1. Sources of Finance and the Cost of Capital

2. learning objectives sources of finance equity capital compared with debt capital gearing the weighted average cost of capital (WACC) cost of debt Session Summary (1)

3. cost of equity risk CAPM and the  factor return on equity and financial structure economic value added (EVA) and market value added (MVA) Session Summary (2)

4. identify the different sources of finance available to an organisation explain the concept of gearing, or the debt/equity ratio explain what is meant by the weighted average cost of capital (WACC) calculate the cost of equity and the cost of debt Learning Objectives (1)

5. appreciate the concept of risk with regard to capital investment outline the capital asset pricing model (CAPM), and the  factor analyse return on equity as a function of financial structure explain the use of economic value added (EVA) and market value added (MVA) as performance measures and value creation incentives Learning Objectives (2)

6. Two main sources of external finance are available to a company equity (ordinary shares) debt (loans or debentures) or a combination of these such as convertible loans (hybrid finance), or preference shares other external sources are leasing UK Government and European funding Sources of Finance (1)

7. Sources of internal finance to a company are its retained earnings extended credit from suppliers benefits gained from more effective management of its working capital Sources of Finance (2)

8. Equity Capital Compared with Debt Capital

9. gearing, or the debt/equity ratio, is the relationship between the two sources of finance, loans and ordinary shares a company having more debt capital than share capital is highly geared, and a company having more share capital than debt capital is low geared Gearing (1)

10. The following are two of the most commonly-used gearing ratios gearing = long-term debt equity + long-term debt debt equity ratio = long-term debt or leverage (D/E) equity Gearing (2)

11. Other important ratios related to gearing are dividend cover (times) = earnings per share (eps) dividend per share interest cover (times) = profit before gross interest and tax gross interest payable cash interest cover = net cash inflow from operations + interest received interest paid Gearing (3)

12. The weighted average cost of capital (WACC) is the average cost of the total financial resources of a company which are the shareholders equity and the net financial debt WACC may be used as the discount factor to evaluate projects, and as a measure of company performance The Weighted Average Cost of Capital (WACC) (1)

13. If shareholders equity is E and net financial debt is D then the relative proportions of equity and debt in the total financing are: E and D__ E + DE + D if the return on shareholders equity is e and the return on financial debt is d, and t is the rate of corporation tax WACC = E x e + D x d (1 - t) (E + D) (E + D) The Weighted Average Cost of Capital (WACC) (2)

14. cost of debt is the cost of servicing debt capital, the interest paid yearly of half-yearly, which is an allowable expense for tax purposes If i is the annual loan interest rate and L is the current market value of the loan and the cost of debt is d then the cost of debt may be stated as d = i x (1 - t) L Cost of Debt

15. cost of equity is the cost to the company of its ordinary share capital cost of equity may be determined from the present value of expected future dividend flows, growing at a constant rate If e is the cost of equity capital, v is the expected future dividends for n years at a constant growth rate of G, and S is the current market value of the share then the cost of equity may be stated as e = v + G S Cost of Equity

16. both the cost of debt and the cost of equity are based on future income flows, and the risk associated with such returns a certain element of risk is unavoidable whenever any investment is made, and unless a market investor settles for risk-free securities, the actual return on investment in equity (or debt) capital may be better or worse than hoped for systematic risk may be measured using the capital asset pricing model (CAPM), and the  factor, in terms of its effect on required returns and share prices Risk

17. If Rf is the risk-free rate of return, and Rm is the return from the market as a whole then (Rm - Rf) is the market risk premium and If e is the cost of equity capital and the beta value for the company's equity capital is  e, then the return expected by ordinary shareholders, or the cost of equity to the company = the risk-free rate of return plus a premium for market risk adjusted by a measure of the volatility of the ordinary shares of the company e = Rf + {  e x (Rm - Rf)} CAPM and the Beta  Factor

18. the return on equity may be considered as a function of the gearing, or financial structure of the company If D is the debt capital, E the equity capital, t the corporation tax rate, i the interest rate on debt, ROI the return on investment, and ROS the return on sales then ROE return on equity may be expressed as ROE = {ROI x (1 - t)} + {(ROI - i) x (1 - t) x D/E} Return on Equity and Financial Structure

19. the recently-developed techniques of economic value added (EVA) and market value added (MVA) are widely becoming used in business performance measurement and as value creation incentives If profit after tax is PAT, weighted average cost of capital is WACC, and the adjusted book value of net assets is NA then we may define EVA as EVA = PAT - (WACC x NA) Economic Value Added (EVA) and Market Value Added (MVA) (1)

20. at the company level, the present value of EVAs equals a business’s market value added (MVA) MVA may be defined as the difference between the market value of the company and the adjusted book value of its assets Economic Value Added (EVA) and Market Value Added (MVA) (2)