Finance for Non-Financial Managers , 6 th edition

1. Finance for Non-Financial Managers, 6th edition PowerPoint Slides toaccompany Prepared by Pierre Bergeron, University of Ottawa

2. Finance for Non-Financial Managers, 6th edition CHAPTER 9 COST OF CAPITAL, CAPITAL STRUCTURE, AND FINANCIAL MARKETS

3. Cost of Capital, Capital Structure and Financial Markets Chapter Objectives 1. Explain the financial and capital structures and cost concepts. 2. Clarify the meaning of cost of financing, why is is used and how it is calculated. 3. Explain the concept of the economic value added and how it is calculated. 4. Explain the components of the weighted average cost of capital and how it is calculated. 5. Explain the importance of leverage analysis and how it is calculated. 6. Give a profile of the financial markets, the stock market, and various theories related to the dividend theories and payments. Chapter Reference Chapter 9: Cost of Capital, Capital Structure and Financial Markets

4. Return on Assets and Cost of Capital ROA 12% Cost of financing 11% Spread New non-current assets New capital (financing) Capital budget (IRR) 14% Cost of capital 12% EVA Statement of Financial Position Non-current assets Current assets Equity Non-current liabilities Current liabilities

5. Cost of capital …or the composition of the sources of funds… …to determine the financial attractiveness of capital projects …determines the discount rate used… Capital Budgeting Interdependence of the Major Areas of Finance Capital structure

6. Cost of Capital and the Leverage Concept 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 expected 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.

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

8. Cost financing 11.3% Cost financing 7.9% 2. Modern Industries – Cost of Financing VS ROA Before Taxes Statement of financial position @ 14% x .33 = 4.6% Equity $ 400,000 Debt 800,000 Total $ 1,200,000 Assets $ 1,200,000 Total $ 1,200,000 @ 10% x .67 = 6.7% 1.00 = 11.3% Profit $ 160,000 ROA 13.3% After Taxes Statement of financial position Equity $ 400,000 Debt 800,000 Total $ 1,200,000 @ 14% x .33 = 4.6% Assets $ 1,200,000 Total $ 1,200,000 @ 5% x .67 = 3.3% 1.00 = 7.9% Profit $ 80,000 ROA 6.7% Refer to slides 4.6 and 4.7 for details.

9. Cost of Capital (after tax) Equity $ 400,000 Long-term borrowings 600,000 Notes payable 80,000 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) Statement of Financial position Non-current assets $ 800,000 Current assets 400,000 Total $ 1,200,000 Equity $ 400,000 Long-term borrowings 600,000 Notes payable 80,000 Other liabilities 120,000 Total $ 1,200,000 @ 14.0% @ 5.0% @ 6.0% X .371 X .555 X .074 1.000 = 5.19 % = 2.77 % = 0.44 % 8.40 %

10. 4. Modern Industries – Cost of Capital Statement of Financial Position B.T. A.T. Assets $ 300,000 New equity $100,000 @ 15% 15% x .33 = 4.95% ________ New debt 200,000 @ 12% 6% x .67 = 4.02% 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 statement of financial position) should give at least 8.97% or more. This will be examined in Chapter 11 (Capital Budgeting)

11. Using Profit Before Finance Costs but After Taxes (slide 9.7) 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) Profit for the Year (slide 9.8) 8.97% (IRR) 8.97% (CC) To Summarize Different Cost Calculations Profit for the year (slide 9.6) 7.9% (cost of financing) 6.7% R.O.A. $80,000$1,200,000 =

12. 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 borrowings ($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%

13. 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)

14. 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 Borrowings $ 7,000,000 .35 x 5.28% 1.848% Preferred shares $ 1,000,000 .05 x 12.50% .625% Common share $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

15. 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)

16. 5. Leverage 14% 18% Earnings Per Share Revenue EBIT 10% 10% Total leverage Operating leverage Financial leverage

17. 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 leverage Deals with the cost behaviour of an operating unit (fixed and variable costs) and excludes finance costs Financial leverage Deals with the capital structure of a business, the one that will generate the greatest financial benefits to the shareholders (capital share versus debt).

18. Operating Leverage From transparency 5.8 (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

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

20. Calculating the Financial Leverage For the proposed production methods (high) EBIT $ 400,000 $ 440,000 10.0% Finance costs (150,000) (150,000) ----- Profit before taxes $ 250,000 $ 290,000 16.0% EBIT$400,000 EBIT – Finance costs $250,000 = = 1.60 times

21. Contribution margin$700,000 EBIT – Finance costs $250,000 OR 1.75 X 1.6 = 2.8 times Calculating the Combined Leverage For the proposed production methods (high) 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% Finance costs (150,000) (150,000) ----- Profit before taxes $ 250,000$ 320,000 28.0% = = 2.8 times

22. 6. Financial Markets Deal with businesses, individual and government institutions including procedures involved in the buying and selling of financial assets. • Types of markets • • Money markets • • Capital markets • • Primary markets • • Secondary markets • • Spot and future markets • • Mortgage markets • • Consumer credit markets • • Physical asset markets

23. Stock Market Net of exchanges, brokers, and investors that trade securities (e.g., TSX). 1. Stock exchange 2. Types of companies: • Privately held companies • Publicly trade companies 3. Prospectus 4. Initial Public Offering 5. Listed company

24. Dividend Theories Dividend irrelevance theory Dividend payment has little effect to share price because if earnings are retained in the business for growth purposes, the incremental re-invested cash may cause the business to become more profitable and/or grow faster in the future. Dividend preference theory Investors prefer receiving dividends now compared to not receiving any due to the uncertainty factor. Dividend aversion theory Investors prefer not to receive dividends now in order to enhance share prices in the future.