Lecture 6. Long-term and short-term financing decisions by yxx13897

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									   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).

								
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