The Cost of Capital and the Capital Structure Decision

The Cost of Capital and the Capital Structure Decision Cost of Capital     Most projects involve long term finance Cost of Capital should reflect investors expected returns Represents an Opportunity Cost Wrong Cost of capital – wrong NPV 4 main sources of long term capital: External    Ordinary shares Preference shares Loan capital Internal  Retained profit Ordinary shares – two approaches Dividend based valuation  Value of share will be NPV of expected dividends from the share Risk/return based valuation   Capital Asset Pricing Model (CAPM) Concept of risk – free rate plus risk premium Risk Premium – 3 possibilities 1. Whole share market – difference between risk free returns and overall market 2. Compare individual share with whole ordinary share market 3. Compare 2 with 1 Concept of Beta – an attempt to estimate risk/likely performance of shares   Degree to which a share fluctuates compared with the market as a whole Higher the beta, the more risky the share and vice versa Dividend approach v. CAPM  CAPM ‘may’ be a slightly better tool Retained Profit  Theoretically belongs to the shareholders and cost should be the same as for ordinary share capital Loan Capital 2 types  Irredeemable Calculation similar to calculation for ordinary shares  Redeemable Same principles as IRR  Calculations are LESS TAX Preference Shares  Similar to loan capital but no tax deducted Weighted Average Cost of Capital    Belief that managers have a target capital structure in mind aimed at minimising the cost of capital to the business Capital structures tend to be relatively stable over time but can be affected by changes in tax rates, interest rates etc Takes each element of capital x its cost and adds all element together to get WACC (see fig. 7.5 in book) Specific or Average cost of Capital  Even though a project may be funded from a specific source, WACC should still be used (see example in book) WACC Limitations     Does not take account of risk Materiality of risk? Stability of capital structure Most businesses use WACC and recalculate it at least annually Financial Gearing      Changes in profit before interest and tax (PBIT) can have a disproportionate effect on returns to ordinary shareholders Financial gearing = loan capital + preference shares divided by total long term capital x 100% Earnings per share (EPS) are affected by financial gearing More gearing in capital structure – the higher the potential benefits for shareholders Reduced profits can have an adverse effect in higher geared businesses Degree of financial gearing     Degree of financial gearing = % change in EPS divided by % change in PBIT Higher the degree – higher the sensitivity of EPS to PBIT change Impact of gearing on EPS less pronounced as profits grow in relation to fixed capital payments Gearing can be important, especially where it falls outside industry norms Factors affecting the level of gearing    Attitude of owners towards risk (high gear = high risk) Attitude of managers to risk – incentives Attitude of lenders to risk – ability to repay Stable profitability Steady cash generation Loan security Level of business fixed costs  Availability of share capital The capital structure debate  Still a debate