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Cost of Capital

A Firms Primary Objective


TO MAXIMIZE ITS
SHAREHOLDERS VALUE
The Cost of Capital
The REQUIRED RETURN
Where is CAPITAL OBTAINED?
Capital is obtained in three (3) primary
forms:
1. DEBT interest bearing liabilities
provided by investors
2. PREFERRED STOCK equity security
that has preference or a senior claim
to the firms earnings and assets over
common stock
3. COMMON EQUITY acquired by
retained earnings and by issuance of
new stocks
Factors that Influence Cost of Capital
Firms outside control
Interest rates, tax policies, and
general economic conditions
Firms inside control
HOW IT RAISES, HOW IT
INVESTS
WEIGHTED AVERAGE COST OF CAPITAL
(WACC)
A weighted average of the component
costs of DEBT, PREFERRED STOCK and
COMMON EQUITY
The target proportions along with the
costs of these components are used to
calculate the firms WACC
Capital component the types of capital used
by firms to raise funds
the investor-supplied
items include debt,
preferred stock and
common equity
Increases in assets must
be financed by increases
in capital cost
Component Cost the cost of
each of the component
COST OF DEBT
Interest on debt is tax-deductible, so that
debt has a tax adjustment
BEFORE-TAX COST OF DEBT

THE INTEREST RATE THE FIRM MUST PAY ON


NEW DEBT
NOTE: the cost of debt is the interest rate of
new debt, not on already outstanding debt
because our primary concern with oc the
cost of capital is its use in capital budgeting
decisions
AFTER-TAX COST OF DEBT
The relevant cost of new debt, taking into
account the tax deductibility of interest
This is the one used to calculate the WACC
Interest rate on New Debt Tax Savings
COST OF PREFERRED STOCK
The rate of return investors require on
the firms preferred stock
It is calculated as the preferred
dividend divided by the current price
COST OF COMMON EQUITY
The rate of return required by stock
holders on a firms common stock
Cost of new common stock the
cost of external equity based on
the cost of retained earnings
but increased for flotation costs
Flotation the
percentage cost of
issuing new common
stock
NOTE that new common equity is
raised in two (2) ways
By retaining some of the current
years earnings
By issuing new common stock
or external equity
COST OF NEW COMMON STOCK the
total cost of the capital raised is the
investors required return plus the flotation
cost
CAPITAL BUDGETING
Turning to investment decisions involving
fixed assets where:
Capital refers to long-term assets used in
production, while a Budget is a plan that
outlines projected expenditures during some
future period.

Thus, capital budgeting is the whole


process of analyzing projects and
deciding which ones to include in the
capital budget
A process used for evaluating and

ranking potential expenditures or


investments that are significant in
amount
Large expenditures could
include the
purchase of new equipment, delivery
vehicles, rebuilding existing equipment ,
constructing additions to buildings, etc and
these are called CAPITAL EXPENDITURES

Involves the calculation of each


projects
1. future accounting profit by
period
2. The cash flow by period
3. The present value of cash flows
after considering the time value
of money
4. The pay back time
5. An assessment of risk
6. Other factors

CAPITAL EXPENDITURES
Analyzing capital expenditure proposals is
not costless-benefits can be gained.
Following are generally categorized projects
1. Replacement: needed to continue
current operations.
2. Replacement: cost reduction
3. Expansion of existing products or
markets
4. Expansion into new products or
markets
5. Safety and/or environmental projects
6. Mergers
CAPITAL BUDGETING METHODS
Decision criteria to accept or not
investment proposals
NET PRESENT VALUE
A method of ranking investment
proposals using the net present value
(NPV) , which is equal to the present
value of future net cash flows,
discounted at the cost of capital
Tells us how much a project
contributes to shareholder wealth
the larger the NPV, the more value the
project adds and added value means a
higher stock price.
CONCEPTUAL ISSUES IN
CASH FLOW ESTIMATION
1. Cash Flow versus Accounting

Income
Many things can lead to differences
between net cash flows and net
income:
Depreciation is not a cash
outlay but it is deducted when
net income is calculated
Net income is based on the
depreciation rate
An addition to working capital
directly affects cash flows but
not net income
FOR CAPITAL BUDGETING PURPOSES,
THE PROJECTS CASH FLOWS, NOT ITS
ACCOUNTING INCOME, IS THE KEY ITEM

CONCEPTUAL ISSUES
1. Timing of Cash Flows - We generally
assume that all cash flows at the end
of the year
3. Incremental Cash Flows A cash
flow that will occur , if and only if, the
firm takes a project
4. Replacement Projects A type of
project where the firm replaces
existing assets, generally to reduce
costs
5. Sunk Costs A cash outlay that has
already been incurred and that cannot
be recovered regardless of whether
the project is accepted or rejected
6. BEING SUCH, THEY ARE NOT
RELEVANT IN THE CAPITAL
BUDGETING ANALYSIS
7. Opportunity Costs Associated with
Assets the Firm owns The best
return that can be earned on assets
the firm already owns if those assets
are not used for the new project
DECISION CRITERIA USED IN PRACTICE
A summary of all surveys: what
method is given more weight, what
methods are actually calculated and
used
SUMMARY ON THE METHODS
NPV tells us how much value each
project contributes to share holders
wealth
Other methods provide useful
information and in this age of
computers, it is easy to calculate all of
them
Decision makers generally look at all
the criteria when deciding to accept or

reject projects and when choosing


among mutually exclusive projects
CONCEPTUAL ISSUES
1. Externalities Effects on the firm or
the environment that are not reflected
in the projects cash flow
a) Negative Within-Firm like
Cannibalization or the situation
when a new project reduces
cash flows that the firm would
otherwise have had
b) Positive Within-Firm projects
resulting to complementary
effect
c) Environmental Externalities
MERGER & ACQUISITION
Most corporate growth occurs by
internal expansion which takes place
when a firms existing divisions grow
through normal capital budgeting
activities.
However, the most dramatic examples
of growth and often the largest
increases in firms stock prices result
from MERGER
The combination of two or more
entities to form a single firm
When one company takes over
another and clearly establishes itself
as the new owner, the purchase is
called an ACQUISITION
RATIONALE FOR MERGERS
1. IN SYNERGY the condition wherein
the whole is greater than the sum of
the parts
In synergetic merger , effects can arise
from four sources
1) Operating economies result
from economies of scale of
management, marketing,
production or distribution
2) Financial economies includes
lower transactions costs and
better coverage by security
analysts
3) Differential efficiency, which
implies that the management of
one firm is more efficient and
that the weaker firms assets
will be more productive after
the merger
4) Increased market power, due
to reduced competition
2) TAX CONSIDERATION Mergers can

3)

4)
5)

6)

serve as a way of minimizing taxes


when disposing of excess cash
PURCHASE OF ASSETS BELOW
THEIR REPLACEMENT COST A
better cash flow will result versus the
implementation of or improvision of
existing and/or present capital
budgeting activity
DIVERSIFICATION helps stabilize a
firms earnings and thus benefits its
owners
MANAGERS PERSONAL
INCENTIVES includes the idea of
defensive merger which is designed to
make a company less vulnerable to
takeover
BREAKUP VALUE The value of the
individual parts of the firm if they are
sold off separately

TYPES OF MERGER
1. HORIZONTAL MERGER a
combination of two firms that produce
the same type of goods or services
2. VERTICAL MERGER A merger
between a firm and one of its suppliers
or customers
3. CONGENERIC MERGER A merger of
firms in the same general industry but
for which no costomer or supplier
relationship exists
4. CONGLOMERATE MERGER A
merger of companies in totally
different industries
EFFECTS OF MERGER
HOSTILE VS. FRIENDLY TURNOVERS
Acquiring Company a company
that seeks to purchase another firm
Target Company A firm that
another company seeks to acquire
Friendly Merger a merger whose
terms are approved by management
of both companies
Hostile Merger a merger in which
the target firms management resists
acquisition
Tender offer the offer of one firm to
buy the stock of another firm by going
directly to the stockholders, frequently
but not always over the opposition of
the target companys management
ONCE AN ACQUIRING COMPANY HAS
IDENTIFIED A POSSIBLE TARGET COMPANY

It must establish a suitable price or


range of prices
Tentatively set the terms of payment
Its managers must decide how to
approach the target companys
managers
MERGER ANALYSIS
Valuing the Target Firm
Regardless of the valuation methodology,
two facts need to be recognized: (1) The
target company typically does not continue
to operate as a separate entity (2) The goal
of merger valuation is to value the target
firms equity.

VALUATION METHODS
Discounted Cash Flow Analysis
this approach to valuing a business
involves the application of capital
budgeting procedures to an entire firm
rather than to a single project. To
apply this method, two key items are
needed:
1. Pro-forma statements
2. Discount rate, or cost of capital
Market Multiple Analysis a
method of valuing a target company
that applies a market determined
multiple to net income, earnings per
share, sales, book value and so forth
WHAT HAPPENS AFTER THE MERGER?
Merger bring together two
organizations with different histories
and corporate cultures
Change of management
Staff reductions
Economies of scale
Improved market reach and industry
visibility
Improved companys standing
FINANCE MANAGER ETHICS
Should be above approach
Includes more than just acting in an
honest, above-board manner
Means establishing boundaries that
prevent professional and personal
interests from appearing to conflict
with the interest of the employer
TOP ETHICAL RESPONSIBILITIES
Must provide accurate, competent and
timely information
Responsible for protecting the
confidentiality of the employer
Stays within the boundaries of law

FINANCE CODE OF ETHICS


Informs professionals about rules and
operating procedures that they must
follow to comply with:
Industry standards
Corporate policies
Government requirements
Varies depending on role, industry,
company size and transaction
Helps top management avoid
significant legal problems or
regulatory fines
Prevents employees from engaging
illegal activities or act unprofessionally
Typically affect how a professional
performs duties and interacts with a
client or reports financial information
8 TREASURY FUNCTIONS
(MANAGEMENT)
The treasury occupies a central role in the
finances of the modern corporation. It takes
responsible for the companys liquidity
ensures that a company has enough cash
available at all times to meet the needs of its
primary business operations. The general
mission of the treasury department is to
manage the liquidity of a business. This
means that all current and projected cash
inflows and outflows must be monitored to
ensure that there is sufficient cash to fund
company operations, as well as to ensure
that excess cash is properly invested. While
accomplishing this mission, the treasurer
must engage in considerable prudence to
ensure that existing assets are safeguarded
through the use of safe forms of investment
and hedging activities.
Treasury management is the process of
administering to the financial assets and
holdings of a business. The goal of most
treasury management departments is to
optimize their company's liquidity, make
sound financial investments for the future
with any excess cash, and reduce or enter
into hedges against its financial risks
But here are the major treasury functions
that are equally important and are
interrelated as well.
Treasury Role-1. Cash Forecasting
This is the beginning of all other roles carried
on the operation of a treasury department.

Unlike the accounting staffs who handle the


cash receipt and disbursement activities on a
daily basis, treasury staffs need to draw all
those accounting records and compile it to
generate a cash forecast (short and longrange).
The forecast and all its components are
needed to:
1. Determine if more cash is needed. If that
is the case, then they can go on to plan for
fund inquiry either through the use of debt or
equity.
2. Plan for investment purposes, if the
forecast results in surplus and cash excess
shows up.
3. Plan its hedging operations by using the
information at the individual currency level.
Treasury Role-2. Working Capital
Management
Major usage of companys cash is in the
working capital area.
Working capital is a key component of cash
forecasting.
It involves changes in the levels of current
assets and current liabilities in response to a
companys general level of sales of goods
and services. The treasurer should be aware
of working capital levels and trends, and
advises management on the impact of
proposed policy changes on working capital
levels.
Treasury Role-3. Cash Management
Combining information in the cash forecast
and working capital management activities,
Treasury is able to ensure that sufficient cash
is available for operational needs.
Treasury Role-4. Investment
Management
When the forecast shows some excess funds
at, the treasury is responsible for the proper
investment of it. Three primary goals of the
role are:
(a) maximum return on investment; (b)
matching the maturity dates of investments
with a companys projected cash needs; and
most importantly is
(c) not putting funds at risk.

Treasury Role-5.Treasury Risk


Management
The treasury is also responsible to create risk
management strategies and implement
hedging tactics to mitigate the whole
companys riskparticularly in anticipating
(a) markets interest rates may rise and
leave the company pays on its debt
obligations; and
(b) companys foreign exchange positions
that could also be at risk if exchange rates
suddenly worsen.
Treasury Role-6. Credit Rating Agency
Relations
A company may issue marketable debt. In
this case, a credit rating agency will review
the companys financial condition and assign
a credit rating to the debt. The treasury
would need to show quick responds to
information requests from the credit
agencys review team.
Treasury Role-7. Bank Relation
A long-term relationship can lead to some
degree of bank cooperation if a company is
having financial difficulties, and may
sometimes lead to modest reductions in
bank fees. The treasurers should therefore,
often meets with the representatives of any
bank that the company uses to: discuss the
companys financial condition, the bank s
fee structure, any debt granted to the
company by the bank, and foreign exchange
transactions, hedges, wire transfers, cash
pooling, and so on.
Treasury Role-8. Fund Raising
Maintaining an excellent relations with the
investment community for fund raising
purposes, is importantfrom the
(a) brokers and investment bankers who sell
the companys debt and equity offerings; to
the
(b) the investors, pension funds, and other
sources of cash, who buy the companys
debt and equity.
Other than those main roles, fundamentally
the treasury also monitors market conditions
constantly, and therefore is an excellent
resource for the management team should

they want to know about interest rates that


the company is likely to pay on new debt
offerings, the availability of debt, and
probable terms that equity investors will
want in exchange for their investment in the
company.
If a company engages in mergers and
acquisitions on a regular basis, then the
treasury should have expertise in integrating
the treasury systems of acquirees into those
of the company. Another activity is the
maintenance of all types of insurance on
behalf of the company.

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