Hello again and welcome back to Corporate Finance Essentials too. We have a new topic today. We're going to talk about capital structure, it's a fundamental topic for any company for a very simple reason. A capital structure is how we finance the long term projects of the company and the goal of the capital structure. The goal of the combination of financial financial sources is basically to pay as little as possible. In terms of the return that you have to offer investors, and so you know when you're looking for financing when you're looking for money, of course you're going to go to the place where is the cheapest. Where you have to pay the least, and companies do exactly the same thing. That's exactly what capital structure is all about, so we're going to start with a quick introduction, and then we're going to look at a specific case. So capital structure, by definition, is basically what are the first sources of financing that we use you could use. Only equity you can use debt and equity. You can use debt and equity and preferred stock. You can use debt and equity and preferred stock and convertible debt. There is a very large number of instruments that you can use to finance a long-term activities of a company. And the capital structure of a company is the proportion in which you use those sources of financing. So you have from the simplest possible case which is a company fully financed by equity to more complicated companies that actually use several sources of financing. And their capital structure would be, which are those sources of financing? And what is the proportion in which each one of those is actually used? So as you see, this is a topic that sometimes as people say, well, this is related to the right hand side of the balance sheet. That is to the liabilities of the company, because that is where you have the sources of financing as opposed to the left hand side of the balance sheet where you have the assets of the company. This is a right hand side topic if you will. Now capital structure is not only finding what are the right instruments that we can use to finance the long term projects of the company, but also to find the right proportions. Should we have if we stick to debt and equity so we have 10% debt, 90% equity or should we have 50-50 as a proportion? Well that's exactly what capital structure is all about. If you remember in our previous course we talked about the cost of capital. And when we talked about the cost of capital at that point in time, we took the capital structure pretty much as given, meaning that we observed how much that the company had. We observed how much equity the company had. We observed the market values of those two, and we calculated the proportions. So we didn't think whether those were the right proportions. We simply used the proportions that were there in the capital structure of the time. Well, capital structure is coming up with those proportions. But in the best possible way, meaning and again will get into the details in just a second. But that meaning how we minimize the cost of capital so those two proportions that we use in the cost of capital, they're not random numbers. The usually very carefully plan numbers for any company with a very specific goal which is lowering as much as possible the cost of financing. And again I insist on the word long term projects of the company were not going to be looking at short term debt. We are going to be looking at how companies finance the day-to-day activity. We are looking at basically how companies finance their long-term project. Now what do we mean by best combination is basically the cheapest combination for you. The best bank from which to borrow money will be the one that gives you the lower rate or the lowest rate. Well the same thing is for companies. What we mean by the optimal proportion by the best proportion of debt and equity or any proportion of any financial instruments is the one that gives me the minimum cost of capital. And we're going to look at an example a few minutes from now. But the key question in capital structure is double. Number one, what instruments should I use? Should I use only equity? Should I add debt? Should I add prefer stock? Should I add convertible debt? So first we need to look at the possibilities and then we need to, once we say we're going to be using this one and this one or this one's. Then we need to look at the proportions and we're going to find the optimal capital structure. When we minimize the cost of capital, we have those two and let's for the sake of the argument thing in terms of debt and equity. When we find the proportion of debt in the proportion of equity that lead me to the minimum possible cost of capital now and I'm going to remind you this a little bit later. But remember, if you put in the back of your head, the expression of EVA, the economic value added expression we had, there's two ways of expressing that. But one was capital multiplied by return on capital minus the cost of capital. So think about it, if everything else is equal and you manage to lower the cost of capital, then you will be increasing the EVA, meaning you will be creating more value. So another way of saying the same thing is that regardless of what the companies do in terms of producing in terms of selling from the financial side of the company. You can always increase its value by lowering the cost of capital. That's important that you keep in mind because when we think about how to create value for shareholders? We always focus on producing more efficiently or selling things that people really want to buy or increasing prices or increasing the markets in weeks. We expand and sell products and so forth. Well, another way of creating value is simply to find the cheapest possible way to finance all those activities for the company. So we have, i'll get back to the left hand side in just a second. Let's go to the right hand side. We have the corporate tax rate, that's the statutory number and may be very different across. All the countries where you guys come from, we have the Xs, XD and XE, the proportions of total capital that we're using of debt, and the proportion of total capital that we're using an equity. And then we have the Rs, RD and RE are the required return on each of these two instruments. RD is the required return on debt and RE is the required return on equity. Now if you for get about the (1-Tc) for just a second. What you have on the right hand side, is basically a weighted average of require returns. Which means that the left hand side must be a required average also that is required return also. So that way I like to put instead of just the WACC, I like to put the RWACC to remind people that this is an an average of require returns and by definition it also has to be a require return. You can call it the required return on capital if you will, although what some people call return on capital is different from the WACC expression that you have there. But be that as it may, remember that because the cost of capital is an average of require returns, then we can call that the RWACC and require return capital too. And that require return capital, now if we go back and use that notation, an optimal capital structure would be finding the XD on the XE. The proportions that we need to use of debt and equity in order to come up with a minimum possible WACC or or RWACC. Which is basically that cost of capital, and although we will not go back into those details now. But remember that the typical way of thinking about the required return on equity on the right hand side. That's what we use the CAPM4 to come up with a number which depends on the beta of the equity, of the company that we're dealing with. So that was a quick timeout more than anything else, to remind you of the notation. And now we're going to proceed with exploring a little bit further the issue of capital structure.
