1. Copyright © 2014 Nelson Education Ltd. 9–1 PowerPoint Presentations for Finance for Non-Financial Managers: Seventh Edition Prepared by Pierre Bergeron University of Ottawa

2. Copyright © 2014 Nelson Education Ltd. 9–2 CHAPTER 9 Cost of Capital, Capital Structure, and Financial Markets

3. Copyright © 2014 Nelson Education Ltd. 9–3 1.Describe the relationship between the major components of finance. 2.Explain financial and capital structure, and explain the cost concepts. 3.Explain why the cost of financing is used and how it is calculated. 4.Show how economic value added is used to measure managerial performance related to maximizing shareholder wealth. 5.Describe the parts of the average weighted cost of capital: common shares, retained earnings, preferred shares, and long- term borrowings. 6.Demonstrate the importance of leverage analysis and how operating leverage, financial leverage, and combined leverage are calculated. 7.Discuss financial markets, the stock market, and three theories related to dividend payments. Learning Objectives

4. Copyright © 2014 Nelson Education Ltd. 9–4 Relationship between Major Components 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… LO 1

5. Copyright © 2014 Nelson Education Ltd. 9–5 Financial Structure –how the firm’s assets are financed by equity and all debts (long- and short- term) LO 2 Financial Structure and Capital Structure

6. Copyright © 2014 Nelson Education Ltd. 9–6 Capital Structure –permanent forms of financing such as common shares, preferred shares, retained earnings, and long-term borrowings (ignores short-term credit or current liabilities) LO 2 Financial Structure and Capital Structure

7. Copyright © 2014 Nelson Education Ltd. 9–7 Financial Returns versus Costs 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 LO 2

8. Copyright © 2014 Nelson Education Ltd. 9–8 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 $ 1,200,000 @ 14% ×.33 = 4.6% @ 10% ×.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 $ 1,200,000 @ 14% ×.33 = 4.6% @ 5% ×.67 = 3.3% 1.00 = 7.9% Profit $ 80,000 ROA 6.7% Cost financing 7.9% LO 3

9. Copyright © 2014 Nelson Education Ltd. 9–9 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 tax) @ 14.0% @ 5.0% @ 6.0% ×.371 ×.555 ×.074 1.000 = 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 LO 4

10. Copyright © 2014 Nelson Education Ltd. 9–10 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 $ 50,000 0.50 × 9.0% = 4.5% Source A $ 20,000 0.20 × 10.0% = 2.0% Source B $ 20,000 0.20 × 12.0% = 2.4% Source C $ 10,000 0.10 × 14.0% = 1.4% $100,000 1.0010.3% 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). e.g., A 10% increase in revenue produces an 18% increase in EBIT. A 10% increase in EBIT produces a 22% increase in ROE. Leverage LO 5

11. Copyright © 2014 Nelson Education Ltd. 9–11 Statement of Financial Position B.T. A.T. Assets$ 300,000 New equity $100,000 @ 15% 15% x.33 = 4.95% ________ New debt 200,000 @ 12% 6% x.67 = 4.02% Total$ 300,000Total $300,000 1.00 = 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). Modern Industries—Cost of Capital LO 5

12. Copyright © 2014 Nelson Education Ltd. 9–12 Using Profit Before Finance Costs but After Taxes (Slide 9-9) $117,500 $1,200,000 9.79% (ROA) = To Summarize Different Cost Calculations Profit for the year (Slide 9-8) $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 9-10) 8.97% (CC)8.97% (IRR) LO 5

13. Copyright © 2014 Nelson Education Ltd. 9–13 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 million @ 10% Bond B amounting to $2 million @ 12% Step 1: Average cost of bonds Step 2: Effective cost of debt = Before tax cost x (1.0 - tax rate) 10.57% x (1.0 -.50) = 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 LO 5

14. Copyright © 2014 Nelson Education Ltd. 9–14 $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 $100 4. Retained earnings ($2 million) Cost of retained earnings = + 4 % = 14 % Cost of Capital (for publicly owned companies) LO 5

15. Copyright © 2014 Nelson Education Ltd. 9–15 After-tax Sources of capital Total amount Percentage cost of Proportion _______________ __________ of total capital of cost Borrowings $ 7,000,000.35 x 5.28% 1.848% Preferred shares $ 1,000,000.05 x12.50%.625% Common share $10,000,000.50 x15.11% 7.555% Retained earnings $ 2,000,000.10 x14.00% 1.400% $20,000,000 1.00 11.428% Cost of Capital (for publicly owned companies) LO 5

16. Copyright © 2014 Nelson Education Ltd. 9–16 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) 01015202530 MCC Cost of projects exceed 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% LO 5

17. Copyright © 2014 Nelson Education Ltd. 9–17 Leverage Analysis Operating leverageFinancial leverage Total leverage 10% 18% Revenue EBIT 14% 10% Earnings Per Share LO 6

18. Copyright © 2014 Nelson Education Ltd. 9–18 Leverage Leverage consists of determining the most appropriate cost structure, at both the operating and financial levels, which will optimize the profitability of a business. LO 6

19. Copyright © 2014 Nelson Education Ltd. 9–19 Leverage Operating leverage –Deals with the cost behaviour of an operating unit (fixed and variable costs) and excludes finance costs. LO 6

20. Copyright © 2014 Nelson Education Ltd. 9–20 Leverage Financial leverage –Deals with the capital structure of a business, the one that will generate the greatest financial benefits to the shareholders (capital share versus debt). LO 6

21. Copyright © 2014 Nelson Education Ltd. 9–21 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 $ 150 00 Refer to Slide 5-10. 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) LO 6

22. Copyright © 2014 Nelson Education Ltd. 9–22 For the proposed production methods (high) Revenue$1,500,000$1,650,00010.0% Variable costs (800,000) (880,000)10.0% Contribution margin 700,000 770,00010.0% Fixed costs (300,000) (300,000) ---- Profit (EBIT)$ 400,000$ 470,00017.5% Calculating the Operating Leverage Contribution margin$700,000 Contribution – Fixed costs $400,000 = = 1.75 times LO 6

23. Copyright © 2014 Nelson Education Ltd. 9–23 For the proposed production methods (high) EBIT$ 400,000$ 440,00010.0% Finance costs (150,000) (150,000) ----- Profit before taxes $ 250,000 $ 290,00016.0% Calculating the Financial Leverage EBIT$400,000 EBIT – Finance costs $250,000 = = 1.60 times LO 6

24. Copyright © 2014 Nelson Education Ltd. 9–24 For the proposed production methods (high) Revenue$1,500,000$1,650,00010.0% Variable costs (800,000) (880,000)10.0% Contribution margin 700,000 770,00010.0% Fixed costs (300,000) (300,000) ---- Profit (EBIT)$ 400,000$ 470,00017.5% Finance costs (150,000) (150,000) ----- Profit before taxes$ 250,000$ 320,00028.0% 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 LO 6

25. Copyright © 2014 Nelson Education Ltd. 9–25 Deal with businesses, individuals, and government institutions including procedures involved in the buying and selling of financial assets Financial Markets LO 7

26. Copyright © 2014 Nelson Education Ltd. 9–26 Types of markets: –Money markets –Capital markets –Primary markets –Secondary markets –Spot and future markets –Mortgage markets –Consumer credit markets –Physical asset markets Financial Markets LO 7

27. Copyright © 2014 Nelson Education Ltd. 9–27 Stock Exchanges Net of exchanges, brokers, and investors that trade securities (e.g., TSX) 1. Stock exchange 2. Types of companies: Privately held companies Publicly traded companies 3. Prospectus 4. Initial public offering (IPO) 5. Listed company LO 7

28. Copyright © 2014 Nelson Education Ltd. 9–28 Dividend Theories Dividend irrelevance theory –Dividend payment has little effect on 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. LO 7

29. Copyright © 2014 Nelson Education Ltd. 9–29 Dividend Theories 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. LO 7