39. Capital structure and company’s cost of capital.
The cost of capital for a firm is a weighted sum of the cost of equity and the cost of debt (see Corporate finance & Capital investment decisions). Firms finance their operations by external financing, issuing stock (equity) and issuing debt, and internal financing, reinvesting prior earnings.
Summary
Capital (money) used for funding a business should earn returns for the capital owner who risked his/her saved money. For an investment to be worthwhile the projected return on capital must be greater than the cost of capital. Otherwise stated, the risk-adjusted return on capital (that is, incorporating not just the projected returns, but the probabilities of those projections) must be higher than the cost of capital.
The cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid. In practice, the interest-rate paid by the company will include the risk-free rate plus a risk component, which itself incorporates a probable rate of default (and amount of recovery given default). For companies with similar risk or credit ratings, the interest rate is largely exogenous.
Cost of equity is more challenging to calculate as equity does not pay a set return to its investors. Similar to the cost of debt, the cost of equity is broadly defined as the risk-weighted projected return required by investors, where the return is largely unknown. The cost of equity is therefore inferred by comparing the investment to other investments with similar risk profiles to determine the "market" cost of equity.
The cost of capital is often used as the discount rate, the rate at which projected cash flow will be discounted to give a present value or net present value.
Cost of debt
The cost of debt is computed by taking the rate on a non-defaulting bond whose duration matches the term structure of the corporate debt, then adding a default premium. This default premium will rise as the amount of debt increases (since the risk rises as the amount of debt rises). Since in most cases debt expense is a deductible expense, the cost of debt is computed as an after tax cost to make it comparable with the cost of equity (earnings are after-tax as well). Thus, for profitable firms, debt is discounted by the tax rate. Basically this is used for large corporations only.
Cost of equity
Cost of equity = Risk free rate of return + Premium expected for risk
Expected return
The expected return can be calculated as the "dividend capitalization model", which is (dividend per share / price per share) + growth rate of dividends (that is, dividend yield + growth rate of dividends).
Capital asset pricing model
The capital asset pricing model (CAPM) is used in finance to determine a theoretically appropriate price of an asset such as a security. The expected return on equity according to the capital asset pricing model. The market risk is normally characterized by the β parameter. Thus, the investors would expect (or demand) to receive:
Where:
Es - The expected return for a security
Rf - The expected risk-free return in that market (government bond yield)
βs - The sensitivity to market risk for the security
RM - The historical return of the stock market/ equity market
(RM-Rf) - The risk premium of market assets over risk free assets.
In writing:
The expected return (%) = risk-free return (%) + sensitivity to market risk * (historical return (%) - risk-free return (%))
Put another way the expected rate of return (%) = the yield on the treasury note closest to the term of your project + the beta of your project or security * (the market risk premium)
the market risk premium has historically been between 3-5%
Comments
The models states that investors will expect a return that is the risk-free return plus the security's sensitivity to market risk times the market risk premium.
The risk free rate is taken from the lowest yielding bonds in the particular market, such as government bonds.
The risk premium varies over time and place, but in some developed countries during the twentieth century it has averaged around 5%. The equity market real capital gain return has been about the same as annual real GDP growth. The capital gains on the Dow Jones Industrial Average have been 1.6% per year over the period 1910-2005 . The dividends have increased the total "real" return on average equity to the double, about 3.2%.
The sensitivity to market risk (β) is unique for each firm and depends on everything from management to its business and capital structure. This value cannot be known "ex ante" (beforehand), but can be estimated from "ex post" (past) returns and past experience with similar firms.
Note that retained earnings are a component of equity, and therefore the cost of retained earnings is equal to the cost of equity. Dividends (earnings that are paid to investors and not retained) are a component of the return on capital to equity holders, and influence the cost of capital through that mechanism.
Weighted average cost of capital
The Weighted Average Cost of Capital (WACC) is used in finance to measure a firm's cost of capital.
The total capital for a firm is the value of its equity (for a firm without outstanding warrants and options, this is the same as the company's market capitalization) plus the cost of its debt (the cost of debt should be continually updated as the cost of debt changes as a result of interest rate changes). Notice that the "equity" in the debt to equity ratio is the market value of all equity, not the shareholders' equity on the balance sheet.
Calculation of WACC is an iterative procedure which requires estimation of the fair market value of equity capital.
Formula
The cost of capital is then given as:
Kc= (1-δ)Ke+δKd
Where:
Kc - The weighted cost of capital for the firm
δ - The debt to capital ratio, D / (D + E)
Ke - The cost of equity
Kd - The after tax cost of debt
D - The market value of the firm's debt, including bank loans and leases
E - The market value of all equity (including warrants, options, and the equity portion of convertible securities)
In writing:
WACC = (1 - debt to capital ratio) * cost of equity + debt to capital ratio * cost of debt
Capital structure
Because of tax advantages on debt issuance, it will be cheaper to issue debt rather than new equity (this is only true for profitable firms, tax breaks are available only to profitable firms). At some point, however, the cost of issuing new debt will be greater than the cost of issuing new equity. This is because adding debt increases the default risk - and thus the interest rate that the company must pay in order to borrow money. By utilizing too much debt in its capital structure, this increased default risk can also drive up the costs for other sources (such as retained earnings and preferred stock) as well. Management must identify the "optimal mix" of financing – the capital structure where the cost of capital is minimized so that the firms value can be maximized.
The Thomson Financial league tables show that global debt issuance exceeds equity issuance with a 90 to 10 margin.
Modigliani-Miller theorem
If there were no tax advantages for issuing debt, and equity could be freely issued, Miller and Modigliani showed that the value of a leveraged firm and the value of an unleveraged firm should be the same. (Their paper is foundational in modern corporate finance.)
A calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation.
40. Profit and profitability: definition, methods of calculation.
Profit - A financial benefit that is realized when the amount of revenue gained from a business activity exceeds the expenses, costs and taxes needed to sustain the activity.
Profitability – expected or average ratio of revenue to cost for a particular investment or trading system
The profitability ratios include: operating profit margin, net profit margin, return on assets and return on equity.
Return on equity (ROE) %
Return on Equity. It is the most fundamental indication of a company's ability to increase its earnings per share. Return on equity is one way to measure the return an investor receives on the capital that has been invested in the business. Simply by taking a year's worth of earnings and comparing it to the amount of shareholder's equity on the balance sheet, you get a percentage measure of how much was returned for each dollar of equity that has been created by the business. Shareholder equity is equal to total assets minus total liabilities. It’s what the shareholders “own”. Shareholder equity is a creation of accounting that represents the assets created by the retained earnings of the business and the paid-in capital of the owners.
ROE % = Net Income/ Sharesholder’s equity
The ROE allows quickly determine if a company will generate assets or just continue to seek investment dollars to maintain operations.
Return on Assets ( ROA)
Return on assets measures a company’s earnings in relation to all of the resources it had at its disposal (the shareholders’ capital plus short and long-term borrowed funds). Thus, it is the most stringent and excessive test of return to shareholders. If a company has no debt, it the return on assets and return on equity figures will be the same.
There are two acceptable ways to calculate return on assets.
ROA % = Net Income/ Total Assets
Option 1: Net Profit Margin x Asset Turnover
Option 2: Net income/ Average Assets for the Period
The lower the profit per $ of assets, the more asset-intensive a business is. The higher the profit per $ of assets, the less asset-intensive a business is. All things being equal, the more asset-intensive a business, the more money must be reinvested into it to continue generating earnings. This is a bad thing. If a company has a ROA of 20%, it means that the company earned $0.20 for each $1 in assets. As a general rule, anything below 5% is very asset-heavy (manufacturing, railroads), anything above 20% is asset-light (advertising firms, software companies). Profit Margin
(Operating Profit/ Sales)*100
It shows what % or how many pence of profit is on average generated for each $ of Sales.
The expected value of this ratio will differ quite considerably for different types of businesses. A high volume business, such as a retailer, will tend to operate on low margins that make the assets involved work very hard. By contrast a low business, such as a contractor will tend to require much greater margins.
Profit Margin % = (Profit before Taxation plus Interest Payable/ Sales)*100
Any action that will improve the profit margin % should improve the ROA %
If in comparing results with previous years or another company the profit margin % is found to be considerably lower it can be further analyzed with a view to identifying likely problem areas:
% growth in sales
Product mix from various activities
Market mix for profit and sales by division and geographical area
Expansion of activities by merger or acquisition
Changes in selling prices ( usually only available from management accounts and not from published accounts
Change in costs
41. Cash Flow. Methods of its estimation. Cash Flows management at the company.
The concept of cash flow is one of the central elements of financial analysis, planning, and resource allocation decisions. Cash flows are important because the financial health of а firm depends on its ability to generate sufficient amounts of cash to pay its creditors, employees, suppliers, and owners. Only cash can be spent. You cannot spend accounting net income because net income does not reflect the actual cash inflows and outflows of the firm. For example, an accountant records depreciation expense on an asset each period over the depreciable life of that asset in an attempt to recognize the decline in value of the asset over its life. However, depreciation expenses require no cash outlays. The entire cash outflow related to а depreciable asset occurs at the time the asset is purchased.
The value of common stock, bonds, and preferred stock is based upon the present value of the cash flows that these securities are expected to provide to investors. Similarly, the value to а firm of а capital expenditure is equal to the present value of the cash flows that the capital expenditure is expected to produce for the firm. In addition, cash flows are central to the prosperity and survival of а firm. For example, rapidly expanding firms often grow faster than their ability to generate internally the cash flows needed to meet operating and financial commitments. As а result, these firms may be faced with difficult financial decisions regarding the external sources of funds needed to sustain rapid growth. On the one hand, increases in debt to support expansion result in an increase in the firm's financial risk. On the other hand, if new shares of common stock are sold, ownership in the firm may be diluted more than is desired by the firm's controlling group of owners. Therefore, it is important for managers to pay close attention to the projected cash flows associated with investment and firm expansion strategies.
For financial analysis purposes, two important definitions of cash flows are used. The two most common cash flow definitions are after-tax operating cash flow and free cash flow.
AFTER-ТАХ OPERATING CASH FLOW. The after-tax operating cash flow concept is used primarily when estimating cash flows for capital investment analysis purposes. After-tax operating cash flow (CF) is defined as operating cash flows before tax minus tax payments. Operating cash flows before tax equal total cash revenues minus total cash operating costs. Depreciation expenses are not included directly in this calculation because depreciation does not require the outlay of any funds. Rather, the effect of depreciation is to reduce taxable income by the amount of the depreciation and therefore reduce the cash outlay for taxes by an amount equal to the depreciation charge times the firm's marginal tax rate. Thus, CF is equal to the cash flow before tax times one minus the firm's marginal tax rate plus noncash expenses (primarily depreciation) times the firm's marginal tax rate, or
CF = (R — 0)(1 — Т) + Dep(T)
where R is total cash revenues, О is cash operating expenses, Dep is depreciation, and Т is the firm's marginal tax rate. An equivalent formula for computing operating cash flow is
CF = (R — 0 — Dep)(1 — Т) + Dep
FREE САSH FLOW. The free cash flow (FCF) concept is particularly important in long-range corporate financial planning and when evaluating companies for the purpose of acquisition. FCF recognizes that part of the funds generated by an ongoing enterprise must bе set aside for reinvestment in the firm. Therefore, these funds are not available for distribution to the firm's owners. Free cash flow can be computed as
FCF = CF — I(1 — Т) — Dp — Рf — В — WC — У
where CF is the after-tax operating cash flow as defined in previous equations, I is the before-tax interest payments, Dp is the preferred stock dividend payments, Pf is the required redemption of preferred stock, В is the required redemption of debt, WC is the required net investment in working capital (increases [decreases] in inventories and receivables less increases [decreases] in non-interest bearing current liabilities), and Y is the investment in property, plant, and equipment required to maintain cash flows at their current levels. FCF represents the portion of а firm's total cash flow available to service additional debt, to make dividend payments to common stockholders, and to invest in other projects.
The FCF concept is particularly useful when evaluating а firm for potential acquisition. When valuing а takeover prospect it is important to recognize that explicit cash outlays normally are required to sustain or increase the current cash flows of the firm. For example, if one firm were considering the acquisition of an oil production company, it is not correct to project current cash flows into an indefinite future without explicitly recognizing that crude oil reserves are а depleting resource that require continual, significant investment to assure future cash flow streams.