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Corporate Finance

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Corporate Finance ­FIN 622
VU
Lesson 18
COST OF CAPITAL & CAPITAL STRUCTURE
The following topics will be discussed in this lecture.
Cost of Capital & Capital Structure
Components of Capital
Cost of Equity
Estimating g or growth rate
Dividend growth model
Cost of Debt / Bonds
Cost of Preferred Stocks
COST OF CAPITAL
The required return is necessary to make a capital budgeting project such as building a new factory
worthwhile. Cost of capital would include the cost of debt and the cost of equity.
The cost of capital determines how a company can raise money (through a stock issue, borrowing, or a mix
of the two). This is the rate of return that a firm would receive if it invested its money someplace else with
similar risk.
CAPITAL STRUCTURE
Capital structure of a typical company may consist of ordinary shares, preference stock, short term and long
term loan, bonds and leases. These components in capital structure have their own cost and if we add all
the individual components cost after adjusting with the weight age of each, the resultant value is known as
weighted cost of capital. As you have already covered in your earlier lessons that normally we use WACC as
discount rate to find the present value of future cash flows emerging from a project, so it is of immense
importance to calculate the correct WACC. And you are also aware that if the WACC is incorrect it may
lead to serious consequences.
In order to compute the WACC we need to calculate the individual components cost. First of all we take up
the Equity part of the capital and will see how we can compute the cost of equity.
COST OF EQUITY
In financial theory, the return that stockholders require for a company is called cost of equity. The
traditional formula is the dividend capitalization model:
A firm's cost of equity represents the compensation that the market demands in exchange for owning the
asset and bearing the risk of ownership.
Let's look at a very simple example: let's say you require a rate of return of 10% on an investment in stock
A. The stock is currently trading at $10 and will pay a dividend of $0.30. Through a combination of
dividends and share appreciation you require a $1.00 return on your $10.00 investment. Therefore the stock
will have to appreciate by $0.70, which, combined with the $0.30 from dividends, gives you your 10% cost
of equity.
We shall discuss two methods we can use to determine the cost of equity.
First, we'll take up dividend growth models and then security market line approach to calculate the cost of
equity.
Assuming that dividends will grow at a constant rate in future (growth rate =g), price per share Po (current
price) can be found by the following formula:
Po = Do x (1 + g) / Re ­ g
Or
Po = D1 / Re ­ g
Where D1 is the dividend after period 1 and Re represents return on equity.
We can re-arrange this equation in order to calculate the Re as under:
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Corporate Finance ­FIN 622
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Re = D1 / Po + g
This equation tells us that we need three variables to work out the cost of equity. These are current price
Po, dividend in period 0, and Do and growth rate.
Most complex variable in the above equation is to determine the "g" variable. You can obtain the Po and
Do very easily from internal or external sources. We can use some statistical techniques to forecast g using
the historical data. More precisely using trend and regression analysis we can obtain the value of g.
The primary advantage of dividend growth model is that it is very simple to understand and use. However,
there are some problems also associated with this approach.
It is only applicable to the firms which pay dividend regularly if not constantly. Therefore, a firm with no
dividend history will find it useless.
The other problem is an unrealistic assumption of constant growth of dividends. We may not find any such
company which has a history of constant growth in dividends. These two limitations make this model to be
used in selected scenarios, for example, where the company may have distributed the dividends consistently
in the past.
The other problem is that the estimated cost of equity is very sensitive to the estimated growth rate.
Finally, this approach does not take into account the risk level. There is no direct adjustment for the risky-
ness of the investment. For instance, there is no adjustment for the degree of certainty or uncertainty in
estimated growth rate for dividends
The other way to compute the cost of equity is SML (security market line) which tells us that the required
rate of return on a risky investment depends on three things.
i)
The risk free rate, Rf
ii)
Market risk premium, (Erm ­ Rf)
iii)
Systematic risk of the asset known as beta, B
Using SML we can write the equation as under:
Ere = Rf + Be x (Erm ­ Rf)
Where
Ere = is expected return on equity.
Be = is Beta of equity.
This method is also suffering from advantages and disadvantages. First it explicitly adjusts the risk and
second, it is applicable to companies other than just those with steady dividend growth. Thus it may be
useful in wider circumstances.
The SML approach heavily relies on two things ­ the market risk premium and beta coefficient. And if our
estimates are not very accurate then the cost of equity number will be incorrect and misleading as well.
The demerit of both dividend model and SML is that both consider past data to predict the future.
Economic conditions and indicator in future are not the same as were in past. However, both methods do
provide us relative guidance in computing the cost of equity.
Before we move ahead to cost of debt, let's take a look how we can raise capital in the long run. From a
firm's perspective, followings are the ways to build the capital:
­
venture capital
­
issuing share to public ­ IPOS
­
subsequent issue of share ­ right issue
­
private placement of shares
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Corporate Finance ­FIN 622
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­  bank loans
­  debt instruments
­  leases
There are some rules and regulations for raising capital for each of the above categories. We shall discuss
here some of the issues relating to Equity capital ­ issuing shares through IPOs and subsequent issue of
shares like right issue.
·  company must be listed on stock exchange
·  must be registered with security & exchange commission of Pakistan ­ SECP
·  company issues prospectus
·  underwriting the share issue
­  Underwriter refers to a firm that acts as intermediary between a company issuing shares and
the public.
­  underwriter normally perform following services
·  devising method for issuing shares
·  setting the price of new shares
·  marketing / selling of securities
­  Underwriters may buy securities for less than the price set by the company and then selling
them to public. if any amount of shares not subscribed by the public then underwriter takes
up the under-subscribed shares.
­  Often underwriter forms a group to share the risk, known as syndicate.
COST OF DEBT:
Debt component of capital may include several line items like preferred stocks, loans from various financial
institutions with varying terms and cost. Some of the loans may be having fixed or floating interest rate. The
other items in the debt are bonds and leases.
The effective rate that a company pays on its current debt can be measured in either before- or after-tax
returns; however, because interest expense is deductible, the after-tax cost is seen most often. This is one
part of the company's capital structure, which also includes the cost of equity.
A company will use various bonds, loans and other forms of debt, so this measure is useful for giving an
idea as to the overall rate being paid by the company to use debt financing. The measure can also give
investors an idea as to the risky-ness of the company compared to others, because riskier companies
generally have a higher cost of debt.
To get the after-tax rate, you simply multiply the before-tax rate by one minus the marginal tax rate (before-
tax rate x (1-marginal tax)). If a company's only debt were a single bond in which it paid 5%, the before-tax
cost of debt would simply be 5%. If, however, the company's marginal tax rate were 40%, the company's
after-tax cost of debt would be only 3% (5% x (1-40%)).
Like loans, bonds may have several issues of varying terms, carrying different interest cost with wide gap
between their cost and market value. Leases may have the same characteristics like loans and debts.
To find the cost of debt, we need to calculate the cost of each class of debt and then finding the weighted
average of the cost of debt. For example, if there are five bond issues outstanding at any time, we will
calculate the cost of each issue and then move to weighted average of cost of bond by using their individual
weight in total bond capital.
COST OF PREFERRED STOCK:
To start computing the cost of debt, we take up the first item in debt family ­ preferred stock, which is
fairly straightforward calculation.
As we know that preferred stocks carry fixed dividend every period. There's no variation in dividend level.
This means that dividend from preferred stock is essentially perpetuity.
·  cost of preferred stock can be calculated from the following
·  R = D/ Po
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Corporate Finance ­FIN 622
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·
for example if the dividend is R 3.50/- per share and current market price is rs.40/-, then the Rp
will be:
·  Rp = 3.50 / 40 = 8.75%
We shall take up the two main issues for calculating cost of debt for loans and leases in other hand outs to
be delivered in future.
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Table of Contents:
  1. INTRODUCTION TO SUBJECT
  2. COMPARISON OF FINANCIAL STATEMENTS
  3. TIME VALUE OF MONEY
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  6. TERM STRUCTURE OF INTEREST RATES
  7. COMMON STOCK VALUATION
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  10. METHODS OF PROJECT EVALUATIONS 2
  11. METHODS OF PROJECT EVALUATIONS 3
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  42. FOREIGN EXCHANGE MARKET’S OPTIONS
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk