Finance for NonFinancial Managers Fifth Edition

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Finance for Non-Financial ManagersFifth Edition

• Slides prepared by
• Pierre G. Bergeron
• University of Ottawa

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Cost of Capital and Capital Structure
Chapter Objectives

• 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
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Return on Assets and Cost of Capital
Balance Sheet
Current assets Capital assets
Current liabilities Long-term debts Equity
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Interdependence of the Major Areas of Finance
Capital structure
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Cost of Capital and the Leverage Concept
expected
Cost of capital represents a companys 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
demanded
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
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1. Financial Structure versus Capital Structure
Financial
Refers to the way the firms assets are financed
by all debts (short- and long-term) and equity.
structure
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).
Capital
structure
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2. Modern Industries Cost of Financing VS ROA
Before Taxes
Balance Sheet
_at_ 10 x .67 6.7
Debt 800,000 Equity 400,000 Total
1,200,000
Assets 1,200,000 Total 1,200,000
_at_ 14 x .33 4.6
1.00 11.3
Income 160,000 ROA 13.3
After Taxes
Balance Sheet
Debt 800,000 Equity 400,000 Total
1,200,000
_at_ 5 x .67 3.3
Assets 1,200,000 Total 1,200,000
_at_ 14 x .33 4.6
1.00 7.9
Income 80,000 ROA 6.7
Refer to transparencies 4.4 and 4.5 for details.
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3. Modern Industries Economic Value Added (EVA)
Balance Sheet
Current assets 400,000 Capital assets
800,000 Total
1,200,000
Other liabilities 120,000 Notes
payable 80,000 Long-term debt
600,000 Equity
400,000 Total 1,200,000
_at_ 6.0 _at_ 5.0 _at_ 14.0
X .074 X .555 X .371 1.000
0.44 2.77 5.19 8.40
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4. Modern Industries Cost of Capital
Balance Sheet B.T. A.T. Assets
300,000 New debt 200,000 _at_ 12 6 x
.67 4.02 _________ New equity 100,000 _at_
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)
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To Summarize Different Cost Calculations
Net income (page 6.4)

7.9 (cost of financing)
6.7 R.O.A.
80,0001,200,000

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Cost of Capital (for publicly owned companies)

• Long-term debts (7 million)
• Bond A amounting to 5 million _at_ 10
• Bond B amounting to 2 million _at_ 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
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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)
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Cost of Capital (for publicly owned companies)
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
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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)
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5. Leverage Analysis
Operating leverage
Financial leverage
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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).
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Operating Leverage
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.
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
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Calculating the Operating Leverage
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
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Calculating the Financial Leverage
For the proposed production methods
(high) EBIT 400,000 440,000 10.0 Inte
rest 150,000 150,000 ----- Income
before taxes 250,000 290,000 16.0
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Calculating the Combined Leverage
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 Interest 150,000
150,000 ----- Income before taxes
250,000 320,000 28.0