Flashcards in Capital Structure Deck (8)
Why do we calculate a firm’s cost of capital?
The financial management objective is to maximise shareholder wealth. Assuming that everything else remains constant, a company can increase the value (price) of its ordinary shares by lowering its cost of capital. Thus, the company would prefer the capital mix that provides an outcome of the lowest cost of capital. However, measuring the cost of capital for various financial structures is quite difficult in practice.
The cost of capital is used as the minimum acceptable rate of return from capital investments. Projects that are expected to generate a rate of return above this minimum will have a positive net present value. Therefore, the value of the firm (and its shares)
will be maximised by accepting all projects where the net present value is positive when discounted at the firm’s cost of capital.
In computing the cost of capital, which sources of capital do we consider?
All types of capital including debt, preference shares, retained earnings and new ordinary equity, should be incorporated into the cost of capital computation, with the relative importance of a particular source being based upon its market value proportion of financing
to be provided.
In general, what factors determine a firm’s cost of capital? In answering this question, identify the factors that are within management’s control and those
that are not.
General economic conditions and factors that are determined at the firm level have a direct impact upon a company’s cost of capital. General economic conditions such as the demand and supply of funds in the economy, as well as the existing inflationary pressures, determine the rate of return required on a riskless investment and therefore the cost of each source of capital.
In addition, the marketability of a firm’s securities is not completely within the control of management. Although the firm’s managers can take actions that will increase or decrease this marketability, certain factors within the overall marketplace can influence the ability to market a security
Regarding decisions that can be made by management which affect the firm’s cost of capital, both business and financial risk influence the risk premium required by investors. Therefore, as management increases the risk within the firm, resulting from particular investment
decisions or by changing the firm’s financial mix, investors will change their required rate of return in response to the change in the perceived risk of their investment.
What limitations exist in using the firm’s cost of capital as an investment hurdle rate?
It is only appropriate to use the cost of capital as the hurdle (discount) rate to evaluate investment opportunities that are of similar risk to the existing assets within the firm and where the firm’s financial risk – its debt-to-equity structure – is constant. In other words, new investments will be a part of the firm’s existing business and will be financed in the
same manner as past investments.
In reality these assumptions are quite restrictive, and the cost of capital will need to be adjusted (up or down) to evaluate projects that will significantly change the risk of the firm.
How does a firm’s financial structure differ from its capital structure?
A firm’s capital structure consists of owner’s equity and its interest-bearing debt, including short-term bank loans. You may recall that the firm’s capital structure does not include everything listed on the liabilities and owners’ equity side of the balance sheet. We call the
combination of capital structure plus the firm’s non-interest-bearing liabilities, such as accounts payable and accrued expenses, the firm’s financial structure.
What is the significance of the notion that a firm’s financing decisions are irrelevant? What does this meant to the financial manager?
The term ‘relevant’ used here refers to the issue of whether or not the financing choices made by the firm are or are not important in determining the value of the firm to its shareholders. Where financing decisions are not relevant, then managers should treat the financing choice between debt and equity as a matter of indifference
What are the two fundamental assumptions that are used to support the M&M capital structure
theorem? Describe each assumption in common-sense terms.
Assumption 1: The cash flows that a firm generates are not affected by how the firm
is financed. As we will discuss later, this is the case when there are no taxes, no costs
associated with bankruptcy, and when the firm’s debt obligations do not in any way
affect its ability to operate its business.
Assumption 2: Financial markets are perfect. This means that securities can be traded without cost, and that individuals can borrow and lend at the same rate as the firm.