common stock, it's the required return on the stock. For bonds, it's the yield to maturity discounted for taxes.
Let's take a look at another example. We're going to use a web app here that does this calculation for us to calculate the weighted average cost of capital. We have a company here with $140 million in total debt and $50 million in equity.
Well, what's the cost of the debt? Well, the coupon payment is 6%. And what's the required rate of return from the market on the equity? 8%.
But we also have to take into account the corporate tax rate. Here, it's 40%. And the reason we do that is because the interest payments on our bonds, the debt, are tax deductible for corporate taxes.
So if the cost of our debt is 6% and the cost of equity is 8%, what do you think the weighted average cost of capital for this company might be? Well, it may surprise you. It is 4.758%, less than 5%.
This brings the question to manage but how much of the capitalization should be equity and how much should be debt. The fact that debt interest paid is not taxable is a tendency to favor debt. But the amount of leverage through debt could increase to the point where risk increases the required rate of return on the debt. So it raises the cost of credit.
So the decision rests on focusing on this trade-off when choosing how much debt and how much equity should be used in capitalization. Now it's reasonable to think that firms would use much more debt than they actually do in reality.
And the reason they do not is because of the risk of bankruptcy and the volatility that can be found in the credit markets. This volatility increases, particularly when a company tries to take on too much debt.
So let's review these important concepts of the capital structure. The capital structure is the amount of capitalization of the firm financed by equity and the amount financed by debt. There can be a presence of hybrid capitalization, as well.
The amount of debt used by a firm is characterized as its leverage. The cost of that can be lessened because interest payments are tax deductible. What advantage it gives can be lessened if the level of debt becomes too high, thereby raising the associated risk of bankruptcy.
This is Dr. Bob Nolley. And I'll see you in the next lesson.