Tag Cost of capital

Establishing a Value for the Target Company

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An acquiring company may be interested in acquiring entire business or just acquiring individual assets and selling off the rest of the assets. When considering a merger, companies can use capital budgeting techniques to find the value of the company. If the net present value of the relevant cash flows is positive then a merger is considered acceptable.

If the acquiring company is interested in the whole business rather than in just few assets of the target company then post-merger pro forma statements for the target company should be prepared and the cost of capital of the acquiring company must be adjusted to reflect the cost of capital of the target company.

Test yourself:

ABC Company would like to obtain assets of BCD Company. BCD Company is a loss maker, it made losses over the last 4 years. However, it has three assets which ABC needs for its operations which are assets a, b and c. BCD is not willing to sell the assets separately but willing to sell the entire company for $95,000. According to the balance sheet of BCD:

  • asset a is worth $25,000
  • asset b is worth $20,000
  • asset c is worth $50,000
  • BCD also has $5,000 in cash, $12,000 in accounts receivable, and $5,000 in relatively obsolete inventory
  • ABC found out that they can sell accounts receivable and inventory of BCD for $10,000
  • BCD’s liabilities account for $70,000
  • After the merger, three assets of BCD will generate $15,000 in cash inflows over the next 10 years
  • ABC’s cost of capital is 12%

How should ABC establish if it should undertake this investment?

Solution:

BCD requires $95,000. Out of this money, $70,000 will be used to cover liabilities and $25,000 will be going to the owners of the target company. ABC will be able to recover $10,000 from selling accounts receivable and inventory and it will also obtain $5,000 in cash. Therefore, its actual investment is $80,000 ($95,000-10,000-5,000).

Next we need to determine the net present value of the relevant cash flows. Since it is an annuity, we can calculate it very simply. We will use a financial calculator. The calculation is as follows:

PMT: 15,000

N: 10

I: 12

PV: calculate = 84,753

Since investment required is $80,000, we can find the NPV as follows:

84,753 – 80,000 = 4,753

There is another way to calculate NPV using a financial calculator. It is advisable to try them both to make sure that the answer you obtain is correct. The second way is as follows:

CF0: -80,000

CF1: 15,000

Second function Nj: 10

I: 10

Second function NPV: calculate = $4,753

Since both calculations gave us the same answer, we can be confident that the answer is correct.

Since NPV is $4,753 which is higher than zero, a merger with BCD is acceptable.

 

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Purchase versus Lease Decision

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When deciding on whether to purchase or lease an asset, a firm should compare after-tax cash outflows associated with each option. The option with the lowest present value of after-tax cash outflows should be selected.

To make a decision between purchase and lease alternatives, we need to do the following:

  • Determine after-tax cash outflows for lease alternatives.
  • Determine after-tax cash outflows for purchase alternatives.
  • When completing steps 1 and 2,  the purchase option at the end of the lease should be incorporated into analysis in step 1 and sale of purchased asset at the end of the term (equivalent to the lease term) should be incorporated in analysis in step 2. This will ensure that we compare assets of equal lives.
  • Find the present value of the cash outflows under lease and purchase. The after-tax cost of debt should be used as a discount rate. One can use a financial calculator to find present value of the mixed stream of outflows or find the present value of the annuity.
  • Select an option with the lowest present value.

It is also important to remember that financial manager must always attempt to find options with the lowest cost of capital to ensure maximization of the owners’ wealth.

Related Articles:

Weighted Marginal Cost of Capital (WMCC)

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Weighted Marginal Cost of Capital – WMCC – is the WACC applicable to the next dollar of the total new financing. Related to the concept is the break point concept. Weighted average cost of capital (WACC) may change over time due to changes in the volume of financing. This occurs as the volume of financing increases, the risk increases and providers of funds require higher return on the funds that they make available.

The WACC of the next dollar of the total financing may be different from the WACC of the last dollar of the total financing.

Related articles: Break Point, Weighted Average Cost of Capital (WACC)

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The cost of capital

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What is the cost of capital? It is the required rate of return a business must earn on its investments (capital budgeting projects) to maintain the market value of the firm’s shares and to attract funds.

It is a measure used to determine whether or not certain project will decrease or increase the firm’s value in the market place and, consequently, whether or not it should be recommended.

If NPV is more than zero and IRR is greater than the cost of total capital, then a proposed project will increase the market value of the firm and it should be recommended.

If, however, NPV is less than zero and IRR is lower than the cost of all capital, then a proposed project will decrease the market value of the firm and it should not be recommended.

Therefore, if a firm’s risk is assumed to be constant, than any projects with the rate of return higher than the cost of all capital will increase the market value of the firm and any projects with the rate of return below the cost of capital of the enterprise will decrease market value of the firm.

In the discussions that follow we assume that the cost of all capital is measured on the after-tax basis and that a firm’s acceptance of the project does not affect FINANCIAL and BUSINESS RISKS.

FINANCIAL RISK is the chance that a firm will not be able to meet its financial obligations, which can result in bankruptcy. Financial risk is directly affected by a firm’s capital structure (its mix of debt and equity financing). The more debt the firm uses in its capital structure mix, the higher the financial risk.

BUSINESS RISK is the chance that a firm will not be able to cover its operating costs. There are three factors that affect business risk. These are increases in operating leverage, revenue instability and cost instability.

1 – Increase in operating leverage refers to higher use of fixed operating costs.

2 – Increase in revenue instability (or decrease in revenue stability) refers to deterioration of stability of sales of the firm.

3 – Lastly, increase in cost instability (decrease in cost stability) refers to how predictable are costs of the firm, such as labour and raw materials’ costs.

Business risk must be taken as is and the capital structure mix the firm chooses does not influence it.

Firms usually try to maintain an optimal mix of financing (debt and equity) referred to as the target capital structure. Firms have various sources of capital and the cost of capital may be different for each source of financing. When determining the cost of capital, it is helpful to determine an average cost of all sources of capital, which is called the weighted average cost of capital (WACC).

 

Optimal capital structure

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Theoretically, enterprises should try to maintain a certain optimal capital structure, a perfect mix of financing (debt and equity), which results in the lowest possible weighted average cost of capital. At this combination of debt and equity, the stock price is at the maximum. Therefore, attainment of the optimal structure is in line with the main objective of the business, which is the maximization of wealth of the owners of the business. The optimal structure is also referred to as the target capital structure. However, it is important to note the optimal structure exists only in theory.

Theory does not yet offer a methodology that would allow firms’ financial managers to find the optimal capital structure. However, financial managers can determine the approximate optimal structure range, which is close to what they believe the optimal structure for the firm is.

As per above, an optimal structure maximizes the value of the firm. To find the value of the firm, we can use the following formula:

V=EBIT*(1-T)/ra

Which simplifies into:

V=NOPAT/ra

Where:

V = is the value of the firm

EBIT = is earnings before interest and taxes (see the income statement for how it is calculated)

NOPAT = is the net operating profit after taxes (calculated by formula EBIT*(1-T)/ra)

ra = is the weighted average cost of capital (WACC)

If we assume that NOPAT is consistent, then the value of the firm is affected by WACC (ra, weighted average cost of capital). WACC is affected by both, the cost of debt and equity.

The cost of equity

The cost of equity is higher than the cost of debt and increases as financial leverage increases. This is because equity suppliers will demand higher return for increasing financial risk due to increasing financial leverage.

The cost of debt

The cost of debt initially is relatively low. The major reason for this is due to the fact that interest on debt is tax deductible. This tax deductibility of interest paid on debt is also commonly called the tax shield. However, as debt increases, at certain debt ratio lenders will begin to require higher and higher interest payments from the borrower. This is undertaken in order to compensate for increasing risk due to increasing financial leverage.

There are two other costs of debt that the firm needs to consider:

(1) Debt increases the probability of bankruptcy. This is because lenders can force the firm into bankruptcy if the firm cannot meet its financial obligations to the lender.

(2) Another aspect to consider is the agency cost. This refers to the fact that lenders usually protect themselves from increases in risk of the borrower by imposing different loan provisions, which place constraints on actions and choices of the firm. Such provisions commonly include, but are not limited to, minimum levels of liquidity to be maintained, limits on compensation of the executives and limitations on asset acquisitions.

***

As debt increases from a zero point onwards, WACC initially decreases to the theoretical optimal capital structure point. Thereafter, the increasing equity cost and increasing cost of debt causes WACC to start increasing again. Therefore the theoretical optimal capital structure is obtained at the point where the WACC is the lowest.

In other words, the theoretical optimal capital structure occurs at the point where the benefits from using debts are in equilibrium (in balance) with the costs of using debt. The optimal capital structure can also be seen as the balance between risk and return where the firm’s stock price is maximized.

 

Capital structure decisions

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Capital structure decisions refer to the decisions businesses have to make with regards to the mix of financing they use. The mix consists of debt and/or equity as sources of capital. In other words, it is a structure of the liabilities and equity side of the balance sheet, excluding current liabilities. Enterprises usually try to maintain a certain optimal mix of financing (debt and equity), referred to as the target capital structure.

The modern approach to capital structures is largely influenced by the work of Franco Modigliani and Merton H. Miller. This is also known as the M and M, or MM work. Their work published in 1958 in American Economic Review (June 1958) entitled “The Cost of Capital, Corporation Finance, and the Theory of Investment” suggests that under condition of perfect markets, capital structure decisions do not affect the value of the firm. Any increase in Return on Equity goes hand in hand with increase in risk. Therefore, weighted average cost of capital (WACC) stays constant.

In their later work, Franco Modigliani and Merton H. Miller introduced taxes into the model. Their further conclusion was that if corporate taxes are present then the value of the enterprise will increase continuously as more debt is added to capital structure.

This is possible because debt interest payments are tax deductible. However, it is evident that personal taxes will decrease the advantage gained. As a result, it is still profitable to use debt financing. However, the advantage gained is lessened by the existence of personal taxes versus existence of just corporate taxes.

Theoretically, enterprises can increase the value of the firm by finding the optimum capital structure (mix of equity and debt). The optimum capital structure refers to capital structure decisions according to which the weighted average cost of capital is at its minimum value and, as a result, the value of the firm is maximized.

Therefore, the optimum capital structure is in line with the main objective of the business, which is the maximization of wealth of the owners of the business. However, it is important to note that the optimal capital structure exists only in theory.

Sources of capital

Sources of capital include debt and equity. Equity is further subdivided into preferred stock and common stock. In turn, common stock is even further subdivided into new common stock and retained earnings.

When making capital structure decisions, it is important to keep in mind that generally debt is the least expensive source of capital. This is due to the fact that the lender takes much less risk than suppliers of the equity capital. This is occurs because:

(1) Debt has obligatory scheduled payments. Whereas, equity suppliers, especially in case of common stock, will only be paid when company can afford to do so.

(2) In case of liquidation, lenders have priority claim on assets of the company over equity suppliers.

(3) If firm misses obligatory interest or principal payments, lenders can force the firm into bankruptcy. Therefore, lenders have more power in ensuring that payments will be made on time.

Moreover, interest on debt is tax deductible, which makes it an even cheaper source of capital for the firm. Overall, and as stated above, debt is generally the cheapest source of capital for the firm.

How capital structure decisions affect the risk of a company?

Enterprises deal with three types of risks: financial risk, business risk and total risk. The capital structure directly affects the financial and total risk of the firm.

FINANCIAL RISK – a chance that firm will not be able to meet its financial obligations, which can result in bankruptcy. Financial risk is directly affected by the firm’s capital structure (its mix of debt and equity financing). The more debt the firm uses in its capital structure mix, the higher the financial risk.

BUSINESS RISK – a chance that firm will not be able to cover its operating costs. There are three factors that affect business risk. These are an increase in the degree of operating leverage, revenue instability and cost instability. Capital structure decisions do not affect business risk.

TOTAL RISK – a combination of financial and business risk. Since capital structure decisions affect financial risk, the total risk is also affected.

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Risk in Capital Budgeting

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When it comes to capital budgeting, risk refers to probability that project will proof to be unacceptable with net present value (NPV) less than zero or internal rate of return (IRR) less than cost of capital. Particularly, it refers to variability of the returns.

To find the minimum cash inflow level acceptable, we need to calculate breakeven cash inflow.

Breakeven cash inflow refers to the minimum cash inflow that it required for the project to be acceptable. It is calculated as follows:

PV – Initial investment

N – number of periods over which cash inflow is received

I – required cost of capital

Find PMT – breakeven cash inflow

Test yourself:

ABC Corporation have an option to invest in project A which requires investment of $120,000. The duration of the project is 5 years and ABC’s cost of capital is 9%. What is the breakeven cash inflow?

Solution:

We can find breakeven cash inflow of project A with the help of financial calculator.

PV: -120,000

N: 5

I: 10

Find PMT: $31,448.94

The above calculation helps us to determine that the minimum annual cash inflow that will be acceptable for project A is $31,448.94.

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