All cash flows forecasted in the future have to be discounted back to obtain the present value. Cost of capital, an important value driver, is not only governed by business risk but also financial risk based on the capital structure of the company. To determine the cost of capital or discount factor one requires the following information.
What is Capital Structure ?
Capital Structure is the proportion of Debt and Equity in the Balance Sheet used to finance the operations of the company. All investments in businesses, whether investments in fixed assets or working capital, have to be financed. This is done through an appropriate mix of debt and equity called the Capital Structure.
The Cost of Capital or Weighted Average Cost of Capital (WACC) is the ninth step in the process of valuation. To calculate this, we need to learn capital structure, cost of debt, cost of equity, WACC and expected market returns. These are explained in Chapters 13 to 17.
Capital Structure should depend on the lifecycle of the company and type of industry it operates in
If you are a start-up, early growth, or a growth stage company then one can finance its growth through equity and if you are in mature growth or a mature company then financing should ideally be done through debt to increase returns to shareholders.
Capital Structure also depends upon the type of industry; for instance, for cyclical companies the cash flows are unpredictable so the financing should be done by equity to compensate for the business risk. Then there are banking and insurance companies where the business models require large amounts of debt.
Debt Equity Ratio
The Debt Equity Ratio is the ratio how the company expects to finance its growth. The Debt Equity Ratio should be computed based on market values and not book values, since investors demand returns on market valuation and not book value.
For example, if the book value and market value of debt and equity are as follows:
| Particulars |
Book Value |
Market Value |
| Debt |
500 |
500 |
| Equity |
500 |
1000 |
| Debt Ratio |
50% |
33% |
| Equity Ratio |
50% |
67% |
Thus, one should use 33% debt and 67% equity as the capital structure of the company to arrive at the discount rate.
Example for Computing Debt Equity of Black Bay Pizza
Continuing with the example of Black Bay Pizza, the debt is 1000 and market capitalization of Black Bay Pizza is 3000.
In Table 8, we compute the debt equity percentage to determine the weights allocated to debt and equity.
Table 8
| Debt |
1000 |
25% |
| Equity at Market Value |
3000 |
75% |
| Total |
4000 |
100% |
Market Capitalization or Estimated Valuation
Market Capitalization is the market value of a company's outstanding shares. This is calculated by multiplying a company's outstanding shares by the current market price of a share. In the case of private companies, one may use the estimated latest valuation of the company - usually the valuation as on the last round of funding or just an estimate.