ACST252 Lecture Notes - Lecture 7: Hybrid Security, Debenture, Retained Earnings

61 views6 pages

taupemole7

11 May 2018

School

Department

Course

Professor

For unlimited access to Class Notes, a Class+ subscription is required.

Cost of Capital

Introduction:

The cost of capital is the rate of return a firm must earn to maintain the market value of its shares.

i.e. the rate of return required by investors.

It is used to decide whether a proposed corporate investment will increase o deease the fi’s

share price. If isk is held ostat, a ate of etu aoe the ost of apital ill iease the fi’s

value.

Assumptions

1. Busiess isk is ostat. I.e. the fi’s ailit to eet opeatig osts is uaffeted

2. Financial risk is ostat. I.e. the fi’s ailit to eet fiaial oligatios is uaffeted

3. Cost of capital is measured on an after-tax basis.

Purpose of Capital

Long term sources of funds for a business:

• Support operations and investments.

• Provide a buffer against adverse events.

• Allow for the business to grow and expand.

• Symbol of business strength to attract confidence.

Log te soues of apital suh as iteest eaig liailities, ad shaeholde’s euit suppl

peaet fiaig ad suppots the fi’s o-current asset investments.

Types of Capital

Different types:

• Equity – Company stocks.

• Debt – Bank loans, bonds, debentures and notes.

• Hybrid – Instruments with debt and equity mix.

• Retained earnings generated from past profits net of cash dividends paid.

Characteristics:

• Permanency – Equity is permanent while debt has fixed term.

• Charges/Costs – Debt incurs borrowing costs while equity does not.

• Voting Rights and Control – Shareholders have partial ownership of company.

• Collateral – Secured debtholders may take ownership of company assets upon default.

• Convertibility – Hybrid securities may be converted into stocks upon maturity or prior.

Discuss the implications of different forms of capital.

Capital Structure:

• is the mix of debt, equity and hybrid capital companies use to fund their operations and

investments.

• determines cost of capital.

• Impacts on company risk profile:

find more resources at oneclass.com

Unlock document

This preview shows pages 1-2 of the document.
Unlock all 6 pages and 3 million more documents.

Already have an account? Log in

o Economic conditions affects required rate of return and possibility of returns to the

security holders.

o Legislation may drive capital mix including tax structure and deductions on interest

payments.

o Higher debt levels multiply returns but increases insolvency risk.

o Availability of projects to deploy capital affects risk profile.

Cost of Capital:

• Reflets the opa’s epeted aeage futue cost of funds over the long run.

• The minimum rate of return a firm must earn on its project investments to maintain

shareholder value and attract investors.

• Is affected by a variety of economic and firm factors.

o Capital structure – Debt and equity mix.

o Cost of debt and required return from shareholders.

o Economic interest rate and investor expectations.

o Risk profile of company relative to economy.

The Cost of Long Term Debt:

• This is the after-tax cost today of raising long-term funds through borrowing.

• Assumes funds are raised through the issuance and sale or long term bonds or debentures.

• Net Proceeds: Flotation costs reduce the net proceeds from the sale. Flotation Costs

o Underwriting costs: compensation earned by stockbrokers and investment bankers

for selling the security

o Administrative costs : issuer expenses such as legal, accounting, printing and other

expenses.

• Let � be the before tax debt cost. It can be obtained by:

o Quotation:

▪ When the net proceeds from the sale of a debenture equal its face or par

value, the before tax cost would be equal to the coupon interest rate.

▪ The cost of debt is the yield on the periodic interest payments.

• If not on market, take the yield of a similar traded debenture. This is

based on judgements, and you should make adjustments to risk

profile as appropriate.

o Internal Rate of Return (IRR) : Fo the issue’s poit of ie, this alue is the ost

to maturity of the cash flows associated with the debt.

o Bond Approximation Formula: (all values are in years)

rPR







• I = annual interest in dollars

• R = Par Value

• P = net proceeds from thSe sale of debt (bond)

•  = ue of eas to the od’s atuit

o Estimation From Financial Statements

▪ In practice, companies issue multiple debt securites and you cannot pinpoint

a single issue to solve yield to maturity.

find more resources at oneclass.com

Unlock document

This preview shows pages 1-2 of the document.
Unlock all 6 pages and 3 million more documents.

Already have an account? Log in

Document Summary

The cost of capital is the rate of return a firm must earn to maintain the market value of its shares. i. e. the rate of return required by investors. It is used to decide whether a proposed corporate investment will increase o(cid:396) de(cid:272)(cid:396)ease the fi(cid:396)(cid:373)"s share price. If (cid:396)isk is held (cid:272)o(cid:374)sta(cid:374)t, a (cid:396)ate of (cid:396)etu(cid:396)(cid:374) a(cid:271)o(cid:448)e the (cid:272)ost of (cid:272)apital (cid:449)ill i(cid:374)(cid:272)(cid:396)ease the fi(cid:396)(cid:373)"s value. Assumptions: busi(cid:374)ess (cid:396)isk is (cid:272)o(cid:374)sta(cid:374)t. i. e. the fi(cid:396)(cid:373)"s a(cid:271)ilit(cid:455) to (cid:373)eet ope(cid:396)ati(cid:374)g (cid:272)osts is u(cid:374)affe(cid:272)ted, financial risk is (cid:272)o(cid:374)sta(cid:374)t. i. e. the fi(cid:396)(cid:373)"s a(cid:271)ilit(cid:455) to (cid:373)eet fi(cid:374)a(cid:374)(cid:272)ial o(cid:271)ligatio(cid:374)s is u(cid:374)affe(cid:272)ted, cost of capital is measured on an after-tax basis. Long term sources of funds for a business: support operations and investments, provide a buffer against adverse events, allow for the business to grow and expand, symbol of business strength to attract confidence. Lo(cid:374)g te(cid:396)(cid:373) sou(cid:396)(cid:272)es of (cid:272)apital (cid:894)su(cid:272)h as i(cid:374)te(cid:396)est (cid:271)ea(cid:396)i(cid:374)g lia(cid:271)ilities, a(cid:374)d sha(cid:396)eholde(cid:396)"s e(cid:395)uit(cid:455)(cid:895) suppl(cid:455) pe(cid:396)(cid:373)a(cid:374)e(cid:374)t fi(cid:374)a(cid:374)(cid:272)i(cid:374)g a(cid:374)d suppo(cid:396)ts the fi(cid:396)(cid:373)"s (cid:374)o(cid:374)-current asset investments.

Related Questions

Weighted Average Cost of Capital

A firm has determined its optimal capital structure, which is illustrated by the information below.

Source of Capital (Target Market Proportions)

Long term debt (20%)

Preferred Stock (10)

Common Stock Equity (70)

To expand operations, the firm is considering the following sources of financing its capital expenses:

Debt -The firm can sell 12-year, 1,000 par value bond paying a 7% annual coupon for $960. To issue the bond the firm will have to pay bond issuance or flotation cost of 2 percent of the face value of the bond.

Preferred Stock- the firm has determined that it can issue preffered stock at a par value price of $75 per share. The stock will pay $10 annual dividend. The cost of issuing and selling the stock is $3 per share.

Common Stock: A firms common stock is currently selling for $18 per share. The dividend expected to be paid at the end of the coming year is $1.74. The firms dividends have been growing at a constant rate of 4% per year for the last four years and are expected to sustain that growth rate thereafter.

New common stock issue- if the firm decides to issue new common stock, its underwriter indicated that the issue will have to be underpriced by $1 below the current share price. Further, the firm will have to pay $1 per share in issuance or floatation cost.

Additionaly, the firms marginal corporate tax rate is 40 percent.

(Given the information above)

A) find the firms before-tax cost of debt financing

B) find the firms after-tax cost of debt financing

C) find the firms cost of preffered stock financing

D) find the firms cost of financing using the retained earnings

e) find the firms cost of financing using a new common stock issue

f)find the firms weighted average cost of capital, if the firm uses debt, preffered stock and retained earnings to finance its investments. Given this result, explain what rate of return the firm should require from its investors.

g) Find the firms weighted average cost of capital, if the firm uses debt, preffered stock, retained earnings, and new stock issue to finance its investments. Given this results, explain what rate of return the firm should require from its investments.

turquoiseelephant380

1) The principal amount of a bond that is repaid at the end of the loan term is called _________.

2) _________ plots the yields on bonds relative to maturity.

3) A _________ is an unsecured bond, for which no specific pledge of property is made

4) An unexpected decrease in market interest rates will cause a coupon bond's yield to maturity to ___________.

5) The yield to maturity on a premium bond ____________ the bond's coupon rate.

6) Assume a constant dividend growth. The _________ of a stock equals its capital gains yield.

7) If a firm pays a constant annual dividend, then the capital gains yield is equal to ____.

8) According to the dividend growth model, the required rate of return is equal to the capital gains yield if the dividend growth rate is ______.

9) Assume a constant dividend growth. A decrease in the capital gains yield will ______ the current value of a stock.

10) _______________ can be used to value the stock of firms that pay no dividends.

11) The reward for bearing risk is called the ___________.

12) The higher the risk, the _____ the return.

13) The geometric average return is _____ than the arithmetic average return for a given set of returns.

14) A group of assets held together by an investor is referred to as a __________.

15) Unsystematic risk can also be referred to as asset-specific risk, ________ risk, idiosyncratic risk, or unique risk.

16) ________ refers to the practice of investing in a variety of diverse assets as a means of reducing risk.

17) An unexpected increase in the variable costs for a firm is an example of _____________ risk.

18) An unexpected decrease in corporate tax rates is an example of __________ risk.

19) If a risky security has more risk than the overall market, its beta coefficient is _______ 1.

20) All else constant, an increase in the market value of preferred stock will affect a firm's weighted average cost of capital by changing the ______ of preferred stock.

beigefish628

Take a look at and read this article that discusses the cost of capital. What are your thoughts? Elaborate and Explain

Capital for a small business is simply money. It is the financing for the small business or the money used to operate and buy assets. Cost of capital is the cost of obtaining that money or financing for the small business. The cost of capital is also called the hurdle rate.

Should very small businesses even worry about their cost of capital? The answer to that is absolutely yes! Even very small businesses need money to operate and that money is going to cost something. Companies want that cost to be as low as possible.

What is Capital?

Capital is the money businesses use for financing their operations. The cost of capital is simply the rent, or interest rate, it costs the business to obtain financing. In order to understand cost of capital, you must first understand the concept of capital. Capital for very small businesses may just be the supplier credit they rely on. For larger businesses, capital may be the supplier credit and longer term debt or liabilities, which are the firm's liabilities.

If a company is public or takes on investors, then capital will also include equity capital or common stock. Other equity accounts will be retained earnings, paid-in capital, perhaps preferred stock.

Why is Capital Important?

In order to build new plants, buy new equipment, develop new products, and upgrade informationtechnology, businesses have to have money or capital. For every decision like this, a business owner or Chief Financial Officer (CFO) has to decide if the return on the investment is greater than the cost of capital or the cost of the money it takes to invest in the project.

Business owners do not usually invest in new projects unless the return on the capital they invest in these projects is greater than or at least equal to the cost of the capital they have to use to finance these projects. Cost of capital is the key to all business decisions.

What is the Cost of Capital?

A company's cost of capital is simply the cost of money the company uses for financing. If a company only uses current liabilities and long-term debt to finance its operations, then it uses debt and the cost of capital is usually the interest rate on that debt.

If a company is public and has investors, then cost of capital gets more complicated. If the company only uses funds provided by investors, then the cost of capital is the cost of equity. Usually, this type of company has debt but it also finances with equity financing or money that investors supply. In this case, the cost of capital is the cost of debt and the cost of equity.

The combination of debt and equity financing for a company is the company's capital structure.

What is Return on Capital?

Return on capital is the amount of profit you earn out of a business or project as compared to the amount of capital you invested. The key to cost of capital for a company is that a company's return on capital must always equal or exceed the cost of capital for any project in which the firm wants to invest. In other words, the company's investment rate of return (return on capital) must equal or exceed their financing rate of return (cost of capital) in order for the firm to be profitable.

What Composes the Cost of Capital

One component of the cost of capital is the cost of debt financing. For larger businesses, debt usually means large loans or bonds. For very small companies, the debt can mean trade credit. For either, the cost of debt is the interest rate the company pays on debt.

Another component of the cost of capital is the cost of equity financing if your company is a public company; in other words, if you have investors in your company who provide money in exchange for an ownership stake in the company.

There are several components of the cost of equity capital. First, there is the cost of retained earnings or the money that the company invests back into the company, instead of paying outdividends. Next, there is the cost of new common stock or stock that the company issues to raise money. Last, the company may even issue preferred stock to raise money.

For very small firms, the cost of capital may be much simpler. There are advantages and disadvantages to both debt and equity financing, including cost, that any business owner must consider before adding them to the capital structure of the company. Very small firms may just useshort term debt, in which case we have to establish a cost for this capital component.

The Company's Weighted Average Cost of Capital

Once the business owner understands the concepts of capital and cost of capital, the next step is to understand weighted average cost of capital. Each capital component is a certain percentage of the company's capital structure. In order to arrive at the true cost of capital for a business firm, the owner must multiply the percentage of the company's capital structure for each component by the cost of that component and sum them.

Summary of Cost of Capital

Before a company can engage in buying assets or obtaining financing for its operations, it must make some determination of its cost of capital -- what it really costs the firm for the money it has to have to for all its financing. That cost of financing must never exceed its return on capital. Here is a cost of capital video series that you may find helpful. It helps put the return on capital and cost of capital in real world terms for you.

ACST252 Lecture Notes - Lecture 7: Hybrid Security, Debenture, Retained Earnings

Document Summary

Get access

Related Documents

ACST252 Study Guide - Final Guide: Dividend Imputation, Cash Flow, Dividend Policy

ACST252 Lecture Notes - Lecture 11: Dividend Policy, Retained Earnings, Cash Flow

ACST252 Study Guide - Final Guide: Dow Jones Industrial Average, Dividend Yield, Cash Flow Statement

Related Questions