Finance for Non-Financial Managers , 6 th edition

Copyright © 2011 Nelson Education Limited

Finance for Non-Financial Managers, 6th edition

PowerPoint Slidesto accompany

Prepared by Pierre Bergeron, University of Ottawa


Finance for Non-Financial Managers, 6th edition

CHAPTER 9

COST OF CAPITAL, CAPITAL STRUCTURE, AND

FINANCIAL MARKETS


Cost of Capital, Capital Structure and Financial Markets

1. Explain the financial and capital structures and cost concepts.

2. Clarify the meaning of cost of financing, why is is used and how it is calculated.

3. Explain the concept of the economic value added and how it is calculated.

4. Explain the components of the weighted average cost of capital and how it is calculated.

5. Explain the importance of leverage analysis and how it is calculated.

6. Give a profile of the financial markets, the stock market, and various theories related to the dividend theories and payments.

Chapter Reference

Chapter 9: Cost of Capital, Capital Structure and Financial Markets

Chapter Objectives


Return on Assets and Cost of Capital

Statement of Financial Position

Non-current assets

Current assets

Cost of capital 12%Capital budget (IRR) 14%

Equity

Non-current liabilities

Current liabilities

Cost of financing 11%ROA 12%

Spread

New capital (financing)New non-current assets

EVA


Interdependence of the Major Areas of Finance

Capital structure

…or the composition of the sources of funds…

Cost of capital

…to determine the financial attractiveness

of capital projects

Capital Budgeting

…determines the discount rate used…


Cost of capital Represents a company’s composite rate of return _________ or even ___________ by investors.

Amounts of Percentage Cost of Proportion Sources of capital capital of total capital of cost Personal $ 50,000 0.50 x 9.0% = 4.5% Source A $ 20,000 0.20 x 10.0% = 2.0% Source B $ 20,000 0.20 x 12.0% = 2.4% Source C $ 10,000 0.10 x 14.0% = 1.4%

$100,000 1.00 10.3%

Cost of Capital and the Leverage Concept

expected demanded

Determines the cost structure (fixed versus variable costs) and financing structure (debt versus equity) that will amplify the most, profit performance for the business (EVA) and the wealth to the shareholders (MVA).

i.e. A 10% increase in revenue produces an 18% increase in EBIT.

A 10% increase in EBIT produces a 22% increase in ROE.

Leverage


1. Financial Structure versus Capital Structure

structureRefers to the way the firm’s assets are

financed by equity and all debts (long- and

short-term).

Financial

Represents the permanent forms of financing

such as common shares, preferred shares,

retained earnings and long-term borrowings

(ignores short-term credit or current liabilities).

structure

Capital


2. Modern Industries – Cost of Financing VS ROABefore Taxes

After Taxes

Refer to slides 4.6 and 4.7 for details.

Statement of financial position

Assets $ 1,200,000

Total $ 1,200,000

Equity $ 400,000

Debt 800,000

Total $ 1,200,000

@ 14% x .33 = 4.6%

@ 10% x .67 = 6.7%

1.00 = 11.3%

Profit $ 160,000

ROA 13.3% Cost financing 11.3%

Statement of financial position

Assets $ 1,200,000

Total $ 1,200,000

Equity $ 400,000

Debt 800,000

Total $ 1,200,000

@ 14% x .33 = 4.6%

@ 5% x .67 = 3.3%

1.00 = 7.9%

Profit $ 80,000

ROA 6.7% Cost financing 7.9%


3. Modern Industries – Economic Value Added (EVA)Statement of Financial position

Non-current assets $ 800,000Current assets 400,000

Total $ 1,200,000

Equity $ 400,000Long-term borrowings 600,000Notes payable 80,000Other liabilities 120,000Total $ 1,200,000

Equity $ 400,000

Long-term borrowings 600,000

Notes payable 80,000

Total $ 1,080,000

Cost of Capital (after tax)

@ 14.0%

@ 5.0%

@ 6.0%

X .371

X .555

X .074

1.000

= 5.19 %

= 2.77 %

= 0.44 %

8.40 %

Operating profit $ 155,000Add back int. income 80,000Total 235,000Less taxes (117,500)

$ 117,500

EVA

Weighted cost 8.40%

Total capital $ 1,080,000

Minus $ 90,720

EVA

= + $ 26,780


Statement of Financial Position B.T. A.T.

Assets $ 300,000 New equity $100,000 @ 15% 15% x .33 = 4.95%

________ New debt 200,000 @ 12% 6% x .67 = 4.02%

Total $ 300,000 Total $300,000 1.00 = 8.97%

Since the cost of capital is 8.97%, the capital projects (on the asset side of the statement of financial position) should give at least 8.97% or more.

This will be examined in Chapter 11 (Capital Budgeting)

4. Modern Industries – Cost of Capital


Using Profit Before Finance Costs but After Taxes (slide 9.7)

$117,500$1,200,000

9.79% (ROA)=

To Summarize Different Cost Calculations

Profit for the year (slide 9.6)

$80,000$1,200,000

= 6.7% R.O.A. 7.9% (cost of financing)

$117,500$1,080,000

= 10.88% (ROI)

2.48% (EVA)

(8.40%) (CC)

8.40% (cost of capital)

Profit for the Year (slide 9.8)

8.97% (CC)8.97% (IRR)


Cost of Capital (for publicly owned companies)

$5 $2

$7 $7 = 10% + 12% = 10.57%

1. Long-term borrowings ($7 million)

Bond A amounting to $5 million @ 10%

Bond B amounting to $2 million @ 12%

Step 1:

Average cost of bonds

Step 2:

Effective cost of debt

= Before tax cost x (1.0 - tax rate)

10.57% x (1.0 - .50) = 5.28%

2. Preferred shares ($1 million)

Cost of preferred shares =

Cost of preferred shares = = 12.5%$12

$100 - $4

Dividends on preferred shares

Market value of shares – Flotation costs


$10

$100 (1 - .10)

Dividend yield

Market price of shares – Issues costs+ Growth

3. Common shares ($10 million)

Cost of common shares =

Cost of common shares = + 4% = 15.11%

$10

$100

4. Retained earnings ($ 2 million)

Cost of retained earnings = + 4 % = 14 %



After-tax

Sources of capital Total amount Percentage cost of Proportion

_______________ __________ of total capital of cost

Borrowings $ 7,000,000 .35 x 5.28% 1.848%

Preferred shares $ 1,000,000 .05 x 12.50% .625%

Common share $10,000,000 .50 x 15.11% 7.555%

Retained earnings $ 2,000,000 .10 x 14.00% 1.400%

$20,000,000 1.00 11.428%



Marginal Cost of Capital & Internal Rate of Return

Cost of capital &

IRR

IRR

35.0%

30.0%

25.0%

20.0%

15.0%

10.0%

Capital funds raised and capital projects (in millions of dollars)

0 10 15 20 25 30

MCC

Cost of projects exceeds IRR

11.4%

IRR Cumulative

Ranking of capital projects

Project A 35 % 35 %Project B 32% 33%Project C 28% 31%Project D 24% 28%Project E 22% 26%

Classification of capital projects

High risk 35 % and over

Medium risk 25% to 35 %

Low risk 10% to 25 %

Compulsory negative to 10%


5. Leverage

Operating leverage Financial leverage

Total leverage

10%

18%

Revenue EBIT

14%

10%

Earnings

Per

Share


Leverage

Definition

Financial leverage

Operating leverage

Leverage consists of determining the most appropriate cost structure, at both the operating and financial levels, that will optimize the profitability of a business.

Deals with the capital structure of a business, the one that will generate the greatest financial benefits to the shareholders (capital share versus debt).

Deals with the cost behaviour of an operating unit (fixed and variable costs) and excludes finance costs


Operating Leverage

Present methods

$200,000

$15.00

$10.00

$ 5.00

High Expected Low

100,000 70,000 40,000

$ 1,500 $1,050 $ 600

(1,000) (700) (400)

(200) (200) (200)

(1,200) (900) (600)

$ 300 $ 150 00

From transparency 5.8 (Profit Planning and Decision-Making), the company contemplates automating its plant which will increase fixed costs to $300,000 and reduce variable costs to $8.00.

Fixed costs

Selling price

Variable costs

Contribution margin

(in 000$)

No. of units

Revenue

Variable costs

Fixed costs

Total costs

Profit

Proposed methods

$300,000

$15.00

$ 8.00

$ 7.00

High Expected Low

100,000 70,000 40,000

$ 1,500 $1,050 $ 600

(800) (560) (320)

(300) (300) (300)

(1,100) (860) (620)

$ 400 $ 190 ($ 20)


For the proposed production methods (high)

Revenue $1,500,000 $1,650,000 10.0%

Variable costs (800,000) (880,000) 10.0%

Contribution margin 700,000 770,000 10.0%

Fixed costs (300,000) (300,000) ----

Profit (EBIT) $ 400,000 $ 470,000 17.5%

Calculating the Operating Leverage

Contribution margin $700,000

Contribution – Fixed costs $400,000= = 1.75 times



EBIT $ 400,000 $ 440,000 10.0%

Finance costs (150,000) (150,000) -----

Profit before taxes $ 250,000 $ 290,000 16.0%

Calculating the Financial Leverage

EBIT $400,000

EBIT – Finance costs $250,000= = 1.60 times



Revenue $1,500,000 $1,650,000 10.0%

Variable costs (800,000) (880,000) 10.0%

Contribution margin 700,000 770,000 10.0%

Fixed costs (300,000) (300,000) ----

Profit (EBIT) $ 400,000 $ 470,000 17.5%

Finance costs (150,000) (150,000) -----

Profit before taxes $ 250,000 $ 320,000 28.0%

Calculating the Combined Leverage

Contribution margin $700,000

EBIT – Finance costs $250,000

OR

1.75 X 1.6 = 2.8 times

= = 2.8 times


6. Financial Markets

Deal with businesses, individual and government institutions including procedures involved in the buying and selling of financial assets.

Types of markets

• Money markets

• Capital markets

• Primary markets

• Secondary markets

• Spot and future markets

• Mortgage markets

• Consumer credit markets

• Physical asset markets


Stock Market

Net of exchanges, brokers, and investors that trade securities (e.g., TSX).

1. Stock exchange

2. Types of companies:

• Privately held companies

• Publicly trade companies

3. Prospectus

4. Initial Public Offering

5. Listed company


Dividend Theories

Dividend irrelevance theory

Dividend payment has little effect to share price because if earnings are retained in the business for growth purposes, the incremental re-invested cash may cause the business to become more profitable and/or grow faster in the future.

Dividend preference theory

Investors prefer receiving dividends now compared to not receiving any due to the uncertainty factor.

Dividend aversion theory

Investors prefer not to receive dividends now in order to enhance share prices in the future.

Finance for Non-Financial Managers , 6 th edition

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