Managerial Finance Capital Structure: Risk and Return in the Financing Decision Week 4

MF Lecture 4 How do we finance new investments? Who are the players? What are the rules? What does this imply for the “value adding process”? What is your cost of capital?

What is Capital?

DebtEquity Where does Capital come from ?

The Players The Entrepreneur The Lender The Investor

What is Equity? People/organisations that invest in your business and own it (all or a part) Only way they get their money out is to sell to someone else The get their “cash return” through dividends and By selling their shares for more than they paid

Debt What is debt? When do you have to pay it? What do you have to pay?

Assets Generate: Operating Cash Flow Lenders (Debt) Take Interest & Principal Government Takes Taxes Cash Flow to Equity

Types of Capital

Capital Structure Financial Leverage –Using fixed financing costs to magnify effects on earnings before interest and taxes (EBIT) Let’s buy a house with € using different Debt versus Equity financings

You finance 100% of your assets yourself Borrow$0 Invest$100,000 Total$100,000 House value increases by 50% and you sell for $150,000 Sell$150,000 Profit$50,000 ROE50% No Financial Leverage

You finance 75% of your house through debt Borrow$75,000 Invest$25,000 Total$100,000 House value increases by 50% and you sell for $150,000 Sell$150,000 Repay Loan$75,000 Remaining$75,000 Profit$50,000 ROE200% !!! Debt/Equity = 3.0

You finance 75% of your assets through debt Borrow$75,000 Invest$25,000 Total$100,000 Asset value decreases by 10% and you sell for $90,000 Sell$90,000 Repay Loan$75,000 Remaining$15,000 Profit-$10,000 ROE-40% Debt/Equity = 3.0 and things go sour…

Optimal Capital Structure an optimal capital structure exists which balances the risk of bankruptcy with the tax savings of debt. Once established, this capital structure should provide greater returns to stockholders than they would receive from an all-equity firm.

Capital Structure of Non-U.S. Firms In general, US, UK, Canada and Japan use less debt than France, Italy, Germany In most European and Pacific Rim countries, large commercial banks are more actively involved in the financing of corporate activity than has been true in the U.S.

Capital Structure of Non-U.S. Firms (cont.) For example, the same industry patterns of capital structure tend to be found around the world. In addition, the capital structures of U.S.- based MNCs tend to be similar to those of foreign-based MNCs.

Cost of Capital Cost of Equity Cost of Debt

Investment decisions must: 1.Return invested capital (whether debt or equity) 2.Offset anticipated inflation over time 3.Compensate investors for the risk they are taking

Risk Defined In the context of business and finance, risk is defined as the chance of suffering a financial loss. Assets (real or financial) which have a greater chance of loss are considered more risky than those with a lower chance of loss. Risk may be used interchangeably with the term uncertainty to refer to the variability of returns associated with a given asset.

Cost of Equity To estimate a firm’s cost of equity, we need to know two things: Risk free rate plus Extra amount to compensate for additional risk (risk premium)

Cost of Debt Cost of debt a bit easier to calculate: Current interest rate to borrow (r d ), which includes risk premium Tax Rate (T)

Which is more expensive - equity or debt? Why?

Understanding WACC The capital funding of a company is made up of two components: debt and equity. Lenders and equity holders each expect a certain return on the funds or capital they have provided. The cost of capital is the expected return to equity owners (or shareholders) and to debt holders, so WACC tells us the return that both stakeholders - equity owners and lenders - can expect. WACC, in other words, represents the investors' opportunity cost of taking on the risk of putting money into a company. Source: Investopedia.com

Assume the ABC company has the following investment opportunity: - Initial Investment = $100,000 - Useful Life = 20 years - Minimum Return = 7% - Least cost source of financing, Debt = 6% Given the above information, a firm’s financial manger would be inclined to accept and undertake the investment. The Basic Concept Why do we need to determine a company’s overall “weighted average cost of capital?”

Imagine now that only one week later, the firm has another available investment opportunity - Initial Investment = $100,000 - Useful Life = 20 years - Minimum Return = 12% - Least cost source of financing, Equity = 14% Given the above information, the firm would reject this second, yet clearly more desirable investment opportunity. The Basic Concept (cont.) Why do we need to determine a company’s overall “weighted average cost of capital?”

So…. WACC Formula The Weighted Average Cost of Capital is given by: It is because interest expense is tax deductible that we multiply the last term by (1 - Tax Rate) r WACC = Equity + Debt Equity × r Equity + Equity + Debt Debt × r Debt ×(1 – T C )

WACC = r a = w i r i + w e r d (1-T) The weights in the above equation are intended to represent a specific financing mix (where w i = % of debt and w e = % of equity). The Weighted Average Cost of Capital Capital Structure Weights

Some Key Assumptions Business Risk—the risk to the firm of being unable to cover operating costs—is assumed to be unchanged. This means that the acceptance of a given project does not affect the firm’s ability to meet operating costs. Financial Risk—the risk to the firm of being unable to cover required financial obligations—is assumed to be unchanged. This means that the projects are financed in such a way that the firm’s ability to meet financing costs is unchanged. After-tax costs are considered relevant—the cost of capital is measured on an after-tax basis.

Financial Risk

Operational Risk

Risk-Return Tradeoff How much uncertainty? Risk premium

CF/Share Chart What is the point of this? Your Cashflow/Share (EBIT) Best mix for you (Debt/Equity)

The Value Adding Manager Value adding means: Every decision you make is designed to result in a return in excess of the capital resources used to invest in that decision Cost of Capital Value Added

Assignments Questions Par value should remain the same You decide number of shares to issue

Good Luck!