Corporate Financial Management | My Assignment Tutor

Slide 31.1Glen Arnold, Corporate Financial Management, 5th Edition © Pearson Education Limited 2013IFM: Lecture 5Long-Term financing and WeightedAverage Cost of Capital (WACC)Dr. Jia Miao, PhD CFAjia.miao@uwtsd.ac.ukSlide 31.2Glen Arnold, Corporate Financial Management, 5th Edition © Pearson Education Limited 2013• Ordinary shares Ordinary shares represent the equity share capital of the firm Share in the rising prosperity of a company Owners of the firm The right to exercise control over the company Vote at shareholder meetings A right to receive a share of dividends distributed Each shareholder entitled to a copy of the annual report No agreement between ordinary shareholders and the companythat the investor will receive back the original capital invested What ordinary shareholders receive depends on how well thecompany is managedWhat is equity capital?Slide 31.3Glen Arnold, Corporate Financial Management, 5th Edition © Pearson Education Limited 2013• Debt (e.g. bank loans, bonds) Usually the lenders (creditors) to the firm have no official control Usually requires regular cash outlays in the form of interest andthe repayment of the capital sum (firm will be obliged to maintainthe repayment schedule through good years and bad)• Disadvantage of ordinary shares for investors Last in the queue to have their claims met Unlike interests from debt investment, dividends are notguaranteed. No repayment of principal from issuers. Although expected returns are higher than debt investment, thereal returns are more volatile (riskier investments)Debt and Equity for InvestorsSlide 31.4Glen Arnold, Corporate Financial Management, 5th Edition © Pearson Education Limited 2013• Advantages Usually there is no obligation to pay dividends The capital does not have to be repaid• Disadvantages High cost Direct costs of issue The return required to satisfy shareholders Loss of control Dividends cannot be uses to reduce taxable profit (see below)Advantages and disadvantagesof share issues (companies)Slide 31.5Glen Arnold, Corporate Financial Management, 5th Edition © Pearson Education Limited 2013• Preference shares usually offer their owners a fixed rate ofdividend each year• However if the firm has insufficient profits the amount paidwould be reduced, sometimes to zero• The dividend on preference shares is paid before anythingis paid out to ordinary shareholders• Preference shares are part of shareholders’ funds but arenot equity share capitalPreference sharesSlide 31.6Glen Arnold, Corporate Financial Management, 5th Edition © Pearson Education Limited 2013• Advantages: Dividend ‘optional’ Influence over management Extraordinary profits Financial gearing considerations (usually treated as debt)• Disadvantages: High cost of capital compared to other debts (loans/bonds) Dividends are not tax deductibleAdvantages and disadvantagesto the firm of preference shareSlide 31.7Glen Arnold, Corporate Financial Management, 5th Edition © Pearson Education Limited 2013Source: London Stock Exchange: www.londonstockexchange.com. Reproduced courtesty of London Stock Exchange plc.Equity finance raised by UKcompanies through the new issuemarket, 2000-2006Slide 31.8Glen Arnold, Corporate Financial Management, 5th Edition © Pearson Education Limited 2013• A rights issue is an invitation to existing shareholders topurchase additional shares in the company• Pre-emption rights• Shares are usually offered at a significantly discountedprice from the market valueRights issuesSlide 31.9Glen Arnold, Corporate Financial Management, 5th Edition © Pearson Education Limited 2013Cost of capital• The cost of capital is the rate of return that a company has tooffer finance providers to induce them to buy and hold a financialsecurity. This rate is determined by the returns offered onalternative securities with the same risk.• A word of warning– Behind any final number generated lies an enormous amount ofsubjective assessment– Good decision making comes from knowing the limitations ofthe input variables to the decision– Knowing where informed judgement has been employed in thecost of capital calculation is required to make value-enhancingdecisions and thus assist the art of management– Precision is less important than knowledge of what is areasonable rangeSlide 31.10Glen Arnold, Corporate Financial Management, 5th Edition © Pearson Education Limited 2013The required rate of return• The capital provided to large firms comes in many forms• The rate of return offered on government bonds and Treasurybills is the bedrock rate that is used to benchmark other interestrates. It is called the risk-free rate of return, given the symbol rf• The cost of debt for a corporation kd, is:kd = rf + DRP (debt risk premium)• The cost of equity for a corporation ke, is:ke = rf + ERP (Equity risk premium)• The cost of capital for a corporation kp, is:kp = rf + PRP (Preference share risk premium)Slide 31.11Glen Arnold, Corporate Financial Management, 5th Edition © Pearson Education Limited 2013Range of risk and returns• If the form of finance provided is equity capital then the investoris accepting a fairly high probability of receiving no return• On the other hand, if the firm performs well very high returns canbe expected.Exhibit 16.1 Risk–return – hypothetical examplesSlide 31.12Glen Arnold, Corporate Financial Management, 5th Edition © Pearson Education Limited 2013The weighted average cost of capital (WACC)• A corporation is to be established by obtaining one-half of its £1,000million of capital from lenders, who require an 8 per cent rate of returnfor an investment of this risk class, and one-half from shareholders,who require a 12 per cent rate of return Cost of debtkD = 8%Cost of equityWeight of debtWeight of equitykE = 12%WD = 0.5WE = 0.5VD/(VD + VE)VE/(VD + VE)£500 million / £1 billion£500 million / £1 billion VD = Market value of debt, VE = Market value of equityWeighted average cost of capital, WACC = kE WE + kD WDWACC = (12 × 0.5) + (8 × 0.5) = 10%Slide 31.13Glen Arnold, Corporate Financial Management, 5th Edition © Pearson Education Limited 2013Tax DeductibilityTax benefit from a debt instrument in this case is:Interest payable * tax rate = 80,000 * 30% = 24,000Slide 31.14Glen Arnold, Corporate Financial Management, 5th Edition © Pearson Education Limited 2013Lowering the WACC due to the tax shieldkDBT = Cost of debt before tax benefit = 8%kDAT = Cost of debt after tax benefit = 8 (1 – T) = 8 (1 – 0.30)= 5.6%• If we assume a 50:50 capital structure the WACC is:WACC = kE WE + kDAT WDWACC = (12 × 0.5) + (5.6 × 0.5) = 8.8%• Investment project cash flows discounted at this lower rate willhave a higher present value than if discounted at 10 per cent• This extra value flows to shareholdersSlide 31.15Glen Arnold, Corporate Financial Management, 5th Edition © Pearson Education Limited 2013Financial distress constrains gearingExhibit 16.3 Cost of capital with different capital structures (includingconsideration of the tax shield and finance distress)Slide 31.16Glen Arnold, Corporate Financial Management, 5th Edition © Pearson Education Limited 2013WACC• Calculating the weights– Book (accounting) values for debt, equity and hybrid securitiesshould not be used in calculating the weighted average cost ofcapital. Market values should be used– Market capitalisation figure are available in Monday editions ofthe Financial Times for quoted companies – also websites• The WACC with three or more types of financeWACC = kEWE + kDATWD + kpWpWE = ––––––––––––– WD = ––––––––––––– WP = –––––––––––––VE VD VPVE + VD + VP VE + VD + VP VE + VD + VPSlide 31.17Glen Arnold, Corporate Financial Management, 5th Edition © Pearson Education Limited 2013Problems with calculating WACC• Which sources of finance should be included in theWACC calculation?• What about long-term bank debt?– use book value and average interest rate– accounts may not provide adequate data– internal information will be required• Company may have large range of securities.• WACC is not constant.Slide 31.18Glen Arnold, Corporate Financial Management, 5th Edition © Pearson Education Limited 2013• Capital Investment Appraisal using current WACC asdiscount rate.– New financing similar to current financing structure– Size of new financing is relatively small– No material change in financing costs– Risk of new project equivalent to current risk as a whole.WACC

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