ACYMANS: Cost of Capital, Leverage & Capital Structure

Capital

Refers to investor-supplied funds comprising of debt, preferred stock, common stock, and retained earnings.

Capital

It is frequently defined to include only long-term debt, that is, debt due in more than a year. However, many companies use short-term loans from banks on a permanent bases, and for this reason, we include short-term debt that is provided by investors.

True

(True or False) Accounts payable and accruals are not included in the definition of capital since they are not provided by investors.

Capital Structure

Is the percentage of each type of investor-supplied capital, with the total being 100%. It is the mix of the long-term sources of funds used by the firm.

Optimal Capital Structure

It is the mix of debt, preferred stock, and common equity that maximizes the stock's intrinsic value. It is the capital structure that maximizes the intrinsic value of a stock, and at the same time, minimizes the weighted-average cost of capital.

Cost of Capital

Is the rate of return necessary to maintain market value or stock price of a firm.

Cost of Capital

Is used for:

a. Making capital budgeting decisions.

b. Making long-term financing decisions.

c. Helping establish the optimal capital structure.

Cost of Capital

It is often called by a variety of names: minimum acceptable rate of return, required rate of return, hurdle rate, desired rate, standard rate, cut-off rate.

Cost of Capital

Is computed as the weighted average of the various long-term capital sources that are items mostly found on the right-hand side of the balance sheet such as: Long-term debt, Preferred stock, Common stock, and Retained Earnings.

Sales Stability

A factor influencing capital structure decisions. A firm whose sales are relatively stable can safely take on more debt and incur higher fixed charges than a company with unstable sales.

Asset Structure

A factor influencing capital structure decisions. Other factors constant, a company is able to take on more debt if it has more cash on the balance sheet.

Operating Leverage

A factor influencing capital structure decisions. Other factors constant, a firm with less operating leverage is better able to employ financial leverage because it will have less business risk.

Business Risk

A factor influencing capital structure decisions. The uncertainty inherent in projections of future returns on assets. The greater such risk, the less debt should be included in the capital structure.

Growth Rate

A factor influencing capital structure decisions. Other factors constant, faster-growing firms must rely more heavily on external capital.

True

(True or False) Flotation costs involved in selling common stock exceeds that incurred when selling debt, which encourages rapidly growing firms to rely more on debt.

Profitability

A factor influencing capital structure decisions. Firms with very high rates of ROI use relatively little debt. Very profitable firms do not need to do much debt financing. Their higher rates of return enable them to do most of their financing with internally generated funds.

Tax Position

A factor influencing capital structure decisions. Generally, the higher the firm's tax rate, the more debt it should include in its capital structure because interest is tax deductible.

Control

A factor influencing capital structure decisions. Control considerations can lead to the use of debt or equity because the type of capital that best protects management varies from situation to situation.

Market Conditions

A factor influencing capital structure decisions. Conditions in the stock and bond markets undergo long and short run changes that can have an important bearing on a firm's optimal capital structure.

Firm's Internal Condition

A factor influencing capital structure decisions. If a firm forecasts higher earnings in the immediate future, the new earnings would not necessarily be anticipated by the investors and are not reflected in the stock price. The company would not want to issue stock and would prefer to finance with debt until the higher earnings materialize and are reflected in the stock price.

Financial Flexibility

A factor influencing capital structure decisions. The firm's ability to raise capital on reasonable terms even under adverse conditions.

Managerial Aggressiveness

A factor influencing capital structure decisions. Some managers tend to be relatively conservative and thus use less debt than an average firm in the industry, whereas aggressive use a relatively high percentage of debt.

Long Term Debt

Cost of Capital = Yield Rate (100% - Tax Rate)

Preferred Stock

Cost of Capital = Yield Rate

Common Stock

Yield Rate + Growth Rate

Retained Earnings

Yield Rate + Growth Rate

Yield Rate

Is based on a debt instrument's effective interest rate, rather than its nominal interest rate.

Yield to Maturity Rate

Interest (+/-) Discount (Premium) Amortization / (Net Proceeds + Face Value) ⨫ 2

Current Yield

Annual Interest / Current Market Price

Dividend Yield

Dividend per Share / Market Price per Share

Dividend per Share

Preferred Dividend Rate x Par Value per Share

True

(True or False) Market price per share should be net of any flotation or issue costs.

Flotation Cost

Is the cost of issuing or floating securities in the market, normally incurred by issuing IPO shares in the exchange market.

Cost of Selling Stock

Include:

a. Underwriter's spread

b. Direct expenses

c. Indirect expenses

d. Abnormal returns

e. Underpricing

True

(True or False) Unlike the cost of common stock, growth rate is not added to the preferred dividend yield since preferred dividends are relatively fixed per year.

True

(True or False) Tax is not considered since dividends paid are not deductible for tax purposes (No tax shield).

Cost of Common Stock & Retained Earnings

Just like the cost of preferred stock, its cost is also the dividend yield.

True

(True or False) In determining the cost of common stock and retained earnings, the dividend per share must be based on the next dividend to be paid (expected dividend).

Expected Dividend per Share

Past/Present Dividend per Share x (100% + Growth Rate)

True

(True or False) In computing for the cost of retained earnings, flotation cost should be ignored as retained earnings is neither being sold nor issued.

Gordon's Growth Model

The model that serves as the basis of the "Yield Rate + Growth Rate" formula.

True

(True or False) Under the Gordon Model, the growth rate of dividends is assumed to be constant throughout perpetuity.

Debt Financing

In terms of control: Control of the firm is not shared.

In terms of cost of financing: After tax interest expense.

In terms of tax effect: Interest paid is tax deductible.

In terms of financial obligations: Clearly specified and of a fixed nature.

In terms of inflation: Debt may be paid back with "cheaper pesos".

In terms of payment requirement, default risk: Since it is a fixed charge, there is a high risk of not meeting the obligation if the earnings of the firm fluctuate.

In terms of maturity: It has a maturity date.

In terms of limitation: It is limited. Creditors cannot participate in the superior earnings of the firm.

In terms of flexibility: Inclusion of call provisions in the bond indenture.

Equity Financing - Common Stock

In terms of control: There is control (voting rights), and share in earnings are usually diluted.

In terms of cost of financing: Capital Asset Pricing Model or Dividend Growth Model

In terms of tax effect: Not tax deductible

In terms of financial obligations: No specific financial obligations to shareholders.

In terms of inflation: None

In terms of payment requirement, default risk: Does not require a fixed dividend; these are paid from profits when available.

In terms of maturity: No fixed maturity date for repayment of capital

In terms of limitation: It grows in value with success of the firm.

In terms of flexibility: None

Hybrid Financing - Preference Shares

In terms of control: No voting rights, except in the case of financial distress.

In terms of cost of financing: Capital Asset Pricing Model or Dividend Growth Model

In terms of tax effect: Not deductible

In terms of financial obligations: No specific financial obligations to shareholders. However, cumulative preferred stock makes payment of dividends almost mandatory.

In terms of inflation: None

In terms of payment requirement, default risk: No default risk because non-payment of dividend does not necessarily mean bankruptcy.

In terms of maturity: No maturity date.

In terms of limitation: Dividend payment is limited to stated amount.

In terms of flexibility: Call features and provision of sinking fund may be included, so the firm may replace the issue if interest rates decline.

Pre-Emptive Right

Is a provision in the corporation charter or by-laws that gives common stockholders the right to purchase on a pro-rata basis new issues of common stock (or convertible securities). The purpose of this is:

a. It prevents the management of a corporation from issuing a large number of additional shares and purchase those shares itself.

b. It protects stockholders from a dilution of value.

Equity Financing - Retained Earnings

Earnings after deducting interest, taxes, and preferred dividends may be retained and used to pay common cash dividends or be plowed back into the firm in the form of additional capital investment through stock dividends.

Equity Financing - Retained Earnings

Its after-tax opportunity cost is lower than that for newly issued common stock (no flotation costs).

Equity Financing - Retained Earnings

A source of financing that leaves the present control structure intact.

Hybrid Financing

A source of financing that possess a combination of features; they include preferred stock, leasing, and option securities such as warrants and convertibles.

Preferred Stock

These are hybrid securities because some of its characteristics are like those of both common stocks and bonds.

Preferred Stock

Debt Characteristic: It has only a limited claim on a firm's earnings and assets like how a creditor can only claim the proceeds and interest (if any) due to him.

Equity Characteristic: It represents part of ownership or equity in a firm like how common shareholders do.

Preferred Stock

Has priority to assets and earnings. It only has par-value shares. It may either be cumulative or non-cumulative. It may contain a convertibility feature where the preferred shares will be converted into common shares.

Lease Financing

Is a rental agreement that typically requires a series of fixed payments that extend over several periods. Similar to borrowing, payments are very similar to loan amortizations. Like loan agreements, it usually contains restrictive covenants.

Lease Financing

Has become a major means of financing because it offers a variety of tax and other benefits such as:

a. Increased flexibility

b. Known cost of maintenance

c. Lower administrative costs

d. Tax shield from lease payments (if leased) instead of depreciation (if purchased).

Operating Lease

Short-term and often cancellable obligations. It is not shown on the balance sheet; maintenance and upkeep of asset is provided by the lessor; lease payment is treated as rent expense. This is a form of off-balance sheet financing.

Finance Lease

Non-cancellable, longer-term lease that fully amortizes the lessor's cost of the asset; service and maintenance are usually provided by the lessee.

Sale-Leaseback Agreement

Assets that are already owned by a firm are purchased by a lessor and leased back to the firm.

Leveraged Leases

The lessor borrows a substantial portion of the acquisition cost of the leased asset from a third party.

Convertible Securities

Preferred stock or debt issue that can be exchanged for a specified number of shares of common stock at the will of the owner.

Options

Created by outsiders rather than the firm itself; it is a contact that gives its holders the right to buy (or sell) stocks at some predetermined price within a specified period.

Warrant

An option granted by the corporation to purchase a specified number of shares of common stock at a stated price exercisable until sometime in the future called the expiration date. It is often attached to debt instruments as an incentive for investors to buy the combined issue at a lower interest rate.

Cost of Capital

The cost of using funds; it is also called hurdle rate, required rate of return, cut-off rate.

Cost of Capital

The weighted average rate of return the company must pay to its long-term creditors and shareholders for the use of their funds.

Cost of Capital - Common Shares (Retained Earnings)

The cost is an opportunity cost common shareholders would have. (The rate that investors can earn elsewhere on investments of comparable risk).

Capital Asset Pricing Model (CAPM)

Rate of Return = Risk Free Rate + Beta Coefficient (Market Return - Risk Free Rate)

Risk Free Rate

A rate determined by government securities (e.g., treasury bills).

Beta Coefficient of an Individual Stock

Is the correlation between the volatility of the stock market and the volatility of the price of the individual stock.

Market Risk Premium

Is the amount above risk-free rate required to induce average investors to enter the market.

Diversifiable Risk

Also known as controllable risk or unsystematic risk or company specific risk, represents the portion of a security's risk that can be controlled through diversification. This type of risk is unique to a given security.

Business Risk

Risk that is caused by fluctuations of EBIT (Operating Income). It depends on the variability in demand, sales price, input prices, and amount of operating leverage.

Liquidity Risk

Is the possibility that an asset may not be sold on short notice for its market value.

Default Risk

The risk that a borrower will be unable to make interest payments or principal repayments on debt.

Non-Diversifiable Risk

Also known as non-controllable risk, systematic risk, or market-related risk, results from forces outside of the firm's control and is therefore not unique to the given security.

Market Risk

Is the risk that a stock's price will change due to changes in stock market since prices of all stocks are correlated to some degree with broad swings in the stock market.

Interest Rate Risk

Is the risk resulting from fluctuations in the value of an asset as interest rates change.

Purchasing Power Risk

Is the risk that a rise in price will reduce the quantity of goods than can be purchased with a fixed sum of money.

CAPM Model

Is a model developed by American economist, William Sharpe, it deals with the relationship between (1) non-diversifiable/systematic risk and (2) expected return for assets, particularly stocks.

CAPM Model

The fundamental idea behind this model is that investors expect a reward for both waiting and worrying:

a. If you invest in a risk-free T-bill, you just receive the rate of interest. This is the reward for waiting.

b. When you invest in risky stocks, you can expect an extra return or risk premium for worrying.

True

(True or False) The limitation of the CAPM model is that it requires a single measure of systematic risk.

Dividend Growth Model

Also known as the dividend discount model, it is a method of arriving at the value of a stock by using expected dividends per share and discounting them back to present value.

Dividend Growth Model

D1/P0 x (1 - Flotation Costs) + G

D1 = Next Dividend

P0 = Current Price

G = Growth Rate in Dividends per Share

Dividend Growth Model

Assumes that the total return on a share of common stock is comprised of a dividend yield and a capital gains yield.

Dividend Growth Model - Retained Earnings (Internal Equity)

D1/P0 + G

Cost of Common Stock and Retained Earnings (Alternative Approach)

Earnings per Share / Market Price per Share

Cost of Preferred Shares (Alternative Approach)

Preferred Dividends per Share / Current Market Price or Net Issuance Price

Cost of Long-Term Debt

Interest Rate ( 100% - Tax Rate)

Leverage

Is that portion of the fixed costs which represents a risk to the firm.

Operating Leverage

Is a measure of operating or business risk, refers to the degree to which a firm uses and incurs fixed costs in its operations. It is the risk to the firm of being unable to cover operating costs.

Degree of Operating Leverage

CM/EBIT

DOL

Change in EBIT/Change in Sales

Financial Leverage

Is a measure of financial risk, it refers to financing a portion of the firm's assets, bearing fixed financing charges in hopes of increasing the return to the common shareholders. It is the risk to the firm of being unable to cover financial obligations.

Degree of Financial Leverage

EBIT / EBIT - FFC (Fixed Financial Charges: Interest Chargers + Pre-Tax Preferred Dividends)

Degree of Financial Leverage

Change in EPS/Change in EBIT

True

(True or False) The higher the financial leverage, the higher the financial risk, and the higher the cost of capital since it costs more to raise funds for a risky business.

Total Leverage

A measure of total risk, it determines how EPS is affected by a change in sales.

Degree of Total Average

CM / EBIT - FFC

Degree of Total Average

DOL x DFL

Degree of Total Average

Change in EPS / Change in Sales

Capital Structure

Refers to the mix of the long-term financing that comprises the sources of funds used by a firm that do not mature with one year, such as long-term debt, preferred and common equity.