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Finance for Non-Financial Managers Fifth Edition

Finance for Non-Financial Managers Fifth Edition. Slides prepared by Pierre G. Bergeron University of Ottawa. Cost of Capital and Capital Structure. Chapter Objectives. 1. Explain the structure and cost concepts.

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Finance for Non-Financial Managers Fifth Edition

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  1. Finance for Non-Financial ManagersFifth Edition Slides prepared by Pierre G. Bergeron University of Ottawa

  2. Cost of Capital and Capital Structure Chapter Objectives 1. Explain the structure and cost concepts. 2. Clarify the meaning of cost of financing, why it is used, and how it is calculated. 3. Explain that the economic value added concept is a financial technique used to measure managerial performance related to shareholder wealth maximization. 4. Explain that the components of the weighted average cost of capital include long-term debts, common shares, preferred shares, and retained earnings. 5. Explain the importance of leverage analysis and how the operating leverage, financial leverage, and combined leverage are calculated. Chapter Reference Chapter 8: Cost of Capital and Capital Structure

  3. Return on Assets and Cost of Capital ROA 12% Cost of financing 11% Spread New capital assets New capital (financing) Capital budget (IRR) 14% Cost of capital 12% EVA Balance Sheet Current assets Capital assets Current liabilities Long-term debts Equity

  4. Cost of capital Sources of funds Expected return Discount rate Capital Budgeting Interdependence of the Major Areas of Finance Capital structure

  5. Cost of Capital and the Leverage Concept expected Cost of capital represents a company’s composite rate of return _________ or even ___________ by investors. Amounts of Percentage Cost of Proportion Sources of capitalcapitalof totalcapitalof 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 $ 10,0000.10 x 14.0% = 1.4% $100,0001.0010.3% demanded Leverage 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

  6. 1. Financial Structure versus Capital Structure Financial Refers to the way the firm’s assets are financed by all debts (short- and long-term) and equity. structure Represents the permanent forms of financing such as long-term debts, common shares, preferred shares, and retained earnings (ignores short-term credit or current liabilities). Capital structure

  7. Cost financing 11.3% Cost financing 7.9% 2. Modern Industries – Cost of Financing VS ROA Before Taxes Balance Sheet @ 10% x .67 = 6.7% Debt $ 800,000 Equity 400,000 Total $ 1,200,000 Assets $ 1,200,000 Total $ 1,200,000 @ 14% x .33 = 4.6% 1.00 = 11.3% Income $ 160,000 ROA 13.3% After Taxes Balance Sheet Debt $ 800,000 Equity 400,000 Total $ 1,200,000 @ 5% x .67 = 3.3% Assets $ 1,200,000 Total $ 1,200,000 @ 14% x .33 = 4.6% 1.00 = 7.9% Income $ 80,000 ROA 6.7% Refer to transparencies 4.4 and 4.5 for details.

  8. Cost of Capital (after tax) Notes payable $ 80,000 Long-term debt 600,000 Equity 400,000 Total $ 1,080,000 EVA Operating profit $ 155,000 Add back int. income 80,000 Total 235,000 Less taxes 117,500 $ 117,500 Weighted cost 8.40% Total capital $ 1,080,000 Minus $ 90,720 EVA = + $ 26,780 3. Modern Industries – Economic Value Added (EVA) Balance Sheet Current assets $ 400,000 Capital assets 800,000 Total $ 1,200,000 Other liabilities $ 120,000 Notes payable 80,000 Long-term debt 600,000 Equity 400,000 Total $ 1,200,000 @ 6.0% @ 5.0% @ 14.0% X .074 X .555 X .371 1.000 = 0.44 % = 2.77 % = 5.19 % 8.40 %

  9. 4. Modern Industries – Cost of Capital Balance Sheet B.T. A.T. Assets $ 300,000 New debt $200,000 @ 12% 6% x .67 = 4.02% _________ New equity 100,000 @ 15% 15% x .33 = 4.95% Total $ 300,000 Total $300,0001.00 = 8.97% Since the cost of capital is 8.97%, the capital projects (on the asset side of the balance sheet) should give at least 8.97% or more. This will be examined in Chapter 11 (Capital Budgeting)

  10. Using Income Before Interest but After Taxes (page 6.5) 8.40% (cost of capital) = = $117,500$1,200,000 9.79% (ROA) $117,500$1,080,000 = 10.88% (ROI) 8.40% (CC) 2.48% (EVA) Net income (page 6.8) 8.97% (IRR) 8.97% (CC) To Summarize Different Cost Calculations Net income (page 6.4) = 7.9% (cost of financing) 6.7% R.O.A. $80,000$1,200,000 =

  11. Preferred shares ($1 million) • Cost of preferred shares = • Cost of preferred shares = = 12.5% Dividends on preferred shares Market value of shares – Flotation costs $12 $100 - $4 Cost of Capital (for publicly owned companies) • Long-term debts ($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 $5$2 $7 $7 = 10% + 12% = 10.57% = Before tax cost x (1.0 - tax rate) 10.57% x (1.0 - .50) = 5.28%

  12. 4. Retained earnings ($ 2 million) $10 $100 Cost of retained earnings = + 4 % = 14 % Cost of Capital (for publicly owned companies) • Common shares ($10 million) • Cost of common shares = • Cost of common shares = + 4% = 15.11% Dividend yield Market price of shares – Issues costs + Growth $10 $100 (1 - .10)

  13. 11.428% Cost of Capital (for publicly owned companies) After-tax Sources of capital Total amount Percentage cost of Proportion __________________________ of total capital of cost Debts $ 7,000,000 .35 x 5.28% 1.848% Preferred shares $ 1,000,000 .05 x 12.50% .625% Common shares $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

  14. Classification of capital projects Ranking of capital projects IRRCumulative High risk 35 % and over Medium risk 25% to 35 % Low risk 10% to 25 % Compulsory negative to 10% Project A 35 % 35 % Project B 32% 33% Project C 28% 31% Project D 24% 28% Project E 22% 26% 11.4% Marginal Cost of Capital & Internal Rate of Return Cost of capital & IRR 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% MCC Cost of projects exceeds IRR IRR 0 10 15 20 25 30 Capital funds raised and capital projects (in millions of dollars)

  15. 5. Leverage Analysis 14% 18% Earnings Per Share Sales revenue EBIT 10% 10% Total leverage Operating leverage Financial leverage

  16. Leverage Definition Leverage consists of determining the most appropriate cost structure, at both the operating and financial levels, that will optimize the profitability of a business. Operating Deals with the cost behaviour of an operating unit (fixed leverage and variable costs) and excludes financing charges. Financial Deals with the capital structure of a business, the one that leverage will generate the greatest financial benefits to the shareholders (debt versus capital shares).

  17. Operating Leverage From transparency 9.9 (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. 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 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 Fixed costs Selling price Variable costs Contribution margin (in 000$) No. of units Revenue Variable costs Fixed costs Total costs Profit

  18. Contribution margin$700,000 Contribution – Fixed costs $400,000 = = 1.75 times Calculating the Operating Leverage For the proposed production methods (high) Sales 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%

  19. EBIT$400,000 EBIT - Interest $250,000 = = 1.6 times Calculating the Financial Leverage For the proposed production methods (high) EBIT $ 400,000 $ 440,000 10.0% Interest 150,000 150,000 ----- Income before taxes $ 250,000 $ 290,000 16.0%

  20. Contribution margin$700,000 EBIT - Interest $250,000 OR 1.75 X 1.6 = 2.8 times = = 2.8 times Calculating the Combined Leverage For the proposed production methods (high) Sales 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% Interest 150,000 150,000 ----- Income before taxes $ 250,000$ 320,000 28.0%

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