Finance for Non-Financial Managers , 6 th edition
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Transcript of 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
Copyright © 2011 Nelson Education Limited
Finance for Non-Financial Managers, 6th edition
CHAPTER 9
COST OF CAPITAL, CAPITAL STRUCTURE, AND
FINANCIAL MARKETS
Copyright © 2011 Nelson Education Limited
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
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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
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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…
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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
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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
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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%
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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
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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
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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)
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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
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$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 %
Cost of Capital (for publicly owned companies)
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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%
Cost of Capital (for publicly owned companies)
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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%
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5. Leverage
Operating leverage Financial leverage
Total leverage
10%
18%
Revenue EBIT
14%
10%
Earnings
Per
Share
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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
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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)
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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
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For the proposed production methods (high)
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
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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%
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
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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
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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
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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.