Lecture 6. Long-term and short- term financing decisions 6.1. Cost of capital. Capital structure of firm 6.2. Weighted average cost of capital (WACC) 6.3. Main concept about optimal capital structure 6.4. Financial leverage and value of firm 6.5. Dividend policy 6.6. Short-term financing decisions: models of working capital financing 6.1. Cost of capital. Capital structure of firm Cost of capital is a percent or other financial payment of firm to it investors. Cost of capital is rates of return on financial instruments of firm from point of view of such firm. Firm pay cost of capital taking into account own financial performance, future of projects and market opportunities, situation on capital market. That is why cost of capital turn to interest rates that must be on level to motivate investors and creditors to buy firms financial instruments. 6.1. Cost of capital. Capital structure of firm Capital structure reflects sources of long-term financing of firm. Relation to capital is due to possibilities to create new production capacities, finance investment decisions and so on. So capital structure consist of two main parts: Shareholders equity or own capital; Debt capital or borrowed capital. 6.1. Cost of capital. Capital structure of firm Equity: Stocks; Preferred stocks; Net earning. Debt capital: Bonds issued; Long-term credit. 6.1. Cost of capital. Capital structure of firm Proportion between equity and debt reflects capital structure of firm. Dominance of equity is mean that firm has stock or equity orientation in financing. Dominance of debt is mean that firm has debt orientation in financing. Taking into account preferred stocks it is possible to reformulate capital structure: Financing by fixed income instruments; Financing by non-fixed income instruments. 6.1. Cost of capital. Capital structure of firm Cost of capital calculation Different source of capital has different payment structure. That is way approaches on cost of capital calculation is different case. Main course of capital and its ordinary cost calculation is follow: Cost of capital by common stock = Dividend / Market value of stock; Cost of capital by preferred stock = Fixed Dividend / Market Value of Stock; Cost of capital by net earnings = cost of capital by common stock = Dividend / Market value of stock; Cost of capital by bonds = Coupon / Nominal of bond. 6.1. Cost of capital. Capital structure of firm But in the case of initial offering cost of capital is higher when in the case of ordinary situation. Main factor of this is real costs of underwriting and other fees. So calculation of cost of capital in a case of initial offering is follow: Cost of capital by common stock = Dividend / (Face value of stock * (1 - % of costs of offering)); Cost of capital by preferred stock = Fixed Dividend / (Face Value of Stock * (1 - % of costs of offering); Cost of capital by net earnings in the case of initial offering is not exist; Cost of capital by bonds = Coupon / (Nominal of bond * (1 - % of costs of offering). 6.1. Cost of capital. Capital structure of firm From formulas it is easy to see that cost of capital is function that opposite to value of stock or bond. That is why firms value maximization is the same as minimization of the cost of capital. Such rule has another interpretation: Good market and financial performance of firm affects rising of firms financial instruments value. It is mean that firm represent low riskness of business. Markets highly evaluate firms assets by demanding on them. This turn to lowering interest rates. And this turn to lowering cost of capital. 6.2. Weighted average cost of capital (WACC) Different costs of capital from different sources do not reflect whole level of financial costs. Such whole level represent weighted average costs of capital (WACC). The main purpose of WACC: Solve the problem of different costs by different type of securities; Solve the problem of costs on old and new securities; Orienteer of rates of return on average-risk investment projects; Potential discount rate for investment analysis (but with correction on level of project risk). 6.2. Weighted average cost of capital (WACC) General formula for WACC calculation: WACC = part of common stock * cost of capital on common stock + part of preferred stock * cost of capital on preferred stock + part of bonds * cost of capital on bonds + part of net earnings * cost of capital on common stock 6.2. Weighted average cost of capital (WACC) General example. WACC = 12,5% Part Cost Part * Cost Common stock 1 mln 50% 15% 7,5 Preferred stock 0,3 mln 15% 10% 1,5 Bonds, 0,5 mln 25% 8% 2 Net earnings, 0,2 mln 10% 15% 1,5 Total capital = 2 mln 100% 12,5% 6.2. Weighted average cost of capital (WACC) There are two methods of WACC calculation: WACC calculation based on face value of stock and bonds (used in initial calculations or in case of WACC calculation without financial market influence); WACC calculation based on market value of stock and bonds (used in context of market influence on structure of capital). Taking in mind that market influence may substantially change capital structure the market based WACC calculation is better. The same is actual taking in mind market expectations about rates of return on firms securities. 6.2. Weighted average cost of capital (WACC) Example of face value based WACC calculation Face Capital Part Cost Part * value Cost per one Common stock, 1$ 1 mln $ 50% 15% 7,5 1 mln Preferred stock, 3$ 0,3 mln $ 15% 10% 1,5 0,1 mln Bonds, 0,01 mln 50$ 0,5 mln $ 25% 8% 2 Net earnings 0,2 mln $ 10% 15% 1,5 Total capital 2 mln $ 100% 12,5% 6.2. Weighted average cost of capital (WACC) Example of market value based WACC calculation Market Capital Part Cost Part * value Cost per one Common stock, 1 3 3 mln$ 74% 15% 11,1 mln Preferred stock, 3,5 0,35 mln$ 9% 10% 0,9 0,1 mln Bonds, 0,01 mln 52 0,52 mln$ 13% 8% 1,04 Net earnings 0,2 mln$ 4% 15% 0,6 Total capital 4,07 mln$ 100% 13,64% 6.3. Main concept about optimal capital structure If firm can chose sources to obtain capital the question about optimal combination of such sources is arising. There are 4 main theories about capital structure: Miller-Modigliani approach (MM-theorem); Net Income approach; Theory of source subordination; Signal theory of capital structure. 6.3. Main concept about optimal capital structure MM-theorem Main idea of MM approach is that value of firm is determined by real factors such as profitability, productivity gains, market position and cash flow in now and in prospect. Main conclusion is that if only real factors determine value of firm so the structure of capital by itself is irrelevant to its value. The same true for cost of capital. Cost of capital is determined by real factors and doesn't depend from capital structure. So capital structure doesn’t matter. 6.3. Main concept about optimal capital structure MM-theorems arguments First. Markets evaluate firms from its possibilities to generate positive cash flow. So the more debt firm create changing capital structure the more decrease value of equity because markets understand that firm is under more risk (more debt to cash flow). Initial capital structure New capital structure Structure Cost of * Structure Cost of * capital capital Equity 50% 12 6 25% ↓ 18 ↑ 4,5 Bonds 50% 6 3 75% ↑ 6 4,5 WACC 9 9 6.3. Main concept about optimal capital structure MM-theorems arguments Second. Due to financial markets arbitrage equal firms (the same real factors) can not be differ only by different capital structure. One firm would be overvalued. Another one undervalued. Investors will sell securities of first firm (waiting for decline of market price) and buy securities of another (waiting for increase market price). So value of firms would be equalized. 6.3. Main concept about optimal capital structure Net income approach The main idea is that increasing debt financing firm will obtain cheaper source of capital. Due to WACC effect changes in capital structure automatically lead to change in cost of capital so – in value of firm. Initial capital structure New capital structure Structure Cost of * Structure Cost of * capital capital Equity 50% 12 6 25% ↓ 12 3↓ Bonds 50% 6 3 75% ↑ 6 4,5 ↑ WACC 9 7,5 ↓ 6.3. Main concept about optimal capital structure Theory of source subordination Main idea is very conservative. Firm should attract capital to finance needs on a base of severe rule: First - retained profits; Second – relative dividends cut (net profits have to rise faster than dividend payments so part of them in profits should decrease); Third – borrowing form banks or through bonds; Forth – stock issue us ultimate financial need. 6.3. Main concept about optimal capital structure Signal theory of capital structure Main idea is that: Managers and markets has different level of understanding what’s going on inside the firm; All financial steps of managers is a signals for markets, so markets try recognize that is really going on interpreting such signals; If managers meet some good opportunities they try to issue bonds because they will try to issue stocks in future when situation will be clear and stocks will very valued; If managers meet not good news they try to issue stocks because its not obligate to pay money if time is really bad; Markets understand such dilemma and meet obligations as a good future of firm and meet stocks as a not very good; But markets understand too that too much debt is very risky and in uncertain environment reduce markets perspective; So capital structure must be such that every next debt issue would be recognized as good signal. In such case cost of capital would be low and value of firm will rise. 6.4. Financial leverage and value of firm If firm get borrowed financing its mean that it use financial leverage. The main idea of financial leverage is to get changes in relation between EBIT (earnings before interest payment and taxation) and earnings per share. If firm get debt securities to finance investment it commit itself to pay fixed interest that become part of cost. In such situation debt financing may increase revenues in future due to new investment. Rise of EBIT in this case goes toward increase earnings per share and firms value. But if firm get trouble in future fixed interest payments automatically decline EBIT and firms value. 6.4. Financial leverage and value of firm So if firm use only stocks to finance new investment it stay unlevered and its value depend only from market value of stock. If firm use mix of stocks and bonds to finance new investment it become levered and its value determined by value of stock itself and how debt financing can increase value of stock due to new opportunities. Debt financing can increase value of stock only through one way – through increasing earnings per share (and partly through increasing net earnings. 6.4. Financial leverage and value of firm To understand this we use static example with 3 firms that have different capital structure but the same EBIT Firm A (debt / Firm B (debt / Firm C (debt / capital = 0) capital = 20%) capital = 50%) Equity in stock 900 000 800 000 750 000 Bonds, cost 10% - 200 000 750 000 Capital 900 000 1 000 000 1 500 000 EBIT 600 000 600 000 600 000 Interest payments - 20 000 75 000 Incomes after interests 600 000 580 000 525 000 Tax 30% 200 000 174 000 157 000 Net earnings 400 000 406 000 367 500 Shares, 10 per share 90 000 80 000 75 000 Earnings per share 4,4 5,1 4,9 6.4. Financial leverage and value of firm Dynamic example: the same capital and EBIT Firm A D/C=0 Firm B D / C = 50% Year 2007 2008 2007 2008 Equity 1 000 000 1 000 000 500 000 500 000 Debt, 10% - - 500 000 500 000 Capital 1 000 000 1 000 000 1 000 000 1 000 000 EBIT 100 000 150 000 100 000 150 000 Interests - - 50 000 50 000 Earnings before tax 100 000 150 000 50 000 100 000 Tax 25% 25 000 37 500 12 500 25 000 Net earnings 75 000 112 500 37 500 75 000 Shares, 10 per 100 000 100 000 50 000 50 000 share Earnings per share 0,75 1,125 0,75 1,5 6.4. Financial leverage and value of firm Degree of financial leverage (DFL) calculation DFL = EBIT / (EBIT – interest payments) Firm A (2007), DFL = 100 000 / (100 000 – 0) = 1; Firm B (2007), DFL = 100 000 / (100 000 – 50 000) = 2. 6.4. Financial leverage and value of firm Dynamic way to DFL calculation DFL = % change in earnings per share / % change in EBIT Firm A (2007-2008), DFL = ((1,125 / 0,75) * 100%) / (( 150 000 / 100 000) * 100%) = 150% / 150% = 1; Firm B (2007-2008), DFL = ((1,5 / 0,75) * 100%) / ((150 000 / 100 000) * 100% = 200% / 150% = 1,33 6.4. Financial leverage and value of firm Financial leverage and value of firm Increase in part of debt financing automatically increase interest payments burden. It is generate some risk about future of firm and influence on cost of capital and firms value: The more interest payments the more severe revenue decline influence on decrease of EBIT and earnings per share; If revenue very volatile EBIT become volatile too influencing on stockholders wealth; If so level of debt to capital is not neutral to riskness of firm and its costs of capital and firm value. 6.4. Financial leverage and value of firm In general increase in debt part of capital increase value of firm only till some threshold. There are two stages: First stage. Increasing in debt financing due to DFL increase earnings per share and value of stocks. Cost of capital decline due to increasing part of more cheap sources (bonds) and rise of stocks. WACC decline and value of firm rise. Second stage. Continuing rising of debt financing lead to increase fixed interest rates burden. So earnings per share and wealth of stockholders start to decline. Markets expectations devalue firm because of debt influence on profitability and future of risks. So there are some optimal debt part in capital structure under which stock value is maximum and cost of capital is minimum. (Graphical representation) 6.4. Financial leverage and value of firm Taking into account that increase of debt in capital structure increase risk of stocks formula of total firm value is follow: Vf = Market value of debt + (Net income / Expected rate of return on equity). Expected rate of return on equity is discount rate that rise with rising of debt weight in capital. 6.4. Financial leverage and value of firm Example. 3 firms has the same capital and EBIT but different capital structure Debt to capital Ratio 20% 30% 40% Debt, 5% 200 000 300 000 400 000 Equity 800 000 700 000 600 000 Capital 1 000 000 1 000 000 1 000 000 EBIT 300 000 300 000 300 000 Interest payment 10 000 15 000 20 000 Earnings after 290 000 285 000 280 000 interest payment Expected rate of 10% 10,1% 10,5% return on equity Value of equity 2 900 000 2 821 782 2 666 667 Value of debt 200 000 300 000 400 000 Value of firm 3 100 000 3 121 782 3 066 667 6.5. Dividend policy Dividend policy is important part of corporate activity: It affect cash balance of firm; Influence on capital structure and cost of capital; Reduce potential resources for investment; Make signal for financial markets and so on. 6.5. Dividend policy Dividend policy of the firm consist of 3 main dimension: Theoretical background of dividend payment; Choosing model of dividend payment (targeting of payout ratio); Choosing model of payment form. Such difficulties arise from: Stockholders wealth consist of two parts – dividend and capital gain; Motivation to keep stocks may be different – to keep ownership on business, to save, to invest in optimal portfolio and so on; To pay dividend is to chose between different ways of increase firms value – through investment and saving cash or through payout increase to attract new stockholders and so on 6.5. Dividend policy Theoretical background based on next approaches: MM-approach of dividends irrelevance; “Bird in hand” approach; Financial market segmentation approach; Financial market imperfections approach; Signal role of dividend policy. 6.5. Dividend policy MM-approach MM postulate that dividend payment is a loose of cash. If all cash used in good investment projects dividend payments irrelevant to stockholders wealth. The needs to payment increase in borrowing that decrease stock value. So wealth of stockholders become unchanged. One $ of dividend payment is one $ of stock value loose. 6.5. Dividend policy “Bird in hand” approach Wealth of stockholders determined by value of stock is very uncertain and mostly depend from markets tendencies. So it is much more better to get dividend and to be independent from market fluctuations. That is why attractiveness of particular stock is impossible without dividend payments. So stock value will increase due to dividend payments. 6.5. Dividend policy Financial market segmentation approach Different investors have different motives buying stocks. So one of them invest to save and they need to get regular dividend. Another invest to get capital gains so value rising is more preferable for them. In such case firm must to do market segmentation and decide what kind of investors is more desirable to hold it stocks. So to pay dividend or to not is a consequence of decision about targeted range of investors and relations between dividends, stock value and they motives to buy stocks. 6.5. Dividend policy Financial market imperfection It is possible that taxation of dividends, interests and capital gain is different. The same is actual for differences in taxation on institutional investors and private investors. This lead to market segmentation and related financial decisions if a frame of dividend policy. 6.5. Dividend policy Signal role of dividends It is possible that investors have any criteria to differentiate firms represented in financial markets. In such case dividends would be one possible measure of reality of firms financial prospects. So to pay dividends is to positioning itself as a firm with sound market and financial future. 6.5. Dividend policy Models of dividends payments: Targeting payout ratio (dividends closely correlate with earnings); Focusing on changes of dividends payments (rise of payment from 2$ to 4$ is problem but it is not very serious if mean payments is 3$); Targeting amount of dividends or dividends smoothing (earning may fluctuate but dividends stay relatively stable); Payout ratio is a random walk (having money – paying, not having – not paying). 6.5. Dividend policy Forms of dividend payment: Cash payments; Stock dividend – payments done in a form of new stocks. 6.6. Short-term financing decisions: models of working capital financing The main focus of short-term financial decisions is to make correspondation between: Time structure of assets and liabilities; Payment needs to finance working capital and liquidity constrains of firm; Costs of founds and costs of loose in operational activity. 6.6. Short-term financing decisions: models of working capital financing Time structure of assets and liabilities should be around equal. If assets time structure is longer than liabilities firm meat problem of liquidity and short-term debt repayment. The risk of such situation is probability of sudden lack of funds to finance operational activity. If liabilities time structure is longer than assets firm carry on additional financial costs because long- term debt is more expansive than short-term one. 6.6. Short-term financing decisions: models of working capital financing To optimize time structure of assets and liabilities all assets divided on 3 groups: Fixed assets (property, plant, equipment and so on); Current assets (inventories, cash, receivables); Season or variable part of current assets (current assets – minimum of current assets). Liabilities divided on short- and long-term. 6.6. Short-term financing decisions: models of working capital financing Example Q1 Q2 Q3 Q4 Fixed assets 1 000 000 1 000 000 1 000 000 1 000 000 Current assets 210 000 180 000 50 000 120 000 Min of current 50 000 50 000 50 000 50 000 assets Variable part of 160 000 130 000 - 70 000 current assets 6.6. Short-term financing decisions: models of working capital financing There are 2 variants of 3 models of short-term financing Variant first. Into account taken fixed assets and current assets. So very conservative model: long-term sources cover fixed assets, minimum of current assets, and part of variable assets. Conservative model: long-term sources cover fixed assets and minimum level of current assets. Aggressive model. Long-term sources cover only part of fixed assets. 6.6. Short-term financing decisions: models of working capital financing Variant second. Into account taken fixed assets and working capital (difference between current assets and current liabilities). Relaxed strategy. Long-term financing cover all required assets and excess capital arise from time to time when variable assets going down. Middle of road strategy. Long-term financing cover fixed assets and permanent working capital (minimum part of working capital). Restrictive strategy. Short-term borrowing always cover asset requirements. 6.6. Short-term financing decisions: models of working capital financing Analytical for cash conversion period Inventory period = Average inventories / (annual costs of goods sold / 365); Receivables period = Average receivables / (annual sales / 365); Payables period = Average payables / (annual costs of goods sold / 365).
Pages to are hidden for
"Lecture 6. Long-term and short-term financing decisions"Please download to view full document