Importance Of Capital Structure And Cost Of Capital Fund Essay

INTRODUCTION

Finance is often referred to as the life wire of any corporation and usually in limited resource. In the parlance of financial management, cash is the most valuable resource and must be efficiently handled. The need for sourcing for fund can't be over emphasized as lack of it may well result to decelerate of functional activities and possible individual bankruptcy.

There are various sources of finance open to large companies but these options can be broadly categorized into two (that is, arrears and equity finance). Firms could use external or internal sources on a long-term or short term basis. The short term financing are beyond your scope of this assignment.

Traditionally, companies are present to make income but this concept is quite thin and subjective as profit alone does not ensure their survival and interest of most stakeholders. What then do organizations make an effort to achieve? That is "maximizing shareholders wealth" which is generally regarded as the aim of businesses. (Ross, Westerfield & Jordan 2003)

Efficient Financial Management always seek to achieve this goal as there is a direct co-relation between adding value to shareholders and reaching the needs of all stakeholders. This view is highlighted by the actual fact that shareholders as owners carry the highest risk and rank in the bottom to get benefits after other stakeholders. In other words, they get the left-over. Adams Smith (1776) was one of the earliest to postulate this view; 'the business manby seeking his own pursuits, frequently stimulates that of the society more effectually than when he really intends to protect it'

Also Al Ehrbar (1998) establishes that, in seeking to gratify the selfish interest of one group (in cases like this, the shareholders), we finish up reaching those of other stakeholder. This is actually the case once we decrease the standing order to collateral holders.

Usually, owners of companies (shareholders) appoint/retain the services of managers (agencies) to carry on the business of taking care of their interest (that is value maximization). This agent-ownership romantic relationship is known as the "agency theory". Frequently than not, there exist turmoil of interest as some agents or managers(whom I wish to describe as harmful directors, in the light of recent collapse of visible companies) seek to follow goals other than the owners. A few of these goals are personal and require engaging in high-risk decisions to accomplish high bonus products. The Firm Theory or recently Commercial Governance issues have a tendency to negate the over all firm goal of increasing shareholders prosperity.

To ensure that brokers do what they are hired to do and to improve on Corporate Governance, several code of conducts(modus-operandi) have been put in place by regulatory systems through the Sarbanes-Oxley Action(USA), Hermes Finance Managers, Cadbury Statement etc.

(College or university of Sunderland Business School APC 308 Financial Management 2007, pp 19-20)

For companies to achieve their total objective, they need to critically evaluate the Capital Framework, Cost of Capital and conduct Project Appraisal for everyone rivalling investment decisions. These key issues do not operate in isolation because they are also directly associated with sourcing for and effective management of fund in terms of associated hazards.

This essay is within two parts: A and B, and defines the scope. Part A - covers the "need for capital structure and cost of capital" and part B - will dwell on the "types of appraising purchases".

PART (A)

COST OF CAPITAL

This is merely the minimum amount expected rate of go back to the providers of money. When seen from the company's point of view this rate is an expense. In order to ensure the successful management of financing, ascertaining the least possible cost of capital is very pertinent. The guideline here is that for each source of fund available to an organization, there's always an associated cost implication. Additionally it is note worthy to say that there is some relationship between the price tag on capital, capital framework and most essentially appraising projects. The expected rate of go back (otherwise discount rate) is used to check the viability of tasks for investment decisions. This point will be evaluated partly B.

In estimating the price tag on capital the time value of money with the chance factor and opportunity cost are considered. An increased risk implies a higher comes back (or cost).

Basically, the business's cost of capital is the Weighted Average Cost of Capital (WACC) and includes the common costs of all the firms' sources of fund (that is, cost of debt and equity financing).

Cost of Collateral: This is actually the estimated results a shareholder expects from investing in a company. Equity owners or shareholders will be the owners of the company and enjoy the rights to vote, appoint directors, receive dividend and show in any residual advantage. But also carry the highest reduction in case of a receivership.

Estimating this cost involves two solutions: the dividend valuation model and the administrative centre asset costs model

Dividend Valuation Model(DVM): this model is predicated on the assumption that the share price is the worthiness into the future dividends reduced to today's value

The manifestation used for estimating this cost is;

Ke = Di / Po + g

Where, Ke = cost of capital, Di = next year's dividend

Po = current share price and g = total annual dividend growth rate.

This approach relies intensely on the historical data which is readily available and requires little work to estimate. This is its major benefits (convenience). Alternatively, the dividend valuation model has lots of short comings, most noticeable could it be applies and then businesses that pay dividend and this is often not the case. The truth is companies might not exactly be making sufficient revenue to pay dividend or own it retained. The model also assumes a frequent growth rate. Show prices are highly volatile rather than very reliable to basic predictions. Furthermore, it takes on down the chance factor let's assume that share prices are present in an successful capital market. This last assumption is a topic of issue as there exists implicit risk associated with the use of current show price in its computation. (Ross, Westerfield & Jordan 2003, pg 497)

Capital Asset Charges Model (CAPM): this is a more suitable approach to estimate the price tag on collateral than the dividend valuation model as risk is core element. It really is a numerical model that estimates the go back expected from an asset (security) in accordance with the security risk (known as the beta).

It is indicated by the Security Market Brand (SML) and a derivative of the Stock portfolio Theory. The Stock portfolio Theory looks for out the perfect mix or mixture of belongings that will make up the chance associated with specific security in a portfolio by spreading the chance across board.

That is, the diversification of investment funds (Markowitz 1952). This is an integral role of financial management and demonstrates good stewardship.

The risk elements are of two types: Organized Risk and Unsystematic Risk

The SML is a series graph which implies the relationship between your risk (beta) and the expected dividends. This range also highlights the Risk Top quality (which is the motivation for an trader accommodating extra risk, in the form of a chance cost for not investing in a low risk security).

This model estimates the expected go back using the expression:

Re = Rf + †e (Rm - Rf)

Where Rf is the risk-free rate,

†e is the beta (organized risk) and

(Rm - Rf) is the chance premium

Unlike the DVM, CAPM is very delicate to risk, thus its advantages is the ability to adapt for risk. And yes it is useful to even companies that not pay dividend.

On the other hand, it still relies largely on previous incidents (historical costs) and these are not reliable indices for predicting future fads. Furthermore, CAPM is founded after some group of assumptions (such as the absence of duty and zero unsystematic risk). These the truth is are not possible as all companies are legal appreciated to pay fees and. Despite these short comings, CAPM continues to be widely employed by potential buyers as it offers a good notion of the way of measuring risk possible in a specific investment decision.

Cost of Debts: This is the interest charge on company's borrowings or by the lending company of funding. Usually, these borrowings could be from bank loans, debentures or relationship options. The expense of credit debt provides potential shareholders useful information as it shows the measure of risk associated with a firm. Very high-risk companies or those recognized to be so, normally bear high interest charges. Personal debt capital has significant cost implications on the company's cash flow and the total outlook of its capital structure (gearing). It should be properly monitored as it is usually associated with distress and personal bankruptcy problems.

It is also of importance to mention other costs such as; cost of preferred stock and retain income.

Preference Stock is categorized under equity funding but has the characteristics of debts. Unlike common stockholders, they don't have voting rights and list below personal debt but before common stock. They are also entitled to permanent interest which gives it credit debt characteristics. It's not very popular nowadays since it has no tax gain unlike interest on personal debt that is taxes deductible. However, they have some usefulness due to its flexibility.

Retained earnings stand for the chance cost to the shareholders if indeed they possessed received it as dividend and perhaps invest somewhere else. It is part of profit held back by the business and not allocated to the owners.

************ possible discussion of personal debt and equity quarrels**************

The Weighted Average Cost of Capital (WACC):

This is the lowest comes back expected by the many providers of fund. It is the average weightings from the mixtures or the different parts of the business's capital composition and where an investment decision is likely to return. Also, is the total average of our cost of arrears and our cost of collateral in proportion to their capitalization.

Expressed as;

(Cost of personal debt - percentage of credit debt) + (cost of collateral - proportion of collateral)

The WACC works on the assumption that the business draws from an individual pool of capital with an associated weighted cost to funding various tasks.

A simple example to spotlight this aspect is; if we believe a certain company XYZ is financed by 50 million personal debt and 50 million equity and invested 100 million in a task. Suppose the debt and collateral holders expect a 10% and 20% comes back respectively.

Using the manifestation above, then your overall return (WACC) will be 15% (that is, 5 and 10 to debts and collateral respectively)

The WACC is an important investment tool in the hands of analyst and financial professionals as it is used to discount expected project cash flows to see their viability.

The underlying concept is not to undertake any task or investment that will not at least come back the expense of capital. In other words, if the comes back go over the WACC then value is been put into traders but if less, it ought to be deserted as it means putting investors money in danger.

The WACC though widely used is not appropriate enough to be the only basis for appraising assignments and investment decisions. Endeavoring to predict the near future based on historical situations is a very slippery floor and the WACC attempts to do that. From our example mentioned above, it can be seen following a closer observation that the average weighting of your debt and equity costs of 15% may well not actually meet up with the expectations of arrears and collateral holders ( debts require 10% and equity 20%). Some analysts have analyzed this loophole and attempted to proffer alternatives;

"the necessary cash flow (normal earnings) implied by the WACC is limited to provide the cash flows to the individual sources of money when considered separatelyWACC is a linear approximation of a non-linear relationship"

(Richard A. Miller, 2006)

This position becomes glaring whenever a project or investment dividends exactly the cost of capital (as believed by WACC) and has to be apportioned to individual providers of funding. It is clear in this esteem our 15% won't satisfy 10% credit debt holders and 20% equity holders separately.

In summary, this problem not withstanding, the WACC should be utilized with other financial and financial management ways to meet stakeholders' targets until such a period when there may be a better alternative.

CAPITAL STRUCTURE

The capital composition refers to the composition of the many sources of money a business has and usually indicated as a proportion. That is the Debt to Equity ratio, often known as gearing or leverage.

This arrears to equity ratio is very key as it means successful financial management in the sense that, financial managers should choose a composition that seeks to increase shareholders wealth with the addition of value to the firm.

Capital structure decision frequently is about the quantity of debt the company wants to show on its balance sheet and has impact on the price tag on capital. As the capital composition changes so does the price tag on capital.

Traditionally, it was considered industry "best practice" to have more arrears (high leverage) as this tend to lower the WACC and has good incentives for stock holders. But as the business enterprise grows it could become more problematic. Leveraging shows how much personal debt an organization is relying on and incredibly high gearing may reveal a "red flag" caution indication.

Significant research works have been completed about capital structure. The most outstanding currently was that of Miller and Modigliani (1958), as they turned out that leveraging and capital structure have no results over a firm's value apart from its investment decisions. As companies continue steadily to bring in cheaper debt, collateral holders penalize them by demanding higher comes back or costs as a punishment for better risk exposure. This has a cancelling effect on increases in size of increased leverage.

Thomas F. Huertas (2010) recently argued that indifference to the administrative centre structure won't keep for large financial institutions like banks. Defects abound and the market place is not a exception. Corporation duty which is required and possible individual bankruptcy costs are issues that make capital structure relevant. Leverage impacts cash moves as companies make an effort to meet their debt obligations until it reaches the main point where collateral holders fidget credited to bankruptcy risk and bail out (by off loading their stocks). This development drops the talk about price value and ultimately the firm's value.

There are other ideas of capital framework (like the trade-off theory and pecking order theory) but are beyond your scope of the essay.

In so far as these imperfections exist, reliable management must constantly seek to achieve the least cost of capital (WACC) within the company's capital structure that will improve shareholders wealth. This leads us the question of Optimal Capital Composition (OCS).

Does Optimal Capital Structure exist? And when not how can it be achieved?

Companies may choose to have some degree of debt (as pursuits onto it are taxes deductible) and also maintain caution with reasonable level of collateral. This balance is to permit them enjoy the benefits proposed by both. Obtaining a perfect combine may establish a intimidating task as the pendulum continues swinging between credit debt and equity.

In practice, businesses try to achieve an maximum capital structure by decreasing leverage, usually by switching its hybrid finance (such as preference stock and some category of bonds) to common stock. That is very convenient in times of stress and to decrease cash outflows. This is quite possible as these hybrids posses the characteristics of arrears and equity.

A recent case in point to site is that of Unilever N. V, (a major player in the food and beverages sector of the capital market located in Rotterdam-Holland) in their press release. The business is wanting to improve its capital structure by converting some preferred stock to collateral. This is restructuring will increase shareholders financial interest. (Uniliver, 2010)

The incentive in this kind of restructuring for the company is to stabilize the business making it much more likely to survive and focus on profitable ventures. To the investor, offer of higher capital increases from future share appreciations could be the incentives.

Also, earlier this year, the $35. 5billion high profile acquisition of AIA (a subsidiary of AIG) by Prudential plc (a UK founded Insurance company) through some collateral and debt funding will change the combined business capital framework outlook.

In conclusion, obtaining an optimal capital composition will be quite impossible almost except on the theoretical basis. But as long as companies strive to boost shareholders value they must be able to achieve a mix that works.

PART (B)

MODELS OF APPRAISING POTENTIAL INVESTMENTS

Estimating a proper capital structure and the least cost of capital to attain company goals brings about an important question - which is; how to allocate or channel its pool of fund and what investments, assets or projects should be carried out?

This is where investment decision comes in which is very central as the goal of successful financial management is to increase shareholders value. Investment decisions usually involve long-term dedication of capital and if wrong may be disastrous (Drury Collin 2002). The usefulness of the WACC involves play as the discount rate used in some ways to appraise the viability of projects.

In making these decisions, certain models have been developed to aid managers, by carefully weighing the potential hazards and rewards associated with possible span of actions.

Basically, the models for appraising assignments are broadly of two types;

Non-discounted cashflow method - that is, Payback period and Accounting or the Average Rate of Return(ARR)

Discounted cashflow method - that is, Net Present Value(NPV) and Internal Rate of Return(IRR)

Payback Period: As the name implies, it is the period the cash flows from a job recovers its initial cost.

The decision guideline is to simply accept the project with the shortest payback period.

This approach is trusted because you can understand and calculate. Another notable merit is that it reduces liquidity problem by causing money available quickly for other opportunities. Also has the probable of eliminating hazards and uncertainty associated with the future by early payback.

On the other hands, its major demerit is the fact that it completely ignores enough time value of money. As cash moves above the payback period aren't considered. Also, the "hurdle rate" in cases like this the pre-set period required is arbitrarily chosen and does not have any relationship with the price tag on capital. Predicated on its decision criteria, it might lead to rejecting potentially profitable projects. Researchers tried to improve on its deficiencies by discounting the money flow.

With all these in mind, the payback is far off the mark to increase shareholders prosperity as it proves to be very limited.

Accounting or Average Rate of Go back (ARR): This technique requires a detour from cash moves and employs accounting profit.

Different computations methods abound but an easy formulation is to divide the average annual profit by the average investment expressed as a share.

The decision rule here is to simply accept a job with ARR above a pre-determined aim for or hurdle rate.

The upside of this technique is that it factors in depreciation and been expressed in percentage terms helps it be quite appealing to use. Also, data for its computation are plentiful and accessible from the financial statements.

On the downside exactly like its predecessor (payback period), it also falls short of making the most of shareholders wealth. It does not factor in the time value of money and uses an arbitrary hurdle rate which is not really a real rate of go back. It depends completely on historical information like revenue which is more subjective than cash flows.

Net Present Value (NPV): That is simply the present value of all future cash moves subtracted from its cost. In another way, it is discounting future cash moves to its present value and comparing with its first cost to get a online value.

The underlying principle is to accept a job with an optimistic NPV otherwise reject.

The implication here's a positive NPV usually will gratify a return higher than the price tag on capital thus leads to maximizing shareholders wealth.

This technique is not flawed by the deficiencies of the non-discounted cash flows as it factors in enough time value of money and uses a rate of return which matches the company's objective function. On top of that, this technique factors in the assignments cash flows through its life routine, thus over coming the limitations of ARR and Payback intervals. Cash flows tend to be more reliable as are less susceptible to manipulations unlike income.

The superiority and versatility of NPV on the non-discounted models will not immune it completely from certain pitfalls. Notably, it generally does not involve taxes and purchase costs. Also, cash moves and discount rates are estimates and not quite straight forward to ascertain. And yes it assumes that shareholders always want to maximize value.

Internal Rate of Come back (IRR): This is another approach using low priced cash flows and thought to be an alternative to NPV. It looks for to determine an interest rate made only from a particular project cash moves internally rather than elsewhere.

It is the speed when the NPV is zero, involves a learning from your errors approach which might be one of its demerits.

The decision rule is to accept an investment when the IRR outweighs the pre-set hurdle rate and reject if in contrast.

This technique also has links to the assignments cost of capital and minimal rate of go back. The IRR also offers the benefit of been portrayed in percentages for simple interpretations other than in Pounds or Money terms.

But the IRR has the problem of generating multiple rates when dealing with successive positive and negative cash flows. This creates an additional problem of what rate to choose. The IRR may also fail to guide adequately when comparing two or more projects. Little surprise, it is an option to the NPV.

Interestingly, there is a notable marriage between NPV and IRR. This association is highlighted whenever we plot the series of NPV against their corresponding discount rates on the graph. It'll be observed that an upsurge in the discount rate leads to a decrease in NPV. The point where the brand intersects the X-axis is the IRR (and NPV equals zero). This typically illustrates an identical decision rule between the two.

A study conducted by Graham and Harvey (1999) of large businesses proved that large ratio of companies use more of the low priced techniques.

From these models, we can say that the merits of reduced appraisal model significantly out weighs in at those of non-discounted models and more suitable in achieving and creating shareholders wealth.

CONCLUSION

All the appraisal techniques have one common denominator - predicting future results. The future as we realize is outside the control of any sophisticated evaluation model and no direct link between outstanding company results and their use has been proven. Although some ailing company's revealed signs or symptoms of improvement by introducing discounted cashflow techniques (Haka S. F 1987).

Potentially, other factors like the decision making process (which includes to do with recognition, development and procedures of job) can greatly undermine the use of these techniques.

No subject how plausible an appraisal strategy, it takes quite some convincing to get it through approval. In practice, management of companies may have different ideas or targets other than just relying on estimates and evaluation.

This is a question we can ask in the face of recent collapse of high profile companies widely certified by using sophisticated models or techniques and skilled consultants.

The models are quantitative in nature, aiming to simulate actuality in a controlled state and susceptible to qualitative questions of "internal politics".

However, you have the continuous interplay between the price of capital, capital structure and appraisal techniques as their use shows successful financial management practice in a company.

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