Sources of Finance and the Cost of Capital

1. Sources of Finance and the Cost of Capital

2. learning objectivessources of financeequity capital compared with debt capitalgearingthe weighted average cost of capital (WACC)cost of debt Session Summary (1)

3. cost of equityriskCAPM and the  factorreturn on equity and financial structureeconomic value added (EVA) and market valueadded (MVA) Session Summary (2)

4. identify the different sources of finance available toan organisationexplain the concept of gearing, or the debt/equity ratioexplain what is meant by the weighted average cost of capital (WACC)calculate the cost of equity and the cost of debt Learning Objectives (1)

5. appreciate the concept of risk with regard to capital investmentoutline the capital asset pricing model (CAPM), and the  factoranalyse return on equity as a function of financial structureexplain the use of economic value added (EVA) and market value added (MVA) as performance measures and value creation incentives Learning Objectives (2)

6. Two main sources of external finance are available toa companyequity (ordinary shares)debt (loans or debentures)or a combination of these such as convertible loans (hybrid finance), or preference sharesother external sources areleasingUK Government and European funding Sources of Finance (1)

7. Sources of internal finance to a company areits retained earningsextended credit from suppliersbenefits gained from more effective management of its working capital Sources of Finance (2)

8. Equity Capital Compared with Debt Capital

9. gearing, or the debt/equity ratio, is the relationship between the two sources of finance, loans andordinary sharesa company having more debt capital than share capitalis highly geared, and a company having more sharecapital than debt capital is low geared Gearing (1)

10. The following are two of the most commonly-usedgearing ratiosgearing = long-term debt equity + long-term debtdebt equity ratio = long-term debtor leverage (D/E) equity Gearing (2)

11. Other important ratios related to gearing aredividend cover (times) = earnings per share (eps) dividend per share interest cover (times) = profit before gross interest and tax gross interest payablecash interest cover = net cash inflow from operations + interest received interest paid Gearing (3)

12. The weighted average cost of capital (WACC) isthe average cost of the total financial resources ofa companywhich arethe shareholders equity and the net financial debtWACC may be used as the discount factor to evaluate projects, and as a measure of company performance The Weighted Average Cost of Capital (WACC) (1)

13. If shareholders equity is E and net financial debt is Dthen the relative proportions of equity and debt in thetotal financing are: E and D__E + D E + D if the return on shareholders equity is e and the return on financial debt is d, and t is the rate of corporation tax WACC = E x e + D xd (1 - t) (E + D) (E + D) The Weighted Average Cost of Capital (WACC) (2)

14. cost of debt is the cost of servicing debt capital, the interest paid yearly of half-yearly, which is an allowable expense for tax purposes If i is the annual loan interest rate and L is the current market value of the loan and the cost of debt is d then the cost of debt may be stated asd = ix (1 - t) L Cost of Debt

15. cost of equity is the cost to the company of its ordinary share capitalcost of equity may be determined from the present value of expected future dividend flows, growing at a constant rate If e is the cost of equity capital, v is the expected future dividends for n years at a constant growth rate of G, and S is the current market value of the share then the cost of equity may be stated ase = v + G S Cost of Equity

16. both the cost of debt and the cost of equity are based on future income flows, and the risk associated with such returnsa certain element of risk is unavoidable whenever any investment is made, and unless a market investor settles for risk-free securities, the actual return on investmentin equity (or debt) capital may be better or worse than hoped forsystematic risk may be measured using the capital asset pricing model (CAPM), and the  factor, in terms of its effect on required returns and share prices Risk

17. If Rf is the risk-free rate of return, and Rm is the return from the market as a whole then (Rm - Rf) is the market risk premium andIf e is the cost of equity capital and the beta value for the company's equity capital is e, thenthe return expected by ordinary shareholders, or the costof equity to the company = the risk-free rate of return plus a premium for market risk adjusted by a measure of the volatility of the ordinary shares of the companye = Rf + {e x (Rm - Rf)} CAPM and the Beta  Factor

18. the return on equity may be considered as a function ofthe gearing, or financial structure of the company If D is the debt capital, E the equity capital, t the corporation tax rate, i the interest rate on debt, ROI the return on investment , and ROS the return on sales then ROE return on equity may be expressed as ROE = {ROI x (1 - t)} + {(ROI - i) x (1 - t) x D/E} Return on Equity and Financial Structure

19. the recently-developed techniques of economic value added (EVA) and market value added (MVA) are widely becoming used in business performance measurementand as value creation incentives If profit after tax is PAT, weighted average cost of capital is WACC, and the adjusted book value of net assets is NAthen we may define EVA asEVA = PAT - (WACC x NA) Economic Value Added (EVA) and Market Value Added (MVA) (1)

20. at the company level, the present value of EVAs equalsa business’s market value added (MVA)MVA may be defined as the difference between themarket value of the company and the adjusted bookvalue of its assets Economic Value Added (EVA) and Market Value Added (MVA) (2)