REVISION

QUESTION? WHAT ARE THE KEY SOURCES OF FINANCE AVAILABLE TO A COMPANY ?

EXTERNAL FUNDING EQUITY EQUITY COMMON STOCK COMMON STOCK PREFERRED STOCK PREFERRED STOCK INTEREST BEARING DEBT INTEREST BEARING DEBT COMPANY ISSUED COMPANY ISSUED DEBENTURES DEBENTURES COMPANY BONDS COMPANY BONDS EXTERNALLY RAISED EXTERNALLY RAISED LOANS LOANS WARRANTIES WARRANTIES

CAN THE COMPANY RAISE FINANCE BY OTHER MEANS TO REDUCE THE VOLUME OF CAPITAL REQUIRED?

OTHER SOURCES LEASING OF PROPERTY OR CAPITAL ASSETS SUCH AS MACHINERY. – THIS CAN REDUCE THE SIZE OF THE DEBT REPAYMENTS AND ASSOCIATED CASH OUTFLOWS HIRE PURCHASE – WHEN RAISING FINANCE WHAT MUST ALWAYSBE TAKEN INTO CONSIDERATION?

ALL SOURCES OF FINANCE HAVE A COST ! What is the cost of equity THE RISK PREMIUM RATE THE RISK PREMIUM RATE THIS RATE IS BASED UPON THE RISK ASSOCIATED WITH THE PROJECT FOR WHICH THE EQUITY IS RAISED THIS RATE IS BASED UPON THE RISK ASSOCIATED WITH THE PROJECT FOR WHICH THE EQUITY IS RAISED AND THE COMPANY ITSELF

FROM WHERE IS THIS RATE COMMONLY DETERMINED?

COMMON STOCK COMMONLY DETERMINED USING THE; COMMONLY DETERMINED USING THE; CAPITAL ASSET PRICING MODEL = CAPM CAPITAL ASSET PRICING MODEL = CAPM THIS MODEL PLOTS THE RISK ASSOCIATED WITH THE SHARES ON A GRAPH THIS MODEL PLOTS THE RISK ASSOCIATED WITH THE SHARES ON A GRAPH A COMPARISON IS MADE WITH THE RISK FREE RATE AND THE CAPITAL MARKET VALUE A COMPARISON IS MADE WITH THE RISK FREE RATE AND THE CAPITAL MARKET VALUE

PREFERRED STOCK CALCULATED BY DIVIDING THE AGREED PAYMENT (PERIODIC) BY THE PRICE OF THE PREFERRED SHARES CALCULATED BY DIVIDING THE AGREED PAYMENT (PERIODIC) BY THE PRICE OF THE PREFERRED SHARES E.G 5% / £ 275 E.G 5% / £ 275

WHAT IS CONSIDERED TO BE GOOD FINANCIAL MANAGEMENT WHEN SECURING EXTERNALFUNDING?

TO ARRANGE THE LOWEST AVERAGE COST OF CAPITAL THIS IS MEASURED BY THE WEIGHTED AVERAGE COST OF CAPITAL (WACC) THE WACC = THE REQUIRED RATE OF RETURN THAT IS REQUIRED BY THE LENDERS OF THE FINANCE, AND WEIGHTED ACCORDING TO THE PROPORTION EACH ELEMENT CONTRIBUTES TO THE TOTAL POOL OF CAPITAL

HELP! TO CALCULATE THE WACC IT IS NECESSARY TO; TO CALCULATE THE WACC IT IS NECESSARY TO; MULTIPLY THE COST OF EACH ELEMENT OF CAPITAL FOR A PROJECT BY ITS PERCENTAGE OF THE TOTAL CAPITAL MULTIPLY THE COST OF EACH ELEMENT OF CAPITAL FOR A PROJECT BY ITS PERCENTAGE OF THE TOTAL CAPITAL ADD THE RESULTS TOGETHER ADD THE RESULTS TOGETHER

A NICE EASY CALCULATION WACC = EQUITY PERCENTAGE X EQUITY COST + DEBT PERCENTAGE X DEBT COST EG A COMPANY WISHES TO RAISE £50m Capital structure = Equity (rights Issue) £15m and debt (bond issue) £35m Equity rate of return = 12% Debt rate of return is 5%

answer EP X EC + DP XDC = £15 / 50 = 30% 30% x 12% =3.6 £35 / 5 = 70% 70% x 5% Total = = 7.1% wacc Note taxation!!

INVESTORS USE WACC TO ASSIST IN DECIDING IF THE INVESTMENT REPRESENTS A GOOD OPPORTUNITY WACC CAN REPRESENT THE RATE AT WHICH THE COMPANY WILL GENERATE VALUE FOR THE INVESTORS E.G IF THE COMPANY GENERATES A RETURN ON INVESTMENT OF 9.25% THEN IT HAS GENERATED A 3% INCREASE IN VALUE

REMEMBER WACC SHOULD BECOME THE HURDLE RATE OR DISCOUNT RATE APPLIED IN INVBESTMENT APPRAISAL WACC REPRESENTS THE CAPITAL STRUCTURE OF A COMPANY A PROJECT MUST ADD WEALTH TO THE OWNERS