19.1 Risk and Return, Leverage, and Cost of Capital

Risk and Return, Leverage, and Cost of Capital

Financial management within Management Services covers risk and return, financial and total leverage, the cost of each source of capital, the weighted average cost of capital (WACC), and capital structure decisions. The WACC computed here is the discount rate used in capital budgeting and the capital charge in residual income and EVA.

---

1. Risk and Return

• Expected return = sum of (possible return x probability).
• Standard deviation measures total risk (dispersion around the expected return).
• Coefficient of variation (CV) = standard deviation / expected return, which is risk per unit of return and is used to compare investments with different expected returns.

Project Y has the higher standard deviation, but it is less risky relative to its return because it has the lower CV.

Diversification eliminates unsystematic (diversifiable, firm-specific) risk; systematic (market) risk remains and is measured by beta. A beta of 1.0 moves with the market, above 1.0 is more volatile, and below 1.0 is less volatile.

Capital asset pricing model (CAPM):

$k_e = r_f + \beta\,(r_m - r_f)$

With a risk-free rate of 5%, a market return of 11%, and a beta of 1.2: k = 5% + 1.2(6%) = 12.2%. The term (r_m - r_f) is the market risk premium.

---

2. Financial and Total Leverage

Operating leverage (fixed operating costs) was covered under CVP analysis. Financial leverage comes from fixed financing costs (interest and preferred dividends).

Assume sales of PHP 2,000,000, variable costs of PHP 1,200,000, fixed operating costs of PHP 400,000, and interest of PHP 100,000.

A 10% increase in sales raises EBIT by 20% (10% x 2.0) and earnings per share by about 26.67% (10% x 2.667). If there are preferred dividends, DFL = EBIT / [EBIT - Interest - Preferred dividends / (1 - tax rate)].

---

3. Component Costs of Capital

Interest is tax-deductible, so debt is usually the cheapest source; preferred dividends are not deductible. New common equity costs more than retained earnings because of flotation costs. The example uses the 25% regular corporate income tax rate; smaller domestic corporations that qualify for the 20% rate would use 20%.

---

4. Weighted Average Cost of Capital

WACC weights each component by its share in the target capital structure, preferably at market values:

Marginal cost of capital (MCC) and break points. Once retained earnings run out, the firm must issue new shares at a higher cost. Break point = Amount of the cheaper source available / Its weight in the capital structure. With PHP 1,000,000 of retained earnings and a 50% equity weight, the break point is PHP 2,000,000 of total new capital. Beyond it, WACC rises to 2.40% + 1.00% + 50% x 13.89% = 10.35%. Projects are accepted in descending order of IRR until IRR falls below the marginal cost of capital.

---

5. Capital Structure Decisions

• Modigliani-Miller without taxes: capital structure does not affect firm value.
• Modigliani-Miller with taxes: the interest tax shield makes debt add value.
• Trade-off theory: the optimal structure balances the tax benefit of debt against financial distress and agency costs, and it minimizes WACC.
• Pecking order theory: firms prefer internal funds, then debt, and issue new equity last because of information asymmetry.

EBIT-EPS indifference point. Plan A is all equity with 100,000 shares; Plan B has 60,000 shares plus debt with PHP 200,000 of annual interest. Setting EPS equal (tax cancels out):

$\frac{\text{EBIT}}{100{,}000} = \frac{\text{EBIT} - 200{,}000}{60{,}000} \Rightarrow \text{EBIT} = \text{PHP }500{,}000$

Above PHP 500,000 of EBIT, the leveraged plan gives higher EPS; below it, the all-equity plan does.

---

6. Common Board Traps

• Use the after-tax cost of debt, but no tax adjustment for preferred or common equity.
• In the Gordon model, use D1 (next year's dividend): D1 = D0 x (1 + g).
• A lower CV means lower relative risk, even when the standard deviation is higher.
• Use target or market-value weights, not book values, unless the problem specifies book values.