Lecture 9-Cost of Capital & Capital Structure Flashcards
What are the providers of capital?
- depends on the rate of return investors require, to be willing to provide capital in the first place
- The return investors will demand will depend on the risk they are exposed to:
Ordinary shareholders – Highest Risk, Highest Return
Preference shareholders – Medium Risk, Medium Return
Bondholders – Lowest Risk, Lowest Return
What to use as a provider of capital?
On average, of all new funds used each year:
~50% comes from retained earnings
~35% comes from debt
~15% comes from equity
What are retained earnings?
is the amount of net income left over for the business after it has paid out dividends to its shareholders
What are the advantages of retained earnings?
- No dilution of ownership i.e. ownership decrease when a new equity is introduced
- No issuing costs
- No nee to explain how the funds will be used.
What are the disadvantages of retained earnings?
- Uncertain may not be enough
- Managers may think that it is ‘free’ capital its not as shareholders are foregoing dividends
- Equity holders will expect the same return on retained earnings, as on the rest of their investment
What are the advantages of debt for the company?
- Cheaper than equity due to lower issuing costs, lower rate of return
- Fixed payments, don’t change irrespective of profits, easy to plan
- No loss of control (bondholders have no votes)
- Tax advantages
What are the advantages of debt for the investors?
- Low risk
- Guaranteed income each year (From coupon)
What are the disadvantages of debt for the company?
Has to be repaid
Usually involves regular cash flows which can’t be avoided
Non-payment can force the company into liquidation
Too much debt is considered harmful
What are the disadvantages of debt for the investors?
Because they are low risk they only offer a low return
Limited upside, do not share in any abnormal returns
No voting rights
What is equity?
-degree of ownership in any asset after subtracting all debts associated with that asset.
Equity represents the shareholders’ stake in the company.
What are the advantages of equity for company?
- No principal sum to be repaid
- Dividends are optional
What are the advantages of equity for investors?
- Can make very high returns
- Voting rights give some control over company
- Potential for dividends
What are the disadvantages of equity for the company?
Have to offer a higher return
Relatively high issuing costs
No tax advantages
Dilution of control of the company
What are the disadvantages for investors of equity?
Potential for big losses
No guarantee to any cash flows
What is gearing?
- Gearing refers to the amount of debt a company has.
- A highly geared company is one with a high level of debt
What are the two types of gearing?
- Capital gearing
- Income gearing
What is capital gearing?
Focuses on how much of the firm’s capital is in the form of debt
What is income gearing?
Focuses on how much of the firm’s income is used to pay off interest charges associated with that debt
What is the Weighted average cost of capital (WACC)?
- If the firm has more than one source of capital then we need to know what average return the company has to make in order to keep everybody happy
- This is the discount rate we use to find the NPV
Non-traded securities
If the bonds or shares are not traded then we won’t be able to observe prices or calculate betas
But we can estimate the rates of return by finding similar bonds or shares that are traded and use the returns on those as a “best guess”
As always, by similar we mean the securities would be in the same risk class, i.e. expose the holder to the same level of risk
Bank Loans in the WACC
We could include bank loans as a separate source of funds
Not traded so can’t observe market value
But unless chances of default are high, market value ~ book value
How can you estimate the return on bank loans?
Looking at market rate for equivalent loans, or
Assume its the same as for the firm’s bonds, or
Calculate as interest paid/outstanding loans
What is the right discount rate?
The required returns to debt, equity, etc. were dependent on the risk
This depends to a large extent on what the firm is doing
WACC thus represents the average return needed, for the current given level of risk
Even if a new project is to funded entirely by debt
Still use the WACC as discount rate and not 𝒓_𝒅
Who uses WACC
Today ~80% of firms use it but often in arbitrary ways, e.g.
Guesses for cost of equity instead of using the CAPM or DGM
Coupon rates for required return on debt instead of the YTM
Target Debt/Equity ratios or book values rather than proportions based on current market values