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Financial Management

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Financial Management ­ MGT201
VU
Lesson 28
INTRODUCTION TO DEBT, EFFICIENT MARKETS AND COST OF CAPITAL
Learning Objectives:
After going through this lecture, you would be able to have an understanding of the following topics
·  Intro to Debt, Efficient Markets & Cost of Capital
In today's lecture, we will start our discussion on capital structure and corporate financing. The first
thing which we study about the capital structure is the over view of the financial markets. We have
mentioned that there are two main sources of capital raising i.e. debt and equity. There are various
financial markets where the money is available.
Capital Markets:
Stock Exchange (listed shares, unit trusts, TFC):
In the case of capital market we have study the stock exchange where the common or preferred
stocks of companies are traded. In these we have the supply or availability of the equity capital.
Money Markets (Short-term liquid debt market):
It is the market for short term debt. and it includes the debt instruments like term finance
certificates and bonds etc. bank loans ,leases from leasing company , mortgage agreements from house
building finance corporation insurance policy , credit cards and various other things .it also includes
bank deposits certificates and inter bank short term and over night borrowing and lending Bonds
Real Assets Markets:
The real asset market where the real or tangible asset or physical asset change hand .for
example, you have cotton exchange where raw bales of cotton change hands .computer hardware and
many other examples are available. For example, Cotton Exchange, Gold Market, Kapra Market
Property (land, house, apartment, warehouse) ,Computer hardware, Used Cars, Wheat, Sugar,
Vegetables, etc.
Debt and Equity Markets:
Equity Markets and Institutions
Stock Exchanges
Private Placements
Private Equity Investments
Venture Capital
Islamic Finance
Debt Markets and Institutions
Bond Markets
Money Markets & Call Markets
Bank Loans & Certificate of Deposits (CD's)
Project Financing
Running Finance or Working Capital Finance
Hypothecation and Pledge Financing for Inventory Purchase
Bridge Financing
Mortgage Financing
Lease Financing
Insurance and Credit Card
In previous lectures we have studied about the efficient markets.
Efficient Markets" Assumption:
We assume that Financial Markets are quick and Prices are Right. There are Lots of Rational
Investors in every Financial Market. They are all well-informed and act quickly on information related
to the companies' operations, finances, risk and return. So Prices of Securities (like Stocks and Bonds)
adjust (equilibrate) quickly to new information. Pricing by the Market is Efficient and Accurate.
Observed Market Price is accurate reflection of Fair Price (or Theoretical Price based on Investors'
NPV calculations).
All Stocks have Optimal Risk-Return Combinations, i.e. All Stocks lie right ON the SML Line!
Securities:
These are pieces of legal contractual paper that represent claim against assets
Direct Claim Securities:
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Financial Management ­ MGT201
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Stocks: it is equity paper representing ownership, shareholding. Appears on Liabilities side of
Balance Sheet
Bonds: it is debt paper representing loan or borrowing.
­  When you are issuing Bonds (i.e. borrowing money) then the Value of Bonds
appears under Liabilities side (as Long Term Debt) of Balance Sheet.
­  If you are Investing (or buying) Bonds of other companies then their Value
appears under Assets side (as Marketable Securities) of Balance Sheet.
Value of Direct Claim Security is directly tied to the value of the underlying Real Asset.
Why Take Debt?
If you do NOT have enough money to meet your own or your family's personal living expenses,
then you approach a friend or a Bank for a Personal Loan.
If you can NOT find friends, family, or investors who want to invest Equity into your business
venture, then you approach an Individual Lender or Bank or Leasing Company for a Business Loan. In
an Emergency or Crisis, the quickest way to get money is generally to take a Loan at a high interest rate.
Countries that are short of money do this too.
Debt vs. Equity:
If the Company raises money using Debt or Bonds, then it will have to pay a fixed amount of
interest (or mark-up) regularly for a limited amount of time. Of course, failure to pay interest can
force company to close down.
If the Company raises money using Equity, then it is forced to bring in new shareholders who are
Owners & can interfere in the management and will get a share of the net profits (or dividends) for
as long as the company is in operation
Where Do Bonds & Stocks Appear on the
Balance Sheet?
Stocks & Bonds
Purchased as
Investment
Own Bonds Issued by
Company to Raise Cash
Own Stock Issued by
Company to Raise Cash
Capital Structure:
Most Firms keep a Mix of Both Debt and Equity Capital. In other words most Firms raise
money from both Stockholders (and Shareholders) and Bondholders (and Banks).
The Mixture or Proportion of Debt Capital and Equity Capital are known as the Capital Structure.
This Financial Policy Decision is taken by the CEO, CFO, and Board of Directors
Capital Structure can Change With Time depending on Firm's Financing needs and strategy. Some
Projects like Power Plants and Cement are so Capital Intensive and large that initially the sponsors need
Debt Capital When a Running Business reaches maturity, some owners prefer to fix the Ratio of Debt to
Equity at 20/80 and only for Running Finance. Some Muslim Businessmen use 100% Equity Capital
only (No Debt).
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Financial Management ­ MGT201
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Cost of Capital: Firms try to attract Debt and Equity Investors to invest their Capital (or money). Firms
claim that they are SAFE and PROFITABLE investments. Therefore, Firms try to Get Investment
Capital (or money) at the LOWEST possible Cost of Capital.
Remember that whenever you Borrow or Rent or Buy anything (cycle, house, money), it Costs
You Money in the form of a Rental, Interest or Mark-up, Installment, etc.
Stockholders (Equity owners) expect to receive Dividends
Bondholders (Debt Holders and Banks) expect to receive Interest
Cost of Capital & Required ROR:
Required ROR (or Opportunity Cost) %:
CAPM Theory (SML for Efficient Markets) & NPV
Minimum ROR required attracting investor into buying a Security (i.e. Stock or Bond ...)
Opportunity Cost: Investor Sacrifices the ROR available from the 2nd best investment.
Cost of Capital  %:
Weighted Average Cost of Capital (WACC)
Combined costs of all sources of financing used by Firm (i.e. Debt and Equity)
WACC is Similar to Required ROR BUT Takes into account some Practical Factors:
Taxes: Interest Payments are P/L Expenses and NOT Taxed.
Transaction costs: Brokerage, Underwriting, Legal, and Flotation Costs incurred
when a Firm issues Stocks or Bond Securities
WACC
%Weighted Average Cost of Capital
Assume that Firm markets 3 Types of Financial Products (or Securities or Instruments) to attract
Investors' Capital.
Bonds (Debt):
Cost = Coupon Interest
Common Shares (Equity): Cost = Variable Dividend
Preferred Shares (Hybrid Equity): Cost = Fixed Dividend
The Firm Issues a Security or Financial Instrument to the Investor and Receives Capital (or Money)
in exchange. The Firm has to pay a "Rental Cost" for using the Investors' Capital.
WACC % = Weighted % Cost of Debt +
Weighted % Cost of Common Equity +
Weighted % Cost of Preferred Equity = rDxD + rExE + rPxP
WACC must take Taxes & Transaction Costs into account
Security Market Line (SML)
For Market of Efficient Stocks
Stock A lies
rA = rRF + (rM - rRF )
.
Required
A
ON the SML
Line. Efficient
Return (r*)
Risk-Return
rA= 30%
Combination
Security Market Line
rM= 20%
Risky Stock A's
rRF= 10%
Risk Premium
= 30-10 = 20%
A =+ 2.0
M =+ 1.0
Beta Risk (
)
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Financial Management ­ MGT201
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Summary of Formulas:
Total risk= market risk  + company specific risk
σ  2 + β  2σ  2 + σ  2
NPV Bond Pricing Equation:
Bond Price = PV = C1/ (1+rD) + C2 (1+rD) 2 + C3 / (1+rD)3 +
..... + PAR / (1+rD)3
Gordon's Formula for Share Pricing:
rCE = (DIV 1 / Po) + g = Dividend Yield + Capital Gains Yield
SML Equation (CAPM Theory)
r = rRF + Beta (rM - rRF)
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Table of Contents:
  1. INTRODUCTION TO FINANCIAL MANAGEMENT:Corporate Financing & Capital Structure,
  2. OBJECTIVES OF FINANCIAL MANAGEMENT, FINANCIAL ASSETS AND FINANCIAL MARKETS:Real Assets, Bond
  3. ANALYSIS OF FINANCIAL STATEMENTS:Basic Financial Statements, Profit & Loss account or Income Statement
  4. TIME VALUE OF MONEY:Discounting & Net Present Value (NPV), Interest Theory
  5. FINANCIAL FORECASTING AND FINANCIAL PLANNING:Planning Documents, Drawback of Percent of Sales Method
  6. PRESENT VALUE AND DISCOUNTING:Interest Rates for Discounting Calculations
  7. DISCOUNTING CASH FLOW ANALYSIS, ANNUITIES AND PERPETUITIES:Multiple Compounding
  8. CAPITAL BUDGETING AND CAPITAL BUDGETING TECHNIQUES:Techniques of capital budgeting, Pay back period
  9. NET PRESENT VALUE (NPV) AND INTERNAL RATE OF RETURN (IRR):RANKING TWO DIFFERENT INVESTMENTS
  10. PROJECT CASH FLOWS, PROJECT TIMING, COMPARING PROJECTS, AND MODIFIED INTERNAL RATE OF RETURN (MIRR)
  11. SOME SPECIAL AREAS OF CAPITAL BUDGETING:SOME SPECIAL AREAS OF CAPITAL BUDGETING, SOME SPECIAL AREAS OF CAPITAL BUDGETING
  12. CAPITAL RATIONING AND INTERPRETATION OF IRR AND NPV WITH LIMITED CAPITAL.:Types of Problems in Capital Rationing
  13. BONDS AND CLASSIFICATION OF BONDS:Textile Weaving Factory Case Study, Characteristics of bonds, Convertible Bonds
  14. BONDS’ VALUATION:Long Bond - Risk Theory, Bond Portfolio Theory, Interest Rate Tradeoff
  15. BONDS VALUATION AND YIELD ON BONDS:Present Value formula for the bond
  16. INTRODUCTION TO STOCKS AND STOCK VALUATION:Share Concept, Finite Investment
  17. COMMON STOCK PRICING AND DIVIDEND GROWTH MODELS:Preferred Stock, Perpetual Investment
  18. COMMON STOCKS – RATE OF RETURN AND EPS PRICING MODEL:Earnings per Share (EPS) Pricing Model
  19. INTRODUCTION TO RISK, RISK AND RETURN FOR A SINGLE STOCK INVESTMENT:Diversifiable Risk, Diversification
  20. RISK FOR A SINGLE STOCK INVESTMENT, PROBABILITY GRAPHS AND COEFFICIENT OF VARIATION
  21. 2- STOCK PORTFOLIO THEORY, RISK AND EXPECTED RETURN:Diversification, Definition of Terms
  22. PORTFOLIO RISK ANALYSIS AND EFFICIENT PORTFOLIO MAPS
  23. EFFICIENT PORTFOLIOS, MARKET RISK AND CAPITAL MARKET LINE (CML):Market Risk & Portfolio Theory
  24. STOCK BETA, PORTFOLIO BETA AND INTRODUCTION TO SECURITY MARKET LINE:MARKET, Calculating Portfolio Beta
  25. STOCK BETAS &RISK, SML& RETURN AND STOCK PRICES IN EFFICIENT MARKS:Interpretation of Result
  26. SML GRAPH AND CAPITAL ASSET PRICING MODEL:NPV Calculations & Capital Budgeting
  27. RISK AND PORTFOLIO THEORY, CAPM, CRITICISM OF CAPM AND APPLICATION OF RISK THEORY:Think Out of the Box
  28. INTRODUCTION TO DEBT, EFFICIENT MARKETS AND COST OF CAPITAL:Real Assets Markets, Debt vs. Equity
  29. WEIGHTED AVERAGE COST OF CAPITAL (WACC):Summary of Formulas
  30. BUSINESS RISK FACED BY FIRM, OPERATING LEVERAGE, BREAK EVEN POINT& RETURN ON EQUITY
  31. OPERATING LEVERAGE, FINANCIAL LEVERAGE, ROE, BREAK EVEN POINT AND BUSINESS RISK
  32. FINANCIAL LEVERAGE AND CAPITAL STRUCTURE:Capital Structure Theory
  33. MODIFICATIONS IN MILLAR MODIGLIANI CAPITAL STRUCTURE THEORY:Modified MM - With Bankruptcy Cost
  34. APPLICATION OF MILLER MODIGLIANI AND OTHER CAPITAL STRUCTURE THEORIES:Problem of the theory
  35. NET INCOME AND TAX SHIELD APPROACHES TO WACC:Traditionalists -Real Markets Example
  36. MANAGEMENT OF CAPITAL STRUCTURE:Practical Capital Structure Management
  37. DIVIDEND PAYOUT:Other Factors Affecting Dividend Policy, Residual Dividend Model
  38. APPLICATION OF RESIDUAL DIVIDEND MODEL:Dividend Payout Procedure, Dividend Schemes for Optimizing Share Price
  39. WORKING CAPITAL MANAGEMENT:Impact of working capital on Firm Value, Monthly Cash Budget
  40. CASH MANAGEMENT AND WORKING CAPITAL FINANCING:Inventory Management, Accounts Receivables Management:
  41. SHORT TERM FINANCING, LONG TERM FINANCING AND LEASE FINANCING:
  42. LEASE FINANCING AND TYPES OF LEASE FINANCING:Sale & Lease-Back, Lease Analyses & Calculations
  43. MERGERS AND ACQUISITIONS:Leveraged Buy-Outs (LBO’s), Mergers - Good or Bad?
  44. INTERNATIONAL FINANCE (MULTINATIONAL FINANCE):Major Issues Faced by Multinationals
  45. FINAL REVIEW OF ENTIRE COURSE ON FINANCIAL MANAGEMENT:Financial Statements and Ratios