© 2008 by Nelson, a division of Thomson Canada Limited Transparency 8.1 Finance for Non-Financial Managers Fifth Edition Slides prepared by Pierre G. Bergeron

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 8.1

Finance for Non-Financial ManagersFifth Edition

Slides prepared by

Pierre G. BergeronUniversity of Ottawa


Cost of Capital and Capital Structure

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

Chapter Objectives


Return on Assets and Cost of Capital

Balance Sheet

Current assets

Capital assets

Cost of capital 12%Capital budget (IRR) 14%

Current liabilities

Long-term debts

Equity

Cost of financing 11%ROA 12%

Spread

New capital (financing)New capital assets

EVA


Interdependence of the Major Areas of Finance

Capital structure

Sources of funds Cost of capital

Expected return

Capital Budgeting

Discount rate


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%

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

Cost of Capital and the Leverage Concept

expecteddemanded


1. Financial Structure versus Capital Structure

structureRefers to the way the firm’s assets are

financed by all debts (short- and long-term)

and equity.

Financial

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).

structure

Capital


2. Modern Industries – Cost of Financing VS ROABefore Taxes

After Taxes

Refer to transparencies 4.4 and 4.5 for details.

Balance Sheet

Assets $ 1,200,000

Total $ 1,200,000

Debt $ 800,000

Equity 400,000

Total $ 1,200,000

@ 10% x .67 = 6.7%

@ 14% x .33 = 4.6%

1.00 = 11.3%

Income $ 160,000

ROA 13.3% Cost financing 11.3%

Balance Sheet

Assets $ 1,200,000

Total $ 1,200,000

Debt $ 800,000

Equity 400,000

Total $ 1,200,000

@ 5% x .67 = 3.3%

@ 14% x .33 = 4.6%

1.00 = 7.9%

Income $ 80,000

ROA 6.7% Cost financing 7.9%


3. Modern Industries – Economic Value Added (EVA)Balance Sheet

Current assets $ 400,000Capital assets 800,000

Total $ 1,200,000

Other liabilities $ 120,000Notes payable 80,000Long-term debt 600,000Equity 400,000Total $ 1,200,000

Notes payable $ 80,000

Long-term debt 600,000

Equity 400,000

Total $ 1,080,000

Cost of Capital (after tax)

@ 6.0%

@ 5.0%

@ 14.0%

X .074

X .555

X .371

1.000

= 0.44 %

= 2.77 %

= 5.19 %

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


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 $300,000 1.00 = 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)

4. Modern Industries – Cost of Capital


Using Income Before Interest but After Taxes (page 6.5)

$117,500$1,200,000

9.79% (ROA)=

To Summarize Different Cost Calculations

Net income (page 6.4)

$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)

Net income (page 6.8)

8.97% (CC)8.97% (IRR)


Cost of Capital (for publicly owned companies)

$5 $2

$7 $7 = 10% + 12% = 10.57%

1. 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 = 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


$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 %



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 11.428%



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%


5. Leverage Analysis

Operating leverage Financial leverage

Total leverage

10%

18%

Sales revenue

EBIT

14%

10%

Earnings

Per

Share


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).


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 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.

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


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%

Calculating the Operating Leverage

Contribution margin $700,000

Contribution – Fixed costs $400,000= = 1.75 times



EBIT $ 400,000 $ 440,000 10.0%

Interest 150,000 150,000 -----

Income before taxes $ 250,000 $ 290,000 16.0%

Calculating the Financial Leverage

EBIT $400,000

EBIT - Interest $250,000= = 1.6 times



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%

Calculating the Combined Leverage

Contribution margin $700,000

EBIT - Interest $250,000

OR

1.75 X 1.6 = 2.8 times

= = 2.8 times

Documents

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 8.1 Finance for Non-Financial Managers Fifth Edition Slides prepared by Pierre G. Bergeron