Week 8 Everything Flashcards
Capital
Capital represents the funds used to finance a firm’s assets and operations. Capital constitutes all items on the right hand side of balance sheet, i.e., liabilities and common equity.
Main sources of capital
Debt, Preferred stock, Retained earnings and Common Stock
Opportunity cost of capital
The firms cost of capital is also referred to as the firms opportunity cost of capital.
Investor’s Required Rate of Return
the minimum rate of return necessary to attract an investor to purchase or hold a security. Investor’s required rate of return is not the same as cost of capital due to taxes and transaction costs.
Impact of taxes
For example, a firm may pay 8% interest on debt but due to tax benefit on interest expense, the net cost to the firm will be lower than 8%
Impact of transaction costs on cost of capital
For example, If a firm sells new stock for $50.00 a share and incurs $5 in flotation costs, and the investors have a required rate of return of 15%, what is the cost of capital?
The firm has only $45.00 to invest after transaction cost.0.15 x $50.00 = $7.5k = $7.5/($45.00) = 0.1667 or 16.67% (rather than 15%)
Financial Policy
A firm’s financial policy indicates the desired sources of financing and the particular mix in which it will be used. For example, a firm may choose to raise capital by issuing stocks and bonds in the ratio of 6:4 (60% stocks and 40% bonds). The choice of mix will impact the cost of capital.
The Cost of Debt
Bond market price
The bondholder’s required rate of return on debt is the return that bondholders demand. This can be estimated using the bond price equation:
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The Cost of Debt
Net proceeds per bond
Since firms must pay flotation costs when they sell bonds, the net proceeds per bond received by firm is less than the market price of the bond. Hence, the cost of debt capital (Kd) will be higher than the bondholder’s required rate of return. It can be calculated using the following equation:
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The cost of preferred stock
If flotation costs are incurred, preferred stockholder’s required rate of return will be less than the cost of preferred capital to the firm. Thus, in order to determine the cost of preferred stock, we adjust the price of preferred stock for flotation cost to give us the net proceeds.
Net proceeds = issue price – flotation cost
The cost of preferred stock
formula
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The Cost of Common Equity
Cost of equity is more challenging to estimate than the cost of debt or the cost of preferred stock because common stockholder’s rate of return is not fixed as there is no stated coupon rate or dividend. Furthermore, the costs will vary for two sources of equity (i.e., retained earnings and new issue). There are no flotation costs on retained earnings but the firm incurs costs when it sells new common stock. Note that retained earnings are not a free source of capital. There is an opportunity cost.
Cost Estimation Techniques
Two commonly used methods for estimating common stockholder’s required rate of return are:
The Dividend Growth Model
The Capital Asset Pricing Model
Dividend growth model formula
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Dividend growth model is simple to use but suffers from the following drawbacks:
It assumes a constant growth rate
It is not easy to forecast the growth rate
Capital Asset Pricing Model
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Capital Asset Pricing Model Variable Estimates
CAPM is easy to apply. Also, the estimates for model variables are generally available from public sources.
Risk-Free Rate
Wide range of government securities on which to base risk-free rate
Beta
Estimates of beta are available from a wide range of services, or can be estimated using regression analysis of historical data. Beta is a measure of thevolatility, orsystematic risk, of a security or aportfolioin comparison to the market as a whole. Beta is also known as the beta coefficient.
Market Risk Premium
It can be estimated by looking at history of stock returns and premium earned over risk-free rate.
How to work out the discount rate (r) a firm should use in undertaking a NPV analysis
Use the average rate of return on the firm’s capital (finance) items, weighted according to the percentage of the total capital (finance) of the firm each capital item makes up, i.e. use the weighted average cost of capital (WACC).
Capital Items Used By The Firm
Equity Items: ordinary shares, preference shares.
Debt Items: mortgages, overdrafts, debentures/bonds, term loans.
What Exactly Is Capital?
Firm’s stock of funds. Represented in balance sheet on the right-hand side as the financial assets of the firm. Capital can be viewed as one of the inputs or factors of production of the firm’s operations in the same way as salaries and wages, raw materials, rent, fuel and power. Just like other inputs capital has a cost and must be paid for.
Cost of Capital
Cost of funds used to finance the activities of the firm.
Compensation for providers of capital.
Opportunity cost foregone by providers of capital for investing funds in the real assets of the firm.
Rate of return the firm must generate from investment in real assets to compensate suppliers of capital.
Cost of debt capital – interest expense.
Cost of equity capital – dividends.
The cost of capital is determined by the use to which it is put:
Capital is used to finance investment in real assets. These real assets in turn generate the cash-flows used to service the capital. The risk of the cash-flows/real assets used to service the capital will be determined by the nature of the real assets. The higher the risk of the cash-flows/real assets, the higher will be the return required by the suppliers of the capital. It is the nature of the investments/real assets that determines the cost of capital.
Weighted Average Cost of Capital (WACC)
As a company draws finance (capital) from several sources, the firm’s cost of capital is the sum of the weighted average cost of each source of capital, i.e. the WACC. WACC is one cost representative of the cost of all sources of finance, where each cost is weighted by its relative importance to the total finance of the firm.
The simple WACC formula (with no taxation) is :
WACC = r = Σ ri wi
where:
r = the weighted average cost of capital ri = the cost if the ith source of funds wi= the weighting of the ith source of funds in the firm’s capital structure
Cost of Capital Before Tax
Total Revenue
less
Operating costs
equals
Net Operating Income (NOI)
less
Interest expense ( cost of debt )
less
Tax ( cost of government )
equals
Net Income (NI) ( cost of equity (dividends))
WACC assuming two sources of finance (debt & equity) and no tax:
WACC = r = re E/V + rd D/V
where:
re = the cost of equity capital
E / V = the proportion of equity in the capital structure
rd = the cost of debt capital
D / V = the proportion of debt in the capital structure
E = market value of equity
D = market value of debt
V = total market value of the firm (i.e. D + E)
Cost of Capital After Tax
WACC after tax is the rate of return that the firm needs to earn on its assets/projects in order to compensate debt and equity holders given the government has already been compensated.
Cost of Capital After Tax
Assuming only two sources of capital (debt & equity)
WACC after-tax = cost of debt + cost of equity
Cost of Capital After-Tax
Interest Payments And Tax
Interest payments on debt are tax deductible, while dividend payments on equity are not. When calculating the WACC the after-tax cost of debt is (1-t) of the interest payments (where t = tax rate). Therefore, the firm’s assets gets some “help” from the government in covering the cost of debt which reduces the return that needs to be earned.
WACC After Tax
The cost of servicing the debt is rd(D)(1-t) (where D = total debt). The cost of servicing equity is re(E) (where E = total equity). Therefore, the firm’s assets/capital have to generate a return sufficient to satisfy both debt and equity holders. Let r be the after-tax rate of return the firm can earn on its assets/capital, i.e. r = WACC.
WACC = r = re(E/V) + rd(1-t)(D/V)
Market Value of The Firm
In order to calculate the WACC we need to find the market value of the firm. A firm is a collection of real assets that generate cash-flows.
How to Value The Firm When Calculating WACC?
Value the income claims of those having provided the finance to purchase the real assets of the firm i.e. value the debt and equity of the firm.
Real Assets & Financial assets
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The Cost of Ordinary Shares - CAPM
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The Cost of Preference Shares – Dividend Yield
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Cost of Debt
The cost of debt, rd, is the interest rate on new borrowings.
The historic cost of debt (book value) is not used – we must use the current cost of debt (i.e. the current interest rate in the market or the yield to maturity). Book values represent historical values and, consequently, fail to recognize the concept of the cost of capital as an opportunity cost i.e. the price of using capital as a factor of production
rd is observable:
yields on currently outstanding debt
yields on newly-issued similarly-rated bonds
Cost of Debt - The Effective Interest Rate
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The WACC should only be used when:
The risk of the project the firm is undertaking is similar in nature and risk to projects the firm normally takes on
The way the project is financed is similar to the way in which the firm is financed. This will be the case if the firm currently has the optimal capital structure.
Calculating WACC
The 7 Step Process:
Identify the relevant components of the Capital Base
Calculate the Market Value of each component
Determine the Weighting of each component
Determine the Before-Tax Cost of each component
Determine the After-Tax Cost of each component
Calculate the Weighted Cost of each component
Sum the weighted costs to obtain the WACC
In calculating the WACC of a company you will only have to include the following six items:
Equity: 1. ordinary shares & 2. preference shares;
Debt: 3. mortgage, 4. overdraft 5. debentures/bonds & 6. term loans
Items such as trade credit, provisions for bad and doubtful debts, provisions for taxation & provisions for dividends should be ignored.
