Copyright © 2011 Nelson Education Limited Finance for Non-Financial Managers, 6 th edition PowerPoint Slides to accompany Prepared by Pierre Bergeron, University of Ottawa

Copyright © 2011 Nelson Education Limited Finance for Non-Financial Managers, 6 th edition CHAPTER 9 COST OF CAPITAL, CAPITAL STRUCTURE, AND FINANCIAL MARKETS

Copyright © 2011 Nelson Education Limited Cost of Capital, Capital Structure and Financial Markets 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 Chapter Objectives

Copyright © 2011 Nelson Education Limited Return on Assets and Cost of Capital Statement of Financial Position Non-current assets Current assets Cost of capital 12%Capital budget (IRR) 14% Equity Non-current liabilities Current liabilities Cost of financing 11%ROA 12% Spread New capital (financing)New non-current assets EVA

Copyright © 2011 Nelson Education Limited Interdependence of the Major Areas of Finance Capital structure …or the composition of the sources of funds… Cost of capital …to determine the financial attractiveness of capital projects Capital Budgeting …determines the discount rate used…

Copyright © 2011 Nelson Education Limited Cost of capitalRepresents a company’s composite rate of return _________ or even ___________ by investors. Amounts of PercentageCost of Proportion Sources of capital capital of total capital of cost Personal $ 50, x 9.0% = 4.5% Source A $ 20, x 10.0% = 2.0% Source B $ 20, x 12.0% = 2.4% Source C $ 10, x 14.0% = 1.4% $100, % Cost of Capital and the Leverage Concept expected demanded 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. Leverage

Copyright © 2011 Nelson Education Limited 1. Financial Structure versus Capital Structure structure Refers to the way the firm’s assets are financed by equity and all debts (long- and short-term). Financial 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). structure Capital

Copyright © 2011 Nelson Education Limited 2. Modern Industries – Cost of Financing VS ROA Before Taxes After Taxes Refer to slides 4.6 and 4.7 for details. Statement of financial position Assets $ 1,200,000 Total $ 1,200,000 Equity $ 400,000 Debt 800,000 Total $ 14% x.33 = 10% x.67 = 6.7% 1.00 = 11.3% Profit $ 160,000 ROA 13.3% Cost financing 11.3% Statement of financial position Assets $ 1,200,000 Total $ 1,200,000 Equity $ 400,000 Debt 800,000 Total $ 14% x.33 = 5% x.67 = 3.3% 1.00 = 7.9% Profit $ 80,000 ROA 6.7% Cost financing 7.9%

Copyright © 2011 Nelson Education Limited 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 Equity $ 400,000 Long-term borrowings 600,000 Notes payable 80,000 Total $ 1,080,000 Cost of Capital (after 6.0% X.371 X.555 X = 5.19 % = 2.77 % = 0.44 % 8.40 % Operating profit $ 155,000 Add back int. income 80,000 Total 235,000 Less taxes (117,500) $ 117,500 EVA Weighted cost 8.40% Total capital $ 1,080,000 Minus $ 90,720 EVA = + $ 26,780

Copyright © 2011 Nelson Education Limited Statement of Financial Position B.T. A.T. Assets$ 300,000 New equity 15% 15% x.33 = 4.95% ________ New debt 12% 6% x.67 = 4.02% Total$ 300,000Total $300, = 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) 4. Modern Industries – Cost of Capital

Copyright © 2011 Nelson Education Limited Using Profit Before Finance Costs but After Taxes (slide 9.7) $117,500 $1,200, % (ROA) = To Summarize Different Cost Calculations Profit for the year (slide 9.6) $80,000 $1,200,000 = 6.7% R.O.A. 7.9% (cost of financing) $117,500 $1,080,000 =10.88% (ROI) 2.48% (EVA) (8.40%) (CC) 8.40% (cost of capital) Profit for the Year (slide 9.8) 8.97% (CC)8.97% (IRR)

Copyright © 2011 Nelson Education Limited Cost of Capital (for publicly owned companies) $5 $2 $7 = 10% + 12% = 10.57% 1.Long-term borrowings ($7 million) Bond A amounting to $5 10% Bond B amounting to $2 12% Step 1: Average cost of bonds Step 2: Effective cost of debt = Before tax cost x (1.0 - tax rate) 10.57% x ( ) = 5.28% 2.Preferred shares ($1 million) Cost of preferred shares = Cost of preferred shares = = 12.5% $12 $100 - $4 Dividends on preferred shares Market value of shares – Flotation costs

Copyright © 2011 Nelson Education Limited $10 $100 (1 -.10) Dividend yield Market price of shares – Issues costs + Growth 3.Common shares ($10 million) Cost of common shares = Cost of common shares =+ 4%= 15.11% $10 $ Retained earnings ($ 2 million) Cost of retained earnings = + 4 % = 14 % Cost of Capital (for publicly owned companies)

Copyright © 2011 Nelson Education Limited After-tax Sources of capital Total amount Percentage cost of Proportion _______________ __________ of total capital of cost Borrowings $ 7,000, x 5.28% 1.848% Preferred shares $ 1,000, x12.50%.625% Common share $10,000, x15.11% 7.555% Retained earnings $ 2,000, x14.00% 1.400% $20,000, % Cost of Capital (for publicly owned companies)

Copyright © 2011 Nelson Education Limited Marginal Cost of Capital & Internal Rate of Return Cost of capital & IRR IRR 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% Capital funds raised and capital projects (in millions of dollars) MCC Cost of projects exceeds IRR 11.4% IRR Cumulative Ranking of capital projects Project A 35 % 35 % Project B 32% 33% Project C 28% 31% Project D 24% 28% Project E 22% 26% Classification of capital projects High risk 35 % and over Medium risk 25% to 35 % Low risk 10% to 25 % Compulsory negative to 10%

Copyright © 2011 Nelson Education Limited 5. Leverage Operating leverageFinancial leverage Total leverage 10% 18% Revenue EBIT 14% 10% Earnings Per Share

Copyright © 2011 Nelson Education Limited Leverage Definition Financial leverage Operating leverage Leverage consists of determining the most appropriate cost structure, at both the operating and financial levels, that will optimize the profitability of a business. Deals with the capital structure of a business, the one that will generate the greatest financial benefits to the shareholders (capital share versus debt). Deals with the cost behaviour of an operating unit (fixed and variable costs) and excludes finance costs

Copyright © 2011 Nelson Education Limited Operating Leverage Present methods $200,000 $15.00 $10.00 $ 5.00 HighExpected Low 100,000 70,000 40,000 $ 1,500 $1,050 $ 600 (1,000) (700) (400) (200) (200) (200) (1,200) (900) (600) $ 300 $ 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 $8.00. Fixed costs Selling price Variable costs Contribution margin (in 000$) No. of units Revenue Variable costs Fixed costs Total costs Profit Proposed methods $300,000 $15.00 $ 8.00 $ 7.00 HighExpected 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)

Copyright © 2011 Nelson Education Limited For the proposed production methods (high) Revenue$1,500,000$1,650, % Variable costs (800,000) (880,000)10.0% Contribution margin 700, , % Fixed costs (300,000) (300,000) ---- Profit (EBIT)$ 400,000$ 470, % Calculating the Operating Leverage Contribution margin$700,000 Contribution – Fixed costs $400,000 = = 1.75 times

Copyright © 2011 Nelson Education Limited For the proposed production methods (high) EBIT$ 400,000$ 440, % Finance costs (150,000) (150,000) Profit before taxes $ 250,000 $ 290, % Calculating the Financial Leverage EBIT$400,000 EBIT – Finance costs $250,000 = = 1.60 times

Copyright © 2011 Nelson Education Limited For the proposed production methods (high) Revenue$1,500,000$1,650, % Variable costs (800,000) (880,000)10.0% Contribution margin 700, , % Fixed costs (300,000) (300,000) ---- Profit (EBIT)$ 400,000$ 470, % Finance costs (150,000) (150,000) Profit before taxes$ 250,000$ 320, % Calculating the Combined Leverage Contribution margin$700,000 EBIT – Finance costs $250,000 OR 1.75 X 1.6 = 2.8 times = = 2.8 times

Copyright © 2011 Nelson Education Limited 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

Copyright © 2011 Nelson Education Limited 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

Copyright © 2011 Nelson Education Limited 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.