COST OF CAPITAL SHARES: Buckle and Thompson (1992) suggest that the current price of a share can be determined: E 1 tD P Et P t t t Rg Where: Et is expectation at time t Pt + 1 is price of the share at time t+1 Dt is dividend paid during the period t to t+1 R is the required rate of discount g is annual rate of growth of dividends (assumed constant). Equity capital: New Issues In evaluating any new issue of shares a company must consider the yield on existing shares, the expenses associated with the new issue and the discount it must offer on the new issue to make it sufficiently attractive for takeup. The company must also ensure that the existing shareholders are not disadvantaged due to the new issue. Some existing shareholders will purchase new issue shares and the remainder of the new issue will , therefore, be purchased by new shareholders. Thus,the cost of capital = y1c+ y2k + e where y1 = existing yield on the company's shares y2 = projected yield after new issue c = proportion of new issue taken up by existing shareholders k = proportion of new issue taken up by new shareholders and e = issue expenses (derived from Merrett and Sykes 1973). The firm must pay dividends sufficient to provide the shareholders with their required yield on the investment, so from the firm's viewpoint the yield is the ratio of the dividend to the capital provided by the shares. Equity capital: rights issues k k s of Cost 0 n y y capital 2 1 e K K where e, y1 and y2 are as previous example kn = capital from new shareholders k0 = capital from existing shareholders s = proceeds from sale of rights and K = total new capital (derived from Merrett and Sykes 1973). Retained earnings On the face of things, retained earnings have no cost to the firm. However, they do constitute an increased stake in the firm by the shareholders as they represent profits which have not been distributed as dividends. Thus, retained earnings have an opportunity cost. Merrett and Sykes (1973) argue that a firm employing retained earnings to finance its activities is able to accept a return on its investments which is lower than the return on shareholders' alternative investments by the difference between the tax deducted at source on distribution (Advance Corporation Tax – ACT- from 6 April 1999, the UK government abolished the ACT requirement so, dividends are paid gross) and the rate of personal taxation of the shareholders. (This presumes that the shareholders are taxed on their income at an average rate in excess of standard rate. This analysis also ignores any capital gains tax payable on the increased market value of shares arising from the retained earnings.) Depreciation Depreciation provisions may be considered in a similar manner to retained earnings - they have an opportunity cost and represent an increased stake in the firm by its shareholders. However, a distribution of depreciation provisions would produce a capital reduction, probably requiring outstanding debts to be repaid due to the depletion of the capital base, the security against which the debt was obtained. This indicates a proportional combination between the cost of debt repaid and the cost of retained earnings to calculate the cost of capital in the form of depreciation provisions. Debentures Usually, debentures are issued at a discount. They are subject to a prescribed rate of interest per year until they reach maturity, at which time, the loan is repaid by the company. Hay and Morris (1991) consider the cost of debenture finance to the company to be i in the equation: tn bB B B t N N i 1 t11 i 0 n Where B0 = issue price BN = terminal value b = nominal interest rate on the debenture n = life of the debenture. t = time elapsed from issue. It must be noted that interest paid on debentures is allowed as a cost of the firm's operations prior to the computation of any corporation tax liability. This effectively reduces the cost of this source of capital. Trade creditors Merrett and Sykes (1973) argue that only discounts allowed or foregone should be used to compute the cost of capital from trade creditors. They consider it preferable to treat payment delays, the true credit element, as adjustments to cash flow and their reasoning has been followed in this analysis. Discounts for prompt payment are very common in construction in respect of almost all types of subcontractors' and suppliers' accounts. However, due to the ravages of inflation there has been a marked tendency for domestic suppliers particularly to tighten their credit control, thus domestic suppliers and subcontractors should each be considered on an individual basis (possibly leading to a weighted average calculation for practical uses). It is usual for only the discount to be forfeited by late payment and not for interest to be charged on the outstanding account. The cost of foregoing discount is obtained from: 52 d n 1 cent per 1 100 R p.a. d where d = per cent discount offered n = period for payment in weeks R = rate of interest per annum as cost of foregoing the discount. The annual equivalent rate of interest obtained must be reduced by a factor of (1 - T), where T is the rate of tax which the firm pays as loss of discount adds to the firm's costs which are, of course, tax deductable. Marginal cost of capital The marginal cost of capital is of use to a firm in deciding whether or not to undertake a project or to expand. It considers the cost of the requisite capital from the possible sources and is, obviously, likely to produce a cost in excess of the firm’s average cost of capital due, inter alia, to the additional risks likely to be involved. Weighted average cost of capital The weighted average cost of capital for a firm is of use in two major areas: in consideration of the firm's position and in evaluation of proposed changes necessitating a change in the firm's capital. Thus, a weighted average technique may be used in a quasi- marginal way to evaluate a proposed investment project, such as the construction of a new building. The weighted average cost of capital is obtained by multiplying the net of tax cost of capital (usually expressed as a percentage per annum) for each source of capital by the proportion of total capital (for the firm or project) from that source and summing these products to obtain a single percentage. Optimum capital structure The optimum capital structure is that which provides the greatest benefit to the firm. This may be considered to be providing the greatest possible return to the owner's investments in the firm. Naturally, this is a somewhat complex goal; the requirements and views of the owners will vary (especially for a public company), short-term and long-term objectives and possibilities may conflict and so, given these and other problems of optimizing, it is likely, in fact, that, satisficing, will be employed to determine the capital structure of a firm. (A 'satisficing' situation is one of compromise; it is acceptable in respect of each individual criterion, but is suboptimal.) The optimum capital structure would be such that, within the physical parameters, the marginal cost of capital employed by the firm will be equal from all available sources. This minimzes the cost of capital to the firm and so, in consequence, should maximize the owners' returns. Satisficing, in the context of the long-period minimum return which must be earned on the owners' investment (normal profit), should permit greater flexibility in the selection of the capital structure. In practice, the selection of a firm’s capital structure will be subject to the objectives of the firm, notably the main objective which managers are believed to pursue – growth – as well as the return on investment considerations; further, the availability of capital in the market, given restrictions of time etc. in searching for capital, are important. Thus, it is useful to reconsider the primary objectives of firms in the modern market economies in which management has become divorced from ownership such that Baumol (1959) concluded that firms operate to maximise growth of turnover subject to a minimum profit constraint. Hutton (1996) argues that, due to pressures form investors, mostly institutions, expressed via stock exchange activities, firms are forced to behave in ways to provide short term returns, especially growth in dividends. Further, despite advances in information technology, search patterns for capital remain subject to bounded rationality. Hence, within limits, the capital structures of firms are becoming increasingly oriented to facilitation of expansion and provision of short term returns.
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