WELCOME TO THE COURSE

INTERMEDIATE FINANCIAL MANAGEMENT

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1. OVERVIEW OF FINANCIAL MANAGEMENT
Chapter objectives
• After studying this section you will be able to
• Define the field of finance
• Define scope of managerial finance/ Financial management
• Explain the place of managerial finance in organization
• The role of finance manager
• The environment of financial management decisions
• Forms of business organizations
• The nature of financial markets

•
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 The scope and Environment of Financial Management
What is finance ?
• Finance is the general term used to refer to
 the money resources available to governments, business
firms, not for profit organizations or individuals and the
management of these resources.
• Essentially all individuals, organizations, governments at
various levels, business firms and not for profit organizations
earn, raise, spend or invest money.

• the word finance is used in various contexts, in referring to

money, how money is generated or its management .

• Finance is the art and science of managing money. 3

 Finance cont’d
• Finance is concerned with the process, institutions, markets and
instruments involved in the transfer of money among and between
individuals, businesses, and governments.
• Finance is like a life-blood for a company. Even the best of the
companies and CEOs go out of the business because of poor
financial management policies.

• The study of finance, therefore, necessarily includes the institution

(the financial system and organizations, markets & regulatory
principles involved), the process and how to cope with the system
to properly manage money.

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Cont’d
• The study of finance is often classified into three(3) specialized fields,
namely
1. Financial management (managerial finance) is the management of
financial resources
2. Investment- deals with financial assets such as stocks & bonds.
It investigates :
. What determines the price of a financial asset, such as a share of stock?
. What are the potential risks & rewards associated with investing in financial
assets?
. What is the best mixture of the different types of financial assets to hold?
3. Financial markets & institutions are the financial institutions that supply
capital to businesses
• each of these are interrelated & complement one another
• We are basically concerned with the field of financial management or
managerial finance here. 5
 Decision functions of financial management
• Financial management functions can be broken down into three broad areas,
namely
• Investment decisions
• Financing decisions, and
• Asset management decisions
• Investment decision
• Determination of total amount of assets needed to run operation of the
organization
• The type and mix of assets
• How much of the firms’ investment should be devoted to:
• Cash
• Receivables
• Inventories, fixed assets etc
• It involves capital budgeting decision, that is, the evalution and choice of fixed
assets, replacement decisions, retirement and deposal etc
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 Financing decision
• Represented by the right hand side of a balance sheet
• Determination of source of finance to match the investment
decisions
• Determination of financing mix
• Dividend policy is viewed as part of the financing decisions as it
affects the financial structure/capital structure/,
• how much to distribute,
• how much to plow back in business for further expansion

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 Asset management
• Involves efficient utilization of assets
• Includes management of working capital
• Optimum cash balance
• Management of receivables –credit policy decisions, collections, bad debt
issues
• Inventory management, reduction of carrying and ordering cost, etc
• Management of fixed assets,
• capacity utilization, productivity, maintenance and repair, replacement etc

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 The firm’s
balance sheet

Investment decisions Financing decisions

Asset Assets Liabilities
• & owners’
managem Current assets equity
ent Cash Liabilities
Decision Receivables Current liabilities
Inventories long-term debt
Non-current assets
Owners’ equity
Long-term
investments External equity
Fixed assets Internal equity

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 Scope of financial management decisions
• Financial management decision is related to almost all
functional areas
• The finance manger has to plan, acquire and guide the
utilization of Financial resources to maximize the value of the
firm
• Production plan, marketing or commercial activity, investment,
human resource etc decisions necessarily require involvement
of financial management decisions.

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Finance Relationship to Economics
• The field of finance is closely related to economics.
• Financial managers must understand the economic framework
and be alert to the consequences of varying levels of economic
activity and changes in economic policy.
• They must also be able to use economic theories as guidelines for
efficient business operation.
• Examples include supply-and-demand analysis, profit-maximizing
strategies, and price theory.
• The primary economic principle used in managerial finance is
marginal cost–benefit analysis, the principle that financial
decisions should be made & actions taken only when the added
benefits exceed the added costs.
• Nearly all financial decisions ultimately come down to an
assessment of their marginal benefits and marginal costs. 18
Exercise ( Marginal benefit/cost analysis)
• Zenu is a financial manager for ND Stores. He is currently trying to
decide whether to replace one of the firm’s computer servers with a
new, more sophisticated one that would both speed processing and
handle a larger volume of transactions.
• The new computer would require a cash outlay of $8,000, and the old
computer could be sold to net $2,000.
• The total benefits from the new server (measured in today’s value)
would be $10,000. The benefits over a similar time period from the old
computer (measured in today’s monetary value) would be $3,000.
• Required : Applying marginal cost–benefit analysis,
• A. Determine the marginal benefit
• B. Determine the marginal cost
• C. Determine the net benefit
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Soln.
a,. Benefits with new computer $10,000
• Less: Benefits with old computer 3,000
• (1) Marginal (added) benefits $ 7,000
b. Cost of new computer $ 8,000
• Less: Proceeds from sale of old computer 2,000
• (2) Marginal (added) costs $ 6,000
c. Net benefit [(1) - (2)] $ 1,000

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 Finance Relationship to Accounting
• The firm’s finance and accounting activities are closely related
and generally overlap.
• In small firms, accountants often carry out the finance function;
in large firms, financial analysts often help compile accounting
information.
• There are, however, two differences between finance and
accounting;
• one is related to the emphasis on cash flows, and
• the other is related to decision making.

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 Emphasis on Cash Flows
• The accountant’s primary function is to develop and report data for
measuring the performance of the firm, assess its financial position,
comply with & file reports required by regulators, & pay taxes.
• the accountant prepares financial statements that recognize
revenue at the time of sale (whether payment has been received or
not) and recognize expenses when they are incurred. This approach
is referred to as the accrual basis.
• The financial manager places primary emphasis on cash flows, the
intake and outgo of cash.
• The financial manager uses cash basis to recognize the revenues
and expenses only with respect to actual inflows and outflows of
cash.
• Whether a firm earns a profit or experiences a loss, it must have a
sufficient flow of cash to meet its obligations as they come due. 22
 Exercise
• N Corporation, a car dealer sold one car for $100,000 in the
calendar year just ended. N co. originally purchased the car for
$80,000. Although the firm paid in full for the car during the year,
at year-end it has yet to collect the $100,000 from the customer.
Indicate financial performance of the co. on both
a. the accounting view and
B. the financial view

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Soln.
• Accounting view (accrual basis)
• N Corporation income statement for the year ended 12/31
• Sales revenue $100,000
• Less: Costs 80,000
• Net profit $ 20,000

• Financial view (cash basis) N co

• N Co cash flow statement for the year ended 12/31
• Cash inflow $0
• Less: Cash outflow 80,000
• Net cash flow ($80,000)
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 The Goal of a Business Firm/Financial Management

• Recall that financial management is concerned with

decision making to achieve the goal of a firm.
• The firms investment & financing decision are
unavoidable and continuous. So in order to make them
rationally, the firm must have a goal or objective.
• But what is this goal of a firm? Before trying to
address the question, let us first describe the meaning
of a goal.

A goal is a well-known objective the firm strives in all its action to

achieve it. 27
 Con’t…
• Possible goals:
• Survive,
• Avoid financial distress and bankruptcy,
• Beat competition,
• Maximize sales or market share,
• Minimize cost,
• Maximize profit,
• Maintain steady earning growth… etc. However, most of
the goals mentioned above are vague to use them as a
guideline for decision-making.
• Therefore there are two approaches for the goal of the
firm:
A. Profit Maximization
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B. Wealth Maximization
 Con’t….
Profit maximization:
• Considers profit as the most appropriate
measure of a firm’s performance.
• Maximizing the birr income of firms.

 Profit maximization: implies either “producing

maximum out put for the given amount of input or “use
minimum input to produce a given level of out put.

• Profit maximization is a function of maximizing

revenue and /or minimizing costs.
• If a firm is able to maximize its revenues for a given level of
costs or minimizing costs for a given level of revenues, it is
considered to be efficient. 29
 Shareholders Wealth Maximization
 The contemporary view of the goal of the firm is maximizing
shareholders value.
• Wealth maximization means maximization of the value of a firm.
Hence, wealth maximization is also called value maximization or
net present value (NPV) maximization.
 is the ability of a company to increase the market value of its
common stock over time.
The market value of the firm is based on many factors like their
goodwill, sales, services, quality of products, etc
• To understand and appreciate the essence of wealth maximization,
we need to consider the various stakeholders in a given corporation.
• They include stockholders, debtors, managers, employees,
customers, governmental agencies and others. 30
 Con’t…
• Financial managers are charged with the responsibility of
making decisions that maximize owners’ wealth. i.e. managers
should give priority to stockholders.

There are two ways in which the ownership of common

stocks can change a person's wealth:
• (a) dividends can be paid to the stockholder and;
• (b) the market price of the stocks can change.

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Arguments on profit maximization
Profits serve as a protection against risks that cannot be
insured.
• The accumulated profits enable a business to face risks
like fall in prices, adverse government policies, etc.
Profits are the main sources of finance for the growth of a
business.
• So, a business should aim at the maximization of profits for
ensuring its growth and development.
• With all these arguments, profit maximization is considered as
the main goal of firms.

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Limitations of Profit Maximization Goal
• Many scholars on financial management have criticized the
profit maximization goal of a firm on many grounds.
 First, they argue that a firm following the goal of profit
maximization starts exploiting workers & consumers with a view
of maximizing its profits.
• Hence, it is unethical & leads to a number of corrupt practice.
Further, it leads to social inequalities and lowers human values,
which are essential parts of an ideal social system.

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 Cont’d
• Operationally, profit maximization goal of a firm fails to be the
appropriate goal of a firm for a number of reasons.
 It ignores:
1. The timing of returns or profits,
2. Cash flows available to stockholders,
3. Risk,
4. Different meanings of the word profits.
• Timing of Returns or Profits: ignores the timing of returns or profits.
• It ignores the fact that cash received today is more important than the
same amount of cash received later, say after three years.
• Because the firm can earn a return on funds it receives, the receipt of
funds sooner rather than later is preferred.
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 Cont’d
• For example, assume that Abay Co, is attempting to choose between 2 major
investments, X and Y .
• Each is expected to have the following earnings per share effects over its three-year
life.
Earnings per Share (EPS in Birr)
Investment Alternatives Year 1 Year 2 Year 3 Total
1. X 1.40 1.00 0.40 2.80
2. Y 0.60 1.00 1.40 3.00
• Based on the profit maximization goal, investment Y would be preferred over
investment X, because it results in higher earnings per share over the three years
period (Br. 3 EPS for Y is greater than Br. 2.8 EPS for X).
• However, in spite of the fact that the total earnings from investment X are smaller
than those from Y, investment X may be preferred due to the greater EPS it
provides in the first year.
• So the investment in X has the larger returns in year 1 which could be reinvested to
provide greater future earnings 36
Cash flows available for stockholders:
• A firm's earnings do not represent cash flows available to the
stockholders.
• Owners receive returns either through cash dividends paid to
them or by selling their shares for a higher price than initially
paid.
• A greater EPS does not necessarily mean that dividend
payments will increase.
• This is because the payment of dividends results solely from the
action of the firm's board of directors.

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 Risks:
• The profit maximization goal ignores risk.
• (Risk is the chance that actual outcomes may differ from those
expected.)
• It does not take into consideration the risk of the prospective
earnings or profits. Some projects are more risky than some others.
• For example, two firms may have the same earnings per share, but
if the earning stream is riskier, the investor will select the firm with
less risk.
• In general, investors are risk averters-that is, they want to avoid
risk.
• Where risk is involved, stockholders expect to earn higher rate of
return on investments of higher risk and lower rates on lower risk
investments.
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• Example: Nyala Merchandising Private Limited Company must
choose between two projects. Both projects cost the same.
• Project A has a 50% chance that its cash flows would be actual
over the next three years.
• Project B, on the other hand, has a 90% probability that its cash
flows for the next three years would be realized.
Expected Benefits
YEAR PROJECT A PROJECT B
1 Br. 60,000 Br. 45,000
2 65,000 50,000
3 95,000 85,000
TOTAL Br. 220,000 Br. 180,000

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• Under profit maximization, project A is more attractive because it adds
more to Nyala than project B. However, if we consider the risk of the
two projects, the situation would be reversed.
 Expected benefit of project A = Br. 220,000 x 50% = Br. 110,000

 Expected benefit of project B = Br. 180,000 x 90% = Br. 162,000

• The more certain the expected cash flow (return), the higher the quality of benefits
(i.e., low risk to investor).
• Conversely, the more uncertain or fluctuating the expected benefits, the lower the
quality of benefits (i.e., high risk to investors).

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 Ambiguity of ‘Profit’ Maximization
The term profit or income is vague and ambiguous concept. It
is very illusive and has no precise quotation.
• Different people understand profit in different several ways.
Because there are many different economic and accounting
definitions of profit. i.e
Does it mean short-term or long-term profits?
Does it refer to profit after tax or before tax?
 Net profit available to ordinary share holders
Does it mean total profit or profit per share or
• Then, the question or the problem would be which
profit is to be maximized?
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 It could increase current profits while harming the firm future survival

• A business might increase short term profits at the expense of long-term competitiveness
and performance of a business.
• It could be done by reducing operating expenses:

• Cutting research and development expenditure

• Defer/postpone important maintenance costs

• Cutting staff training and development

• Buying lower quality materials

• Cutting quality control mechanisms

• These policies may all have a beneficial effect on short term profits but may
undermine the long term competitiveness and performance of 43a
business.
 Shareholders’ Wealth Maximization Goal of a Firm
• Because of the above mentioned limitations, profit maximization cannot be an
appropriate financial goal of a firm.
• An appropriate financial goal of a firm that eliminates such limitations is
shareholders’ wealth maximization.
• is the concept of increasing the value of a business in order to increase the value
of the shares held by stockholders
• The wealth of corporate owners is measured by the share price of the stock.
• The share price of the stock, in turn, is based on the timing of returns (cash
flows), the magnitude of cash flows and the risk associated with these cash flows.
• When considering each financial decision in terms of its impact on the share price
of the firm's stock, financial mangers should accept only those actions that are
expected to increase share price.
• Because share price represents the owners' wealth in the firm, share price
maximization is consistent with owner wealth maximization.
• Success is usually judged by value: Shareholders are made better off by any
decision which increases the value of their stake in the firm 44
Cont..
• If this goal seems a little strange or one-dimensional to you,
keep in mind that the stockholders in a firm are residual owners.
• By this we mean that they are only entitled to what is left after
employees, suppliers, and creditors (and anyone else with a
legitimate claim) are paid their due.
• If any of these groups go unpaid, the stockholders get nothing.
• So, if the stockholders are financially improved in the sense that
the leftover or residual portion, is growing, it must be true that
everyone else is improving also.

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The goal of wealth maximization in practice

• In theory, most financial managers would agree with the goal of

shareholder wealth maximization.
• In reality, however, managers are also concerned with their
personal wealth, job security, and fringe benefits.
• Such concerns may cause managers to make decisions that
are not consistent with shareholder wealth maximization.
• For example, financial managers may be reluctant or unwilling
to take more than moderate risk if they perceive that taking too
much risk might jeopardize their job or reduce their personal
wealth.

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 The Agency Problem
• Agency relationship: The relationship between stockholders and
managers is called an agency relationship
• Principal hires an agent to represent his/her interests
• Stockholders (principals) hire managers (agents) to run the company
• Agency problem
• Conflict of interest between principal & agent
• Management goals and agency costs

1-53 53
Agency Considerations in Corporate Finance (cont.)
• Agency problems arise when there is conflict of interest
between the stockholders and the managers.
• Such problems are likely to arise more when the managers
have little or no ownership in the firm.
• Examples:
– Not pursuing risky project for fear of losing jobs, stealing,
expensive benefits.
• All else equal, agency problems will reduce the firm value.

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 How to Reduce Agency Problems?
• 1. Monitoring
• (Examples: Reports, Meetings, Auditors, board of
directors)
• 2. Compensation plans
• (Examples: Performance based bonus, salary, stock
options, benefits)
• 3. Others
• (Examples: Threat of being fired, Threat of takeovers,

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 - 1
f ch
d o
En

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Chapter 2. Capital Budgeting

• The process of making capital expenditure decisions is

known as capital budgeting.
• Capital budgeting involves choosing among various
capital projects to find one(s) that will maximize a
company’s return on its financial investment.

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 The Capital Budgeting Evaluation Process
Many companies follow a carefully prescribed process in capital
budgeting. The process usually includes the following steps:
1 Project proposals are requested from departments, plants,
and authorized personnel.
2 Proposals are screened by a capital budget committee.
3 Officers determine which projects are worthy of funding.
4 Board of directors approves capital budget.

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 Cash Flow Information
• Most capital budgeting decision methods employ cash
flow numbers rather than accrual accounting revenues
& expenses.
• Revenues & expenses often differ significantly from
cash inflow & outflows.
• Although accrual accounting has its advantages over
cash-basis accounting, for purposes of capital
budgeting, estimated cash inflows & outflows are
preferred as inputs into capital budgeting decision
tools.

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Capital project selection Models
•A large majority of firms using capital project selection
models use profit/profitability as the sole measure of
acceptability.
• These models include:
a) Pay back period (PBP)
b) Discounted cash flow
c) Internal rate of return (IRR)
d) Average rate of return
e) Profitability Index
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 Illustrative Data

The following data will be used in a continuing example. This will

allow for comparison of the results of the various capital
budgeting techniques.
 SS Company is considering an investment of $130,000 in new equipment.
 The new equipment is expected to last 10 years and have a zero salvage value at
the end of its useful life.
 The annual cash inflows are $200,000, and the annual net cash outflows are
$176,000. The data are summarized below:

Initial investment $130,000

Estimated useful life 10 years
Estimated salvage value -0-
Estimated annual cash flows
Cash inflow from customers $200,000
Cash outflows for operating costs 176,000
Net annual cash inflow $ 24,000

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 1. Cash Payback
• The cash payback technique identifies the time period required
to recover the cost of the capital investment from the annual
cash inflow produced by the investment.
• The formula for computing the cash payback period is:

Cost of Capital Net Annual Cash Payback

Investment  Cash Inflow = Period

 The shorter the payback period, the more attractive the investment.
Also, the payback period is usually related to the estimated useful life
of the asset.

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Cash Payback Example

• The cash payback period in the SS co. example is 5.42

years, computed as follows:

$130,000  $24,000 = 5.42 years

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 Cash Payback: Advantages and Disadvantages

• The cash payback technique may be useful as an

initial screening tool.
• It is easy to compute & understand.
• However, it should not normally be the only basis
for a capital budgeting decision because it ignores
the profitability of the project.
• It also ignores the time value of money. +–

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 2. Annual Rate of Return Method(Accounting Profit )
• The annual rate of return technique is based on accrual
accounting data.
• It indicates the profitability of a capital expenditure.
• The formula is:

Expected
Average Annual Rate of
Annual Net
Income
 Investment = Return

 The annual rate of return is compared to management’s

required minimum rate of return for investments of similar
risk.
 A project is acceptable under this method if the annual rate
of return is greater than the required rate of return.
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Annual Rate of Return Example
• Assume that Reno Company is considering an investment
of $130,000 in new equipment.
• The new equipment is expected to last 5 years and have
zero salvage value. The straight-line depreciation
method is used for accounting purposes. The expected
annual revenues and costs of the new product that will
be produced from the investment are:

Sales $200,000
Less: Cost and expenses
Manufacturing costs $132,000
Depreciation expense ($130,000  5) 26,000
Selling and administrative expenses 22,000 180,000
Income before income taxes 20,000
Income tax expense 7,000
Net income $ 13,000

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Annual Rate of Return Example
• Average investment is computed as follows:
Average investment = Original investment + Investment at end of useful life
2

 The investment at the end of the useful life is equal to the asset’s salvage value.
 For Reno, average investment is $65,000 [($130,000 + $0)  2].
 The expected annual rate of return for Reno’s investment is therefore 20%, computed
as follows:
$13,000  $65,000 = 20%

 Management then compares the annual rate of return with its required rate of
return for investments of similar risk. The required rate of return is
generally based on the company’s cost of capital.
 The decision rule is: A project is acceptable if its rate of return is greater
than management’s required rate of return. It is unacceptable when the
reverse is true.
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3. Discounted Cash Flow Techniques
• Capital budgeting techniques that take into account both
the time value of money & the estimated total cash flows
from an investment are called discounted cash flow
techniques.
• They are generally recognized as the most informative &
best conceptual approaches to making capital budgeting
decisions.
• The primary capital budgeting method that uses discounted
cash flow techniques are:
• net present value.
• internal rate of return.

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 3.1. Net Present Value Method
• Under the net present value (NPV) method, cash inflows are
discounted/converted to their present value & then
compared with the capital outlay required by the investment.
• The difference between these two amounts is referred to as
the net present value.
• The interest rate to be used in discounting the future cash
flows is the required minimum rate of return.
• A proposal is acceptable when the NPV is zero or positive.
• The higher the NPV, the more attractive the investment.

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Net Present Value (NPV)
• Suppose you are considering investing in a project that will cost you
$10,000 today. The project is expected to generate cash flows of
$3,000 per year for the next five years. The discount rate, which
represents the opportunity cost of capital, is 10%.
• To calculate the NPV of this investment, we need to discount each
cash flow back to its present value using the formula:
• NPV = CF1/(1+r)^1 + CF2/(1+r)^2 + CF3/(1+r)^3 + ... + CFn/(1+r)^n
• where CF is the cash flow, r is the discount rate, and n is the number
of years.
• In our example, the NPV calculation would look like this:
• NPV = -$10,000 + $3,000/(1+0.1)^1 + $3,000/(1+0.1)^2 +
$3,000/(1+0.1)^3 + $3,000/(1+0.1)^4 + $3,000/(1+0.1)^5
• NPV = -$10,000 + $2,727 + $2,479 + $2,254 + $2,052 + $1,872
• NPV = -$1,616
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• As you can see, the NPV of this investment is negative, which
means that it is not profitable. Therefore, you should not invest
in this project.
• The reason why the NPV is negative is because the cash flows in
the later years are worth less today due to the time value of
money. This is because money today is worth more than the same
amount of money in the future due to inflation, interest rates,
and other factors. Therefore, we need to adjust the cash flows
for the time value of money using the discount rate.
• In conclusion, NPV is a powerful tool for evaluating the
profitability of an investment or project. By discounting future
cash flows back to their present value, we can determine
whether the investment is worth pursuing or not
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 Mutually Exclusive Projects
• In theory, all projects with positive NPVs should be
accepted. However, companies rarely are able to adopt all
positive-NPV proposals.
• Proposals are often mutually exclusive, meaning that if the
company adopts one proposal, it would be impossible to adopt
the other proposal.
• Even in cases where projects are not mutually exclusive,
mangers must often choose between various positive-NPV
projects because of limited resources.
• When choosing between alternatives, it is tempting to choose
the project with the highest NPV, but the investment required
by the projects should also be considered.

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Mutually Exclusive Projects: Profitability Index

• One relatively simple method of comparing alternative

projects that takes into account both the size of the original
investment and the discounted cash flows is the profitability
index.
• The profitability index is computed with the following
formula:

Present Value Initial Profitability

of Cash Flows  Investment = Index

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Profitability Index Example
• A company must choose between two mutually exclusive projects. Each
project has a 10-year life & a 12% discount rate can be assumed. Data
related to the two projects is as shown:
Project A Project B
Initial investment $40,000 $90,000
Net annual cash inflows 10,000 19,000
Salvage value 5,000 10,000
Present values of cash flows 58,112 110,574
Net present value 18,112 20,574
 As shown, both projects have positive NPVs. Project B’s NPV is higher, but that
project also requires more than two times the initial investment that Project A
does.
 Project A is more desirable because it has the higher profitability index
Profitability Index = Present Value of Cash Flows
Initial Investment

Project A Project B

$58,112 = 1.45 $110,574 = 1.23

$40,000 $90,000
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Internal Rate of Return Method
• The internal rate of return method results in finding the
interest yield of the potential investment.
• The internal rate of return is the interest rate that will
cause the present value of the proposed capital expenditure
to equal the present value of the expected annual cash
inflows (i.e., a NPV of zero).

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Internal Rate of Return
Step 3: Compare the internal rate of return to management’s required rate of return.
The decision rule is: Accept the project when the internal rate of return is equal to
or greater than the required rate of return, and reject the project when the internal
rate of return is less than the required rate.

Internal Rate of
Return
If equal to or
Compared to:
greater than: If less than:
Minimum
Rate of Return Reject
Accept
(Cost of capital) Proposal
Proposal

• Assuming the minimum required rate of return is 8% for

Tampa Company, the project is accepted because the 9%
internal rate of return is greater than the required rate.

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2.2. Cost of capital and capital structure
• Objectives

• Understand the basic concept and sources of capital associated with the cost
of capital.

• Explain what is meant by the marginal cost of capital.

• Determine the cost of long-term debt, and explain why the after-tax cost of
debt is the relevant cost of debt.

• Determine the cost of preferred stock.

• Calculate the cost of common stock equity, and convert it into the cost of
retained earnings and the cost of new issues of common stock.

• Calculate the weighted average cost of capital (WACC) and discuss

alternative weighting schemes.
 Overview of the Cost of Capital
The cost of capital represents the firm’s cost of financing, and is the minimum rate
of return that a project must earn to increase firm value.

Financial managers are ethically bound to only invest in projects that they
expect to exceed the cost of capital.
The cost of capital reflects the entirety of the firm’s financing activities.

 Most firms attempt to maintain an optimal mix of debt and equity financing.

To capture all of the relevant financing costs, assuming some desired mix
of financing, we need to look at the overall cost of capital rather than just
the cost of any single source of financing.
 How can the firm raise capital?
Long-Term Capital

Long-Term Debt Preferred Stock Common Stock

Retained New Common

Earnings Stock

• Each of these offers a rate of return to investors.

• This return is a cost to the firm.
• “Cost of capital” actually refers to the weighted cost
of capital - a weighted average cost of financing
sources.
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• The cost of capital is the return that must be
provided for the use of an investor’s funds.

• If the funds are borrowed, the cost is related

to the interest that must be paid on the loan.

• If the funds are equity, the cost is the return

that investors expect, both from the stock’s
price appreciation and dividends.

95
Example.
• Let's say a company wants to undertake a new project that requires an investment of $1
million. In order to finance this project, the company can either borrow money from a bank
or issue new shares of stock to investors.
• If the company decides to borrow money from a bank, it will have to pay interest on the
loan, which will be considered as the cost of debt capital. Let's say the interest rate on the
loan is 18% per annum. Therefore, the cost of debt capital in this case would be 18%.
• Alternatively, if the company decides to issue new shares of stock, it will have to pay
dividends to the shareholders, which will be considered as the cost of equity capital. Let's
say the expected dividend yield on the stock is 15% per annum. Therefore, the cost of
equity capital in this case would be 15%.
• So, the cost of capital for this project would be a weighted average of the cost of debt and
equity capital based on the proportion of debt and equity used to finance the project. For
example, if the company finances the project with 70% debt and 30% equity, the cost of
capital would be calculated as follows:
• Cost of capital = (70% x 18%) + (30% x 15%) = 12.6%
• This means that the company will have to earn a return of at least 12.6% on the project to
cover the cost of financing it.
 Cost of Long-Term Debt
• The pretax cost of debt is the financing cost associated with new funds
through long-term borrowing.
• Typically, the funds are raised through the sale of corporate
bonds.
• Net proceeds are the funds actually received by the firm from the sale of a
security.
• Flotation costs are the total costs of issuing & selling a security.
• They include two components:
1. Underwriting costs—compensation earned by investment bankers
for selling the security.
2. Administrative costs—issuer expenses such as legal, accounting,
& printing.
 Cost of Long-Term Debt (cont.)
D Corporation is contemplating selling $10 million worth of 20-year, 9%
coupon bonds with a par value of $1,000.
Because current market interest rates are greater than 9%, the firm must
sell the bonds at $980.
Flotation costs are 2% or $20. The net proceeds to the firm for each
bond is therefore $960
($980 – $20).
Cost of Long-Term Debt (cont.)
• The before-tax cost of debt, rd, is simply the rate of return the
firm must pay on new borrowing.
Approximating the cost:

Where:

I = annual interest in dollars

Nd = net proceeds from the sale of debt (bond)
n = number of years to the bond’s maturity
Cost of Long-Term Debt (cont.)
Approximating the cost
Cost of Long-Term Debt: After-Tax Cost of Debt

• The interest payments paid to bondholders are tax deductible

for the firm, so the interest expense on debt reduces the firm’s
taxable income and, therefore, the firm’s tax liability.
• The after-tax cost of debt, ri, can be found by multiplying the
before-tax cost, rd, by 1 minus the tax rate, T, as stated in the
following equation:
ri = rd  (1 – T)
Cost of Long-Term Debt: After-Tax Cost of Debt (cont.)

D Corporation has a 40% tax rate.

Using the 9.388% before-tax debt cost calculated above, we find an
after-tax cost of debt of 5.6% [9.4%  (1 – 0.40)].
Typically, the cost of long-term debt for a given firm is less than the cost
of preferred or common stock, partly because of the tax deductibility of
interest.
 Cost of Preferred Stock
• Preferred stock gives preferred stockholders the right to receive their stated
dividends before the firm can distribute any earnings to common
stockholders.
• Most preferred stock dividends are stated as a dollar amount.
• Sometimes preferred stock dividends are stated as an annual
percentage rate, which represents the percentage of the stock’s par,
or face, value that equals the annual dividend.
• The cost of preferred stock, rp, is the ratio of the preferred stock
dividend to the firm’s net proceeds from the sale of preferred stock.
Cost of Preferred Stock (cont.)
D Corporation is contemplating the issuance of a 10% preferred stock
that is expected to sell for its $87-per share .
The cost of issuing and selling the stock is expected to be $5 per share.
The dividend is $8.70 (10%  $87).
The net proceeds price (Np) is $82 ($87 – $5).

rP = DP/Np = $8.70/$82 = 10.6%

 Cost of Common Stock
• The cost of common stock is the return required on the stock by
investors in the marketplace.
• There are two forms of common stock financing:
1. Retained earnings
2. New issues of common stock
• The cost of common stock equity, rs, is the rate at which investors
discount the expected dividends of the firm to determine its share
value.
 Cost of Common Stock
• By retaining earnings, the company is using common shareholders’ funds.
• The Cost of Retained Earnings (Reinvested Profits), kr, is equal to the cost of
common equity, ke, as follows:
kr = ke
• Therefore, Cost of Retained Earnings is equivalent to the Cost of Common
Stock.
• These two are popularly measured using the following methods:
1. Constant-Growth Dividend Valuation Model or Gordon Model
2. The Capital Asset Pricing Model (CAPM)

109
 Cost of Common Stock
• Unlike Cost of New Common Stock, it is not necessary to
adjust the Cost of reinvested profits for flotation costs,
because these costs are not incurred.
• Cost of New Common Stock also uses the Constant
growth Model but takes into account Flotation Costs &
other selling costs.
• Since dividends are paid from after-tax income, no tax
adjustment is required.

110
Cost of Common Stock (cont.)
Solving for rs results in the following expression for the cost of
common stock equity:

The equation indicates that the cost of common stock equity can be
found by dividing the dividend expected at the end of year 1 by the
current market price of the stock (the “dividend yield”) and adding the
expected growth rate (the “capital gains yield”).
 Cost of Common Stock (cont.)
• D Corporation wishes to determine its cost of common stock equity, rs.
• The market price, P0, of its common stock is $50 per share.
• The firm expects to pay a dividend, D1, of $4 at the end of the coming year, 2013.
• The dividends paid on the outstanding stock over the past 6 years (2007–2012) were as
follows:
 Cost of Common Stock (cont.)
• We can calculate the annual rate at which dividends have grown, g,
from 2007 to 2012. It turns out to be approximately 5% (more precisely,
it is 5.05%).

• Substituting D1 = $4, P0 = $50, and g = 5% into the previous equation

yields the cost of common stock equity:

• rs = ($4/$50) + 0.05 = 0.08 + 0.05 = 0.130, or 13.0%

• Exercise AB co. has been paying dividends steadily for 20 years. During that time,
dividends have grown at a compound annual rate of 7%. If AB’s current stock price
is $78 and the firm plans to pay a dividend of $6.50 next year, what is AB’s cost of
common stock equity?

• rs= 6.5/78+0.07=.08+.07=15%
 Cost of Common Stock (cont.) the capital asset pricing
model (CAPM)
• The classic theory that links risk & return for all assets is the capital asset pricing model (CAPM).
Total security risk = Non-diversifiable risk + Diversifiable risk

• Diversifiable risk (sometimes called unsystematic risk) represents the portion of an asset’s risk that is
associated with random causes that can be eliminated through diversification. It is attributable to firm-
specific events, such as strikes, lawsuits, regulatory actions, or the loss of key accounts.
• Nondiversifiable risk (also called systematic risk) is attributable to market factors that affect all firms;
it cannot be eliminated through diversification. Factors such as war, inflation, the overall state of
the economy, international incidents, and political events account for nondiversifiable risk.
• The capital asset pricing model (CAPM) describes the relationship between the required return, rs, and
the non-diversifiable risk.
• It is measured by the beta coefficient, b. It is an index of the degree of movement of an asset’s return in
response to a change in the market return.
rs = RF + [b  (rm – RF)]
where
RF = risk-free rate of return
rm = market return; return on the market portfolio of assets
The Capital Asset Pricing Model (CAPM
• is a financial tool used to determine the expected return/cost on an investment based on the level
of risk associated with that investment. It takes into account both the risk-free rate of return and the
expected return on the market as a whole.
• Let's say you're considering investing in a new tech startup. You believe that the startup has a
high level of risk, but also has the potential for a high rate of return.
• Using the CAPM, you would first need to calculate the risk-free rate of return. This is typically the
rate of return on a government bond or other low-risk investment. Let's say the current risk-free
rate is 2%.
• Next, you would need to calculate the expected return on the market as a whole. This can be
determined by looking at the historical returns of a broad index /stock market. Let's say the current
expected return on the market is 8%.
• Finally, you would use the CAPM formula to determine the expected return on your investment:
• Expected return = Risk-free rate + Beta * (Expected return on the market - Risk-free rate)
• The "beta" factor in the formula accounts for the level of risk associated with the investment. A beta
of 1.0 indicates that the investment has the same level of risk as the overall market. Higher betas
indicate higher risk, while lower betas indicate lower risk.
• Let's say you determine that the beta for your tech startup investment is 1.5.
• Expected return = 2% + 1.5 * (8% - 2%) = 2% + 1.5 * 6%= 11%
• So according to the CAPM, you should expect a return of 11% on your investment in the tech
startup, based on its level of risk compared to the overall market.
 Cost of Common Stock (cont.)
D Corporation now wishes to calculate its cost of common stock equity, rs, by
using the capital asset pricing model.
The firm’s investment advisors and its own analysts indicate that the risk-free
rate, RF, equals 7%; the firm’s beta, b, equals 1.5; and the market return, rm, equals
11%.
Substituting these values into the CAPM, the company estimates the cost of
common stock equity, rs, to be:
 rs = 7.0% + [1.5  (11.0% – 7.0%)] = 7.0% + 6.0% = 13.0%
Exercise Assume that (BW) has a company beta of 1.25. Research suggests
that the risk-free rate is 4% and the expected return on the market is 11.2%.
Determine the cost of c/stock.
rs=.04+1.25(11.2%-4%)=.04+.09=13%
Cost of Common Stock: Cost of New Issues of Common Stock

• The cost of a new issue of common stock, rn, is the cost of common
stock, net of underpricing & associated flotation costs.
• New shares are underpriced if the stock is sold at a price below its
current market price, P0.
 Cont’d…

• We can use the constant-growth valuation model expression for the

cost of existing common stock, rs, as a starting point.

• If we let Nn represent the net proceeds from the sale of new common
stock after subtracting underpricing & flotation costs, the cost of the
new issue, rn, can be expressed as follows:
 (cont.)

• To determine its cost of new common stock, rn, D Corporation has estimated
that on average, new shares can be sold for $47 and dividend to be paid $4.
• The $3-per-share underpricing is due to the competitive nature of the market.
• A second cost associated with a new issue is flotation costs of $2.50 per share
that would be paid to issue & sell the new shares.
• The total underpricing & flotation costs per share are therefore $5.50.

• rn = ($4.00/$41.50) + 0.05 = 0.096 + 0.05 = 0.140, or 14.0%

 Weighted Average Cost of Capital

The weighted average cost of capital (WACC), ra, reflects the expected
average future cost of capital over the long run; found by weighting the cost of
each specific type of capital by its proportion in the firm’s capital structure.
ra = (wi  ri) + (wp  rp) + (ws  rr or n)
where

wi = proportion of long-term debt in capital structure

wp = proportion of preferred stock in capital structure

ws = proportion of common stock equity in capital
structure

wi + wp + ws = 1.0
 Weighted Average Cost of Capital (cont.)
In earlier examples, we found the costs of the various types of capital for D
Corporation to be as follows:
• Cost of debt, ri = 5.6%
• Cost of preferred stock, rp = 10.6%
• Cost of retained earnings, rr = 13.0%
• Cost of new common stock, rn = 14.0%
The company uses the following weights in calculating its weighted average cost of
capital:
• Long-term debt = 40%
• Preferred stock = 10%
• Common stock equity = 50%
Calculation of the Weighted Average Cost of
Capital for Dutchess Corporation
 Exercise

• xy Corporation uses debt, preferred stock, and common stock to raise capital.
• The firm’s capital structure targets the following proportions: debt, 55%; preferred stock,
10%; and common stock, 35%.
• If the cost of debt is 6.7%, preferred stock costs 9.2%, and common stock costs 10.6%,
what is xy’s weighted average cost of capital (WACC)?
(1 (2) (3)
Cost Weighted
(after tax) Weights Cost
Debt . . . . . . . . . . 6.7% 55% 3.68%
Preferred stock . . . . 9.4 10 .094
Common equity
(retained earnings) . . . 10.6 35 3.71
Weighted average
cost of capital . . . . . 8.37%
CAPITAL STRUCTURE DECISIONS
• The capital structure refers to the way the firm’s assets are
financed. The financing can be through debt or equity.
• The capital structure theories attempts to explain the value of a
firm in relation to the mode of financing, and attempt to find
what would be a firm’s optimal capital structure
CAPITAL STRUCTURE DECISIONS
• The term capital structure is used to represent the proportionate
relationship between debt and equity
• It is a significant managerial decision and it influences the
shareholder’s return and risk
• The share price may also be affected by the capital structure decisions
FINANCIAL LEVERAGE
• A company can finance its investments by debt and/or equity.
• The rate of interest on debt is fixed irrespective of company’s rate of
return.
• The use of debt and owners equity in capital structure is called
financial leverage or gearing.
CAPITAL STRUCTURE THEORIES

• Capital structure decision should be examined from the point of

its impact on the value of the firm
• There exist conflicting theories on the relationship between value of
the firm and capital structure
1. TRADITIONAL THEORY
It was applied mostly before 1958.
It states that there exist an optimal capital structure in
which the value of the firm is maximized and the overall
cost of capital is minimized.
• It advocates that there is a right combination of equity
and debt at which the market value of the firm is
maximized
• It indicates that debt should exist in the capital
structure only up to a specific point, beyond which any
increase would result in reduction in the value.
Assumptions under Traditional Approach
• Rate of interest on debt remains constant
• The expected rate of equity remains constant
• WACC first decreases and then increases
2. NET INCOME APPROACH
• Developed by Durand, he portrayed the influence of leverage on the
value of the firm.
• Value of debt is identified as a cheaper source of financing than
equity share capital.
• More application of debt brings down the overall capital cost
3. Pecking Order Theory
• It states that a company priorities their source of financing i.e from
internal financing to equity
• Hence internal funds are used first and when that is depleted debt
is issued.
• It starts with asymmetric information as managers know more about
their company’s prospects and risk
• Asymmetric information affects the choice between internal and
external financing
4. Trade Off Theory
• The trade-off theory would suggest that the company should choose
a mix of equity and debt financing that balances the costs of issuing
both forms of financing.
• This may involve issuing more debt if the cost of debt is lower than
the cost of equity, or issuing more equity if the cost of equity is lower
than the cost of debt.
• Ultimately, the optimal capital structure will depend on a number of
factors, including the company's financial goals, its cash flow needs,
and the overall market conditions of the industry in which it operates.
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