sources of finance and the cost of capital. learning objectives sources of finance equity capital...

Sources of Finance and the Cost of

Capital

Sources of Finance and the Cost of

Capital

learning objectives

sources of finance

equity capital compared with debt capital

gearing

the weighted average cost of capital (WACC)

cost of debt

Session Summary (1) Session Summary (1)

cost of equity

risk

CAPM and the factor

return on equity and financial structure

economic value added (EVA) and market valueadded (MVA)

Session Summary (2) Session Summary (2)

identify the different sources of finance available toan organisation

explain the concept of gearing, or the debt/equity ratio

explain what is meant by the weighted average cost of capital (WACC)

calculate the cost of equity and the cost of debt

Learning Objectives (1) Learning Objectives (1)

appreciate the concept of risk with regard to capital investment

outline the capital asset pricing model (CAPM), and the factor

analyse return on equity as a function of financial structure

explain the use of economic value added (EVA) and market value added (MVA) as performance measures and value creation incentives

Learning Objectives (2) Learning Objectives (2)

Two main sources of external finance are available toa company

equity (ordinary shares)

debt (loans or debentures)

or a combination of these such as convertible loans (hybrid finance), or preference shares

other external sources are

leasing

UK Government and European funding

Sources of Finance (1) Sources of Finance (1)

Sources of internal finance to a company are

its retained earnings

extended credit from suppliers

benefits gained from more effective management of its working capital

Sources of Finance (2) Sources of Finance (2)

Equity Capital Compared with Debt

Capital

Equity Capital Compared with Debt

Capital

gearing, or the debt/equity ratio, is the relationship between the two sources of finance, loans andordinary shares

a company having more debt capital than share capitalis highly geared, and a company having more sharecapital than debt capital is low geared

Gearing (1) Gearing (1)

The following are two of the most commonly-usedgearing ratios

gearing = long-term debt equity + long-term debt debt equity ratio = long-term debtor leverage (D/E) equity


Other important ratios related to gearing are

dividend cover (times) = earnings per share (eps) dividend per share

interest cover (times) = profit before gross interest and tax gross interest payable

cash interest cover = net cash inflow from operations + interest received interest paid


The weighted average cost of capital (WACC) is

the average cost of the total financial resources ofa company

which are

the shareholders equity and the net financial debt

WACC may be used as the discount factor to evaluate projects, and as a measure of company performance

The Weighted Average Cost of Capital (WACC)

(1)


(1)

If shareholders equity is E and net financial debt is Dthen the relative proportions of equity and debt in thetotal financing are:

E and D__E + D E + D

if the return on shareholders equity is e and the return on financial debt is d, and t is the rate of corporation tax

WACC = E x e + D x d (1 - t)

(E + D) (E + D)


(2)


(2)

cost of debt is the cost of servicing debt capital, the interest paid yearly of half-yearly, which is an allowable expense for tax purposes

If i is the annual loan interest rate and L is the current market value of the loan and the cost of debt is d then the cost of debt may be stated as

d = i x (1 - t) L

Cost of Debt Cost of Debt

cost of equity is the cost to the company of its ordinary share capital

cost of equity may be determined from the present value of expected future dividend flows, growing at a constant rate

If e is the cost of equity capital, v is the expected future dividends for n years at a constant growth rate of G, and S is the current market value of the share then the cost of equity may be stated as

e = v + G S

Cost of Equity Cost of Equity

both the cost of debt and the cost of equity are based on future income flows, and the risk associated with such returns a certain element of risk is unavoidable whenever any investment is made, and unless a market investor settles for risk-free securities, the actual return on investmentin equity (or debt) capital may be better or worse than hoped for

systematic risk may be measured using the capital asset pricing model (CAPM), and the factor, in terms of its effect on required returns and share prices

Risk Risk

If Rf is the risk-free rate of return, and Rm is the return from the market as a whole then (Rm - Rf) is the market risk premium and

If e is the cost of equity capital and the beta value for the company's equity capital is e, then

the return expected by ordinary shareholders, or the costof equity to the company = the risk-free rate of return plus a premium for market risk adjusted by a measure of the volatility of the ordinary shares of the company

e = Rf + {e x (Rm - Rf)}

CAPM and the Beta Factor

CAPM and the Beta Factor

the return on equity may be considered as a function ofthe gearing, or financial structure of the company

If D is the debt capital, E the equity capital, t the corporation tax rate, i the interest rate on debt, ROI the return on investment

, and ROS the return on sales then ROE return on equity may be expressed as

ROE = {ROI x (1 - t)} + {(ROI - i) x (1 - t) x D/E}

Return on Equity and Financial Structure

Return on Equity and Financial Structure

the recently-developed techniques of economic value added (EVA) and market value added (MVA) are widely becoming used in business performance measurementand as value creation incentives

If profit after tax is PAT, weighted average cost of capital is WACC, and the adjusted book value of net assets is NAthen we may define EVA as

EVA = PAT - (WACC x NA)

Economic Value Added (EVA) and Market

Value Added (MVA) (1)



at the company level, the present value of EVAs equalsa business’s market value added (MVA)

MVA may be defined as the difference between themarket value of the company and the adjusted bookvalue of its assets





sources of finance and the cost of capital. learning objectives sources of finance equity capital...

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