1. Corporate Finance Fundamentals
FN1 Module 6
January 19, 2015

2. CAPITAL STRUCTURE 6.1 Determining the Cost of Capital
6.2 Using the Cost of Capital
6.3 Calculating the Component Costs of Capital
6.4 Calculating the Component Weights
6.5 Calculating the Weighted Average Cost of Capital (WACC)

3. CAPITAL STRUCTURE 6.6 Impact of Capital Structure on WACC
6.7 Debt Financing, Business Risk, and Financial risk
6.8 The Influence of Operating Leverage on Capital Structure
6.9 Selecting Capital Structure

4. 6.1 Determining the Cost of Capital
For projects in the same risk class as the firm, the cost of capital is the minimum after-tax return the firm must earn on new investment projects to just compensate the firm’s investors with their required rate of return
The cost of capital represents an opportunity cost
The cost of capital is an appropriate hurdle rate for new projects
It is the cost of raising new capital – the marginal cost

5. 6.1 Determining the Cost of Capital
WACC (Weighted Average Cost of Capital)
WACC measures the firm’s cost of financing future growth today, based on current capital market conditions, and assuming the firm uses a long-term average of financing sources
WACC is an estimate

6. 6.1 Determining the Cost of Capital
WACC
Why the Marginal Cost?
The return investors required 5 months, 5 years or 5 decades ago is irrelevant
What is relevant is what the next dollar of capital will cost in today’s economic environment for this particular firm

7. 6.1 Determining the Cost of Capital
We need to determine k (required rate of return) for the capital budgeting process
The required return depends on the type of financing (risk and taxation)
Both investors and the firm are concerned with the after tax return and cost

8. 6.1 Determining the Cost of Capital
Required Return – Investors
Investors compare the return from investments in debt or shares with alternative investments of similar risk available to them today
The firm must offer a return sufficient to compensate the investor for the time value of money and risk
Investors then determine the after tax return they would realize from these investments

9. 6.1 Determining the Cost of Capital
Cost of Capital – Firm
The cost of capital to a firm is the cost, in terms of required payments to investors, of raising additional investment capital
The investors determine the required payments
Assume the firm uses its optimal mix of capital sources when raising new funds, regardless of how each project is financed

10. 6.1 Determining the Cost of Capital
Example
A firm is going to finance a new project 100% with debt, through a new bond issue. Since the firm is using only debt to finance the project, the NPV of the project should be calculated using the cost of debt as the discount rate.
Is this statement true, false, or uncertain? Explain

11. 6.1 Determining the Cost of Capital
Solution
The statement is false
The cost of capital for a new project depends on the use of funds, not the source
Even if this particular project will be funded with debt, it is probably only one of many projects that the firm undertakes
The firm, over time, will raise financing through a number of sources, including internal funds, new equity, new preferred shares, and new debt

12. 6.1 Determining the Cost of Capital
Solution
The source of funding for this project is from the pool of available funds
Therefore, the cost of capital for the project should be the WACC, appropriately adjusted for the risk of this particular project

13. 6.1 Determining the Cost of Capital
The Most Important Corporate Finance Decisions
It is the managers job to maximize shareholders’ wealth
Two of the most important ways a manager can add value to the firm are:
Changing the mix of financing used by the firm (changing the relative proportions of debt and equity)
Determining the minimum rate of return needed to maintain the current market value

14. 6.2 Using the Cost of Capital
WACC Purposes/Use
There are three basic applications of the cost of capital (WACC):
In investment evaluation
In capital structure choice
In setting product prices for regulated industries

15. 6.2 Using the Cost of Capital
Investment Evaluation
The cost of capital is based on the investors’ perception of the risk of the entire firm
This hurdle rate is appropriate when computing the NPV of projects in the same risk class as the firm
If the project is in a different risk class, a separate discount rate, or hurdle rate must be determined

16. 6.2 Using the Cost of Capital
Investment Evaluation
For projects that have a NPV = 0, then the project just covers the financing costs
If NPV > 0, then the project will pay the bondholders their required return, and the shareholders will earn more than their required return
If NPV < 0, then the project will hopefully pay the bondholders their required return, but the shareholders will certainly earn less than their required return

17. 6.3 Calculating the Component Costs of Capital
Relevant Sources of Funds
The most common liability/equity accounts that the financial executive can control are:
Bank Debt
Long-term Bonds
Preferred Stock
Common Stock

18. 6.3 Calculating the Component Costs of Capital
Relevant Sources Of Funds
The most common liability/equity accounts that are outside of the control of the financial executive are:
Accounts payable
Taxes payable
These liabilities should not be considered when estimating the firm’s WACC

19. 6.3 Calculating the Component Costs of Capital
To determine the component cost of each source of capital, use the following process:
Step 1: Determine the rate of return the firm must offer for each source to induce investors to invest today
Step 2: Determine the cost to the firm to provide this return

20. 6.3 Calculating the Component Costs of Capital
The Component Cost of Debt
The cost of debt is a function of:
The investor’s required rate of return
The tax-deductibility of interest expense; for the firm
The floatation costs incurred to issue new debt
Tax Deductibility of Interest
The result:
The cost to the firm of interest payments is less than what the investors require, and
The component cost of capital < investor’s required return. WHY, because the firm gets to deduct the interest costs of debt for tax purposes

21. 6.3 Calculating the Component Costs of Capital
Floatation Costs
Issuing or floatation costs are incurred by a firm when it raises new capital through the sale of securities in the primary market
These costs include:
Underwriting discounts paid to the investment dealer
Direct costs associated with the issue including legal and accounting costs
Floatation costs are tax deductible for the firm

22. 6.3 Calculating the Component Costs of Capital
Floatation Costs
The result:
Net proceeds on the sale of each security is less than what the investor invests, and
The component cost of capital > investor’s required return
Floatation costs are a tax deductible expense

23. 6.3 Calculating the Component Costs of Capital
Cost of Debt
To determine the cost of debt, we will use our financial calculator with relevant after tax cash flows
Let’s go through example in module notes
See pdf slide 23
This is a little bit different than what is done in the module notes but you can see we come up with the same answer

24. 6.3 Calculating the Component Costs of Capital
The Component Cost of Preferred Shares
The cost of preferred shares is a function of:
The investor’s required rate of return
The floatation costs incurred to issue new preferred shares
Formula found on page 788 in text book

25. 6.3 Calculating the Component Costs of Capital
Cost of Preferred Shares
Let’s go through example in module notes
See pdf Slide 25

26. 6.3 Calculating the Component Costs of Capital
Common Shares
Estimating the component cost of common stock is the most difficult because:
Promised cash flows are uncertain
Growth opportunities, their timing and magnitude will influence cost
The riskiness of the stock is influenced by corporate decisions such as the use of leverage

27. 6.3 Calculating the Component Costs of Capital
The Component Cost of Common Shares
The cost of common shares is a function of:
The investor’s required rate of return
The floatation costs incurred to issue new common shares
There are 2 sources of common equity financing
Re-invested earnings (Retained earnings)
New common shares issues
If common equity financing comes from reinvested earnings, there are no floatation costs to consider

28. 6.3 Calculating the Component Costs of Capital
The Required Rate of Return
The required rate of return for common shares can be estimated using the following models:
Dividend Growth Model
CAPM
Earnings Yield Model
Common stock valuation is a difficult task
All models used have limiting assumptions

29. 6.3 Calculating the Component Costs of Capital
Dividend Growth Model
Ke = D1/P0 + g
This formula does not consider floatation costs
With floatation costs
Kne = D1/NP + g

30. 6.3 Calculating the Component Costs of Capital
CAPM
Ke = RF + B (ERM – RF)
RF = long term Gov’t of Canada bond yield
This will determine the estimate of the required return for your current investors
This does not adjust the cost to the firm for floatation costs
To adjust for floatation costs
Kne = Ke * P0/NP

31. 6.3 Calculating the Component Costs of Capital
Earnings Yield Model
Ke = E/P0
This does not adjust the cost to the firm for floatation costs
To adjust for floatation costs
Kne = E/NP

32. 6.3 Calculating the Component Costs of Capital
Earnings Yield Model
Kne = E/NP
This method assumes that the firm pays out most of their earnings as dividends, and earnings are relatively constant each year
This model is only valid for static firms where this might be a valid assumption
This method is rarely used

33. 6.3 Calculating the Component Costs of Capital
Let’s look at example in module notes
See pdf slide 33

34. 6.4 Calculating the Component Weights
The weights that are applied to the component costs of capital are meant to reflect the optimal mix of sources of funds
We assume that the firm’s current structure is optimal
Determine the component weights by using Market weights

35. 6.4 Calculating the Component Weights
Estimating Market Value of Bonds
Knowing the term to maturity, the coupon rate and the bondholder’s required return we can determine the market value of bonds with the financial calculator
Once you know the market value of the bonds, you multiply their price by the number of bonds outstanding to determine the total market value
B = Pb * n

36. 6.4 Calculating the Component Weights
Estimating Market Value of Preferred Stock and Common Stock
The market value of all preferred stock is simply the price per share times the number of shares outstanding
P = P0 * n
The market value of equity (market capitalization) is the price per share times the number of shares outstanding
S = P0 * n

37. 6.4 Calculating the Component Weights
Market Value Weights An Example
Given:
Market price for common stock = $21.50
Bonds are trading for 95% of face value
In order to calculate market value (MV) weights, you will need to know the total market value of debt, and common stock (and preferred stock if the company uses it)
To calculate total MV you need to know the current price of the security in each class, as well as the total number of securities outstanding
See pdf Slide 37

38. 6.4 Calculating the Component Weights
Example - Market Value Weights
Total MV of Equity = Price per share times number of shares outstanding
1,000,000 * = 21,500,000
Total MV of Bonds = Price per bond times number of bonds
4,000,000 * 0.95 = 3,800,000
See pdf Slide 38

39. 6.5 Calculating the Weighted Average Cost of Capital (WACC)
The Cost of Capital
The equation for WACC including common equity, preferred share financing and debt is on page 784 in text book and in formula package
Bombardier example in module notes:
See pdf Slide 39
Let’s look at another example
See pdf slide 39B

40. 6.5 Calculating the Weighted Average Cost of Capital (WACC)
Why is the cost of capital an estimate and does this matter?
WACC is calculated based on a current estimate of what it will cost for the next dollar of debt and equity
Since the next dollar hasn’t yet been raised, we are attempting to forecast or estimate that cost
To estimate that cost of debt we often assume it is equal to the required rate of return on existing debt outstanding in the markets (Of course, when a firm actually goes to the market, conditions may have changed, underwriting costs may be greater, etc)

41. 6.5 Calculating the Weighted Average Cost of Capital (WACC)
Why is the cost of capital an estimate and does this matter?
Forecasting WACC also requires estimating the cost of equity
There may be different approaches to this task, and will result in a range of estimates
In the end, WACC will be an estimate
The key thing to ensure is that the NPV of the project be positive over the range of possible WACCs

42. 6.6 Impact of Capital Structure on WACC
One of the important uses of WACC is as a measure of capital structure efficiency
The financial executive should pick the capital structure which minimizes WACC
How can you estimate what the component costs of capital would be at different capital structure mixes?
You can construct several capital structure scenarios and calculate the hypothetical WACC under each of them
See pdf Slide 42
Look at graph in module notes and page 853 of text book
See Exhibit in module notes

43. 6.6 Impact of Capital Structure on WACC
Key Points
Altering the capital structure of the firm changes the WACC
For firms with little or no debt, WACC can typically be reduced by increasing leverage since the cost of debt is lower than the cost of equity
After a point, too much debt increases the costs of debt and equity to the point that WACC will increase as new debt is issued

44. 6.7 Debt Financing, Business Risk, and Financial risk
Financial leverage magnifies business risk, which ultimately results in debt and equity holders requiring a higher rate of return
This, in turn, can increase the firm’s weighted average cost of capital (WACC)

45. 6.7 Debt Financing, Business Risk, and Financial risk
Business Risk & Leverage
An unlevered firm is financed entirely through common equity
The firm’s value equals the value of the common equity
The risk of the return on invested capital (ROI) is solely due to the nature of the firm’s business
Example illustrates how to estimate the return and risk of common shareholders of an unlevered firm
See pdf Slide 45

46. 6.7 Debt Financing, Business Risk, and Financial risk
If an unlevered firm replaces some of its equity with debt financing, it becomes a levered firm
Because the firm now must make payments to its debt holders, there is added financial risk to its shareholders
Example demonstrates the impact of financial leverage on the risk to the common shareholders
See pdf Slide 46

47. 6.7 Debt Financing, Business Risk, and Financial risk
Summary
For value-maximizing firms, the use of debt increases the expected ROE, so shareholders expect to be better off by using debt financing, rather than equity financing
Financing with debt increases the variability of the firm’s ROE, which usually increases the risk to the common shareholders
Financing with debt increases the likelihood of the firm running into financial stress and possibly even bankruptcy

48. 6.8 The Influence of Operating Leverage on Capital Structure
Capital structure theory suggests that there is an optimal level of debt financing that increases share price and minimizes the weighted average cost of capital
Difficult to determine the optimal capital structure with precision, but it is possible to identify factors that influence it
Financial managers need to know how these factors interact, so that they can establish a target capital structure for their firms
Some factors are related to a firm’s industry, while others are unique to the individual firm

49. 6.8 The Influence of Operating Leverage on Capital Structure
Degree of Operating Leverage (DOL)
The degree of operating leverage (DOL) measures the business risk by calculating the sensitivity of a firm’s earnings to changes in sales.
Formula found in formula package

50. 6.8 The Influence of Operating Leverage on Capital Structure
DOL Example
A manufacturing firm has a production capacity of 10,000 units, and the units have a selling price of $70 each. The variable cost per unit is $15 and fixed operating costs are $250,000 per year.
What is the degree of operating leverage?
See pdf Slide 50

51. 6.8 The Influence of Operating Leverage on Capital Structure
A Few Observations on operating leverage
The operating leverage changes from one base sales level to another
See pdf slide 51
DOL is largest at the break-even point
At a sales level below the break-even point, DOL is negative.
For example, DOL might be equal to -3.
In this case, a 1% increase in sales reduces losses by 3%, or a 1% decrease in sales increases losses by 3%

52. 6.8 The Influence of Operating Leverage on Capital Structure
The important point to remember is that operating leverage increases the degree of risk of cash flows from sales
Financial leverage increases risk further as it magnifies the profits and losses to shareholders
A firm with high degree of operating leverage is likely to operate with a low degree of financial leverage to avoid magnifying risk beyond the level desired by shareholders
Generally, managers consider the operating risk of the firm when they decide the degree of financial leverage

53. 6.8 The Influence of Operating Leverage on Capital Structure
Financial and operating leverage both impact on the firm’s WACC
A firm’s beta, to some extent , reflects its underlying business risk, and this risk is magnified by both operating and financial leverage
Recall that CAPM, k = RF + (ERM – RF) * B
As B increases, so does the required rate of return (k)
This in turn affects the company’s WACC

54. 6.9 Selecting Capital Structure
Capital Structure Choice
A firm is concerned with the cost of financing new projects
The firm should find the financing mix that minimizes the WACC
The WACC is affected by the following:
Current relative weights of debt and equity
Component costs of each source of funds

55. 6.9 Selecting Capital Structure
Capital Structure Choice
To understand how the WACC changes as the proportion of debt to equity changes, we must have an understanding of how leverage affects the required return for both the providers of debt and equity

56. 6.9 Selecting Capital Structure
Leverage
There are two types:
Operating leverage
Financial leverage
Both types of leverage have the same effect on shareholders but are accomplished in very different ways, for very different purposes strategically
Leverage magnifies profits and losses

57. 6.9 Selecting Capital Structure
Operating Leverage
You should understand that managers do make decisions affecting the cost structure of the firm
Managers can, and do, decide to invest in assets that give rise to additional fixed costs and the intent is to reduce variable costs

58. 6.9 Selecting Capital Structure
Financial Leverage
Financial leverage can be increased in the firm by:
Selling bonds or preferred stock (taking on financial obligations with fixed annual claims on cash flow)
Using the proceeds from the debt to retire equity (if the lenders don’t prohibit this through the bond indenture or loan agreement)

59. 6.9 Selecting Capital Structure
Financial leverage
Advantages
Magnification of profits to the shareholders if the firm is profitable
Lower cost of capital at low to moderate levels of financial leverage because interest expense is tax deductible

60. 6.9 Selecting Capital Structure
Financial leverage
Disadvantages
Magnification of losses to the shareholders if the firm does not earn enough revenue to cover its costs
Higher break-even point
At higher levels of financial leverage, the low after-tax cost of debt is offset by other effects such as:
PV of the rising probability of bankruptcy costs
Agency costs
Lower operating income (EBIT), etc

61. 6.9 Selecting Capital Structure
Effects of Operating and Financial Leverage
Equity holders bear the added risks associated with the use of leverage
The higher use of leverage (either operating or financial) the higher the risk to the shareholders
Leverage therefore can and does affect shareholder’s required rate of return, and in turn this influences the cost of capital

62. 6.9 Selecting Capital Structure
Indifference Analysis
A tool managers use to assess the effect of financial leverage from capital structure on shareholders earnings
Assessing financial alternatives on expected EBIT levels is helpful in determining an appropriate capital structure of the firm
The process of setting a target capital structure requires a considerable degree of managerial judgment

63. 6.9 Selecting Capital Structure
EPS Indifference Point
The EBIT level at which two financing alternatives generate the same EPS
See pdf Slide 63
Conclusion
Any amount of EBIT > 192, the 70% EPS D/E option is preferred because it produces a higher EPS (as you issue more debt and retire shares, the # of shares will decrease, increasing EPS)
Any amount of EBIT< 192, the all equity is a preferred option