# Cost of Capital & Dividend Policy Flashcards

Capital

What is it used to refer to (2)

What are the different types of capital and who do they get provided by?

- Capital is the term used to refer to the financial resource that a company uses to pay for its activities and projects.
- Usually, the term “capital” is specifically used to refer to its permanent or long-term finance, rather than its short-term financing.
- Long-term capital is provided by the company’s investors: - Equity capital is provided by shareholders - Debt capital is provided by lenders

Cost of capital

The investors do not…?

Equity capital is provided by ___________ in return for __________ and/or ___________ __________ ________ of their ________ (ie __________ _______

Debt capital is provided by __________. Usually this is in the form of ___________. Some forms of _________-________ debt can generate __________ ______ too.

What different types of return for the inverstor (3)

Why must they be generate

From the company’s POV?

- The investors do not provide their capital for free.
- Equity capital is provided by shareholders in return for dividends and/or increased market value of their shares (ie capital gains).
- Debt capital is provided by lenders. Usually this is in the form of interest. Some forms of market-traded debt can generate capital gains too.
- Dividends, interest and capital gains are types of return for the investor.
- Dividends, interest and capital gains must be generated by the company to keep the investors happy.

From the company’s point of view, the returns expected by shareholders are referred to as a cost, THE COST OF CAPITAL

Cost of capital is made up of… (3)

% (2)?

Cost of debt capital =

- the interest rate on the company’s borrowings

Cost of equity capital =

- the rate of return the company delivers to its ordinary shareholders

We will then use these two costs to work out the company’s overall average cost of capital. Usually referred to as the weighted average cost of capital (or WACC)

- The cost of capital is ALWAYS quantified as a % per year.
- It is the annual % return that investors expect/require on the money they put into the company.

Cost of equity capital illustration

- The cost of capital is ALWAYS quantified as a %.
- It is the % return that investors expect/require on the money they put into the company.

Cost of debt capital

What is it?

What is the return?

Companies pay tax…? So…?

Remember?

The cost of debt capital is the annual interest rate%.

- With debt the return for lenders is the interest rate %.

Companies pay tax on profits after interest so the cost of debt for the company should be lower because the interest expense reduces taxable profit and therefore reduces the corporate tax charge.

If the interest rate is 6% and the company pays tax at 25% the post-tax cost of debt = 6% x (1-0.25) = 4.5%

- Remember with bonds or debentures the interest payable by a company is the fixed coupon (interest) rate multiplied by its nominal value not its market value.

- Cost of capital (4)

Most companies are financed by a combination of debt and equity capital. These companies aim to maintain target proportions of debt and equity.

- Cost of debt capital: the after-tax interest cost of raising new debt.
- Cost of equity capital the rate of return a firm pays out equity investors. It can be calculated by using Capital Asset Pricing Model (CAPM)

Cost of capital: is the average cost of all of the firm’s various sources of finance, weighted according to the proportion each element contributes to the total funding (also called the weighted average cost of capital (WACC)).

Cost of capital

Why do we need to know about the cost of capital? (3)

- We have to ensure that our company engages in activities that can generate enough return to satisfy the investors.
- If our investors require 10% returns each year. We know that our company can only invest in projects that generate at least 10%
- The cost of capital is therefore used as the discount rate for NPV calculations

- Cost of capital

Example: Assume that the after-tax cost of new debt capital is 6% and the required rate of return on equity capital is 14%, and that company intends to maintain a capital structure of 50% debt and 50% equity. The overall cost of capital for the company is calculated as follows:

Weighted Average Cost of Capital (WACC) (what is the formula)

3 facts?

Example: Assume that the after-tax cost of new debt capital is 6% and the required rate of return on equity capital is 14%, and that company intends to maintain a capital structure of 50% debt and 50% equity. The overall cost of capital for the company is calculated as follows:

Weighted Average Cost of Capital (WACC) = proportion of debt capital x after-tax cost of debt capital + proportion of equity capital x cost of equity capital = 0.5 x 6% + 0.5 x 14% = 10%.

- The overall cost of capital is also called the weighted average cost of capital (WACC).
- For the discount rate used in NPV computations, it is (usually) the WACC that is used.
- WACC can be measured by using either historical values (ie Balance Sheet) or market values (but only for listed companies)

Weighted average cost of capital (WACC) (5 steps)

- Find cost of equity
- Find cost of debt
- Find proportions of debt and equity for the company
- Average the costs of equity and cost of debt using the market values as weightings.
- Use book values if market values are not given (eg if unlisted)

Using debt to finance your company (4adv, 2dis)

**Advantages**

- Easier, quicker and cheaper to raise
- Interest can be fixed so a bit more predictable
- Tax shield on interest payments makes debt finance cheaper
- Debtholders bare less risk so cost of debt is cheaper

**Disadvantages**

- Interest has to be paid (dividends don’t)
- Reduces the amount of profit that can be distributed to shareholders which can be seen as risky for them, so the cost of equity will raise

Gearing & capital structure

What does gearing refer to?

What is the term leverage?

- The calculation of gearing can be done in a number of ways, the two most commonly used are:

In FINANCE we prefer to use __________ ________ if they are available. In FINANCIAL ACCOUNTING the ______ ________ are used.

What is capital structure?

- ‘Gearing’ refers to the proportion of a company’s financing that is in the form of debt as opposed to equity. A high gearing percentage indicates a high level of debt.
- The term ‘leverage’ is used to refer to gearing in North America.

The calculation of gearing can be done in a number of ways, the two most commonly used are:

- Debt/Equity (value of debt divided by the value of shareholders’ funds)
- Debt/(Debt + Equity) (value of debt divided by total capital employed)

In FINANCE we prefer to use market values if they are available. In FINANCIAL ACCOUNTING the book values are used.

Capital structure is an alternative term which describes the mix of debt and equity

Optimal capital structure

What is the optimal capital structure of a firm?

What is the value of a company like?

How do we maximise the value of the company?

The optimal capital structure of a firm is the best mix of debt and equity financing that maximizes a company’s market value while minimising its cost of capital.

The value of a company is like the value of a project or an investment. Its NPV is higher if the discount rate (the WACC) is lower.

To maximise the value of the company, we therefore need to minimise WACC.

Is there a “correct” capital structure?

Key factors:

Lenders vs Shareholders

Lenders must be?

In the event of a liquidation?

As investors?

Shareholders?

When gearing goes up?

Cost of equity? (2)

Key factors:

- Lenders are guaranteed by law to receive their interest and their capital. Shareholders have no such rights generally.
- Lenders must be paid their interest in full even if there is no profit. Dividends can be cut by the directors if there is a shortage of profit and/or cash.
- In the event of a liquidation, lenders are more likely to recover their investment than shareholders because lenders rank more highly in the pecking order once the company is in financial difficulty.
- As investors, ordinary shareholders bear more risk than lenders.
- Shareholders expect a higher return to compensate for this higher risk.
- When gearing goes up, the shareholders perceive that as additional risk
- Cost of equity is nearly always higher than the cost of debt.
- Cost of equity usually goes up when debt is increased.

Theories of gearing

**Traditional theory**

- There is an ideal level of gearing which minimises the company’s WACC

**Modigliani & Miller’s theory (no tax)**

- WACC is unaffected by gearing so makes no difference to the value of the company

Traditional theory

What happens as the debt is increased?

What happens when debt is very high

What else increases?

But?

So?

What increases as a result of…?

What happens after?

Best to have..?

- As debt is increased the company’s cost of debt remains relatively constant as long as any increase in debt is incremental so it doesn’t adversely affect creditworthiness. Only when debt gets very high does the company’s cost of debt begin to rise because lenders start to worry about the company’s ability to pay back debt.
- Cost of equity starts to rise too, but debt is a more direct risk to the shareholders’ dividend, so the shareholders begin to demand higher returns on their equity much earlier. Cost of equity increases more dramatically as the gearing increases.
- Weighted average cost of capital starts to fall as the much cheaper debt becomes bigger within the capital structure. The cheap debt brings down the average cost of capital. However, past a certain point the increasing much greater increases in the cost of equity starts to pull the WACC up.
- Best to have gearing where the WACC is at its lowest.