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Course 3: The Management of Capital
Chapter 1: Basic Concepts and Theories
IntroductionThe long-term investments we make today will determine the value of our business tomorrow. In order to make long-term investments in new product lines, new equipment and other assets, managers must know the cost of obtaining funds to acquire these assets. The cost associated with different sources of funds is called the cost of capital. Cost of Capital represents the rate a business must pay for each source of funds - debt, preferred stock, common stock, and retained earnings.
Since we want to maintain existing market values, cost of capital is the minimum acceptable rate of return for long-term investments. If the business earns more than its cost of capital, the market value of the business will increase. Likewise, if returns on long-term investments are below the cost of capital, market values will decline. This leads us to a very fundamental objective within financial management - maximizing values for the owners of the business. Therefore, how we manage capital is extremely important to fulfilling the basic objective of increased shareholder value.
The Economics of CapitalAn understanding of economics and capital can also help us understand how we should manage capital within an organization. For example, the total amount of capital available is determined by the total amount of investment. The overall economy has a total capital equal to the sum of all capital goods (assets). Since these goods lose value over time, some level of reinvestment is needed to maintain the asset base at its current size. Additional investments will cause the capital stock of an economy to grow, similar to the assets of a business.
The amount invested in the economy is determined by the after tax rate of return on capital. The actual level of investment depends on the willingness of people to invest in assets. People invest based on the returns they expect to receive. The returns to investors must be adjusted for inflation, taxes, depreciation, and risk related to the investment. It is the after tax real rate of return that drives investment.
Overall, the after tax rate will remain constant over time due to changes in investment spending. For example, if the rate of return on capital were to increase, there will be an increase in investment spending. As the capital stock expands from increased investing, the rate of return on capital will drop back down. Conversely, when the rate of return on capital is low, there will be a decrease in investment. As capital shrinks, the rate of return on capital rises. Consequently, investment spending will keep rates of return on capital at stable levels.
Taxation of capital will increase the cost of capital. In order to supply capital, investors must receive a minimum after tax real rate of return. The users of capital not only pay investors a nominal rate of return, but they also incur the cost of economic depreciation (lost values of capital assets) and related taxes on capital. These total costs represent the cost of capital.
Basic Considerations in Managing CapitalNow that we understand the importance of capital, let's focus on how we manage capital within an organization. The overall objective is to find an "optimal" capital structure - the right mix of capital sources (debt and equity) that minimizes the overall cost of capital and maximizes values to the shareholders (owners of the business). When we raise capital, we have two choices - issue debt or issue stock. Debt is represented by bonds which are long-term instruments sold to investors. Stock is the ownership interest of the business and depending upon the rules of incorporation, stockholders will have certain rights. Therefore, we start our understanding of capital management by looking at the advantages and disadvantages of the two sources of capital:
Some advantages to using stock are:
- No fixed payments are required to investors; dividends are paid only as earnings are available.
- No maturity date on the security, the invested capital does not have to be repaid.
- Improves the credit worthiness of the company.
- Dilutes the earnings per share to shareholders.
- Issuance costs are higher than debt.
- Issuing more stock can increase the overall cost of capital.
- Dividend payments to shareholders are not tax deductible.
- Interest payments are tax deductible.
- Does not dilute earnings per share or control within the company.
- Cost is fixed; interest and principal do not change.
- Expected returns to investors are usually lower than stock.
- Fixed charges must be paid regardless of available earnings or cash flow.
- Adds more risk to the business.
- Has a maturity date and the capital invested must be repaid to investors.
Economic Conditions: The demand and supply of capital in the marketplace can impact how capital is raised. For example, expectations of inflation will influence the cost that is paid for capital. Higher rates of inflation erode the values of investments and thus, investors will demand higher rates of return.
Market Conditions: The demand for higher rates of return will increase the cost of capital. For example, if we raise capital with a security that is not highly marketable, investors will require higher rates of return for the increased risk.
Operating Conditions: The level of fixed costs used to operate the business needs to be considered. For example, higher fixed costs can result in wider variations to operating income from numerous factors - increased competition, slower economic growth, etc. This is referred to as business risk.
Financial Conditions: The existing levels of outstanding debt will impact how capital will be raised. Higher levels of debt (including preferred stock) can result in wider variations to earnings due to higher fixed obligations that must be paid (interest to debt holders and fixed dividends to preferred stock holders). This is referred to as financial risk.
Not only do we need to look at various conditions, but we need to consider how financing will impact capital structure. Capital structure appears on the right side of the Balance Sheet as liabilities and equity; i.e. the long-term sources of funds to finance assets. Assets appear on the left side of the Balance Sheet. Capital structure is the permanent financing of the business through the use debt and stock. The total of all liabilities and equity is referred to as Financial Structure. Therefore, Capital Structure = Financial Structure - Current Liabilities.
Finding the right capital structure encompasses numerous considerations - growth rates in sales, risk attitudes of management, liquidity of assets, control position of the company, etc. Finding the right capital structure also involves finding the right amount of financial leverage. Financial leverage is the financing of assets with fixed obligations - debt and preferred stock. The use of financial leverage increases return on equity up to a certain level of operating income. As you use more financial leverage (debt and preferred stock), higher levels of operating income are needed to cover the additional fixed obligations (interest on debt and fixed dividends on preferred stock).
Generally, the use of financial leverage will improve financial performance whenever returns are higher than the costs of obtaining funds. In a perfect world, management would favor more leverage whenever return on capital exceeds the after tax costs of debt. However, higher returns also result in higher risk to the business (risk return tradeoff). Therefore, the use of financial leverage is a balancing act between higher returns for shareholders vs. higher risk to shareholders.
Financial leverage can be measured with ratios such as debt to total assets. Financial leverage is also expressed as the Degree of Financial Leverage or DFL. DFL is the percentage change in earnings given a change in operating income (Earnings Before Interest & Taxes or EBIT). The higher the DFL, the riskier the business. We can use the following formula to calculate DFL:
DFL = EBIT / EBIT - I - (P / (1-TR)) where I is Interest and P is Preferred Dividends and TR is the tax rate.
In addition to financial leverage, there is operating leverage. Operating leverage is the use of fixed costs in production over variable costs. For example, replacing production workers (variable cost) with robots (fixed cost) would be an example of increased operating leverage. As operating leverage increases, more sales are needed to cover the increased fixed costs. Since variable costs have been reduced, profits will increase more given an increase in sales after the breakeven point has been reached. High levels of fixed costs increase business risk. Like financial leverage, we can measure the Degree of Operating Leverage (DOL) as the percentage change in operating income given a change in sales. The following formula can be used to calculate DOL:
DOL = CM / CM - FC where CM is Contribution Margin and FC is Fixed Cost.
Usually firms use one form of leverage over the other to finance investments. For example, manufacturing companies tend to invest heavily in fixed assets and thus operating leverage is used much more than financial leverage. Service type companies have low levels of investment in fixed assets and therefore, financial leverage is widely used to finance the business. Leverage is relative to the type of fixed cost approach that is appropriate for funding the business and leverage by its very definition creates risk. Therefore, the use of leverage will always include a tradeoff between risk and return.
Approaches to Managing CapitalOne way to understand how to manage capital is to look at the various approaches that can be used for finding the right capital structure. As we previously indicated, the right capital structure is that mix of debt and stock that maximizes the value of the firm while at the same time maintains a relatively low overall cost of capital. Two very different approaches to capital management are the Net Operating Income Approach and the Net Income Approach.
Net Operating Income Approach: This approach to capital management concludes that it does not matter how you mix the capital structure. The value of the business is not determined by how you arrange the right side of the Balance Sheet. Additionally, the overall cost of capital will not change as you change the mix of capital. Therefore, values are determined by the capitalization of operating income or EBIT (Earnings Before Interest Taxes).
Example 3 - Calculate Market Value of Business under Net Operating Income Approach to Capital Management
Norton Company has $ 400,000 in outstanding debt at 7% interest. Norton's cost of capital is 12% and expected operating income or Earnings Before Interest & Taxes (EBIT) is $ 120,000.
Earnings to Shareholders = $ 120,000 - $ 28,000 (7% interest on debt) = $ 92,000.
Total Market Value = $ 120,000 / .12 = $ 1,000,000
Market Value of Stock = $ 1,000,000 - $ 400,000 = $ 600,000
Cost of Equity = $ 92,000 / $ 600,000 = 15.3%
Net Income Approach: In contrast to the Net Operating Income Approach, the Net Income Approach concludes that the capital structure of an organization has a major influence on the value of the organization. Therefore, the use of leverage will change both the cost of capital and the value of the firm. Net Income is capitalized in arriving at the market value of the firm.
Example 4 - Calculate Market Value of Business under Net Income Approach to Capital Management Referring back to Example 3, we can calculate the following values:
Market Value of Stock = $ 92,000 / 15.3% = $ 601,307
Total Value = $ 601,307 + $ 400,000 = $ 1,001,307
Overall Cost of Capital = $ 120,000 / $ 1,001,307 = 12%
Franco Modigliani and Merton Miller have provided some guidance between the Net Operating Income Approach and the Net Income Approach. Modigliani and Miller concluded that capital structure is not a major factor in the determination of values. Values are determined by the investment and operating decisions that generate cash flows. It is cash flows that give rise to values. This approach to valuation has become a mainstay within financial management. But what about capital structures? Mike Jenson, founder of the Journal of Financial Economics, may have resolved the answer to this question. Jenson noted that whenever a company makes a change in its capital structure, it sends a signal to investors. This signaling effect does in fact result in changes to valuations. For example, when the Chairman of the Federal Reserve speaks about interest rates, a signal is sent to the marketplace and valuations quickly change. Therefore, shifts in capital structure do impact the value of a business.
Jenson also noticed that managers have a tendency to guard capital and minimize the distribution of dividends to shareholders. This follows with the so-called "pecking order" of financing whereby managers prefer internal sources of capital to external sources of capital. The specific pecking order is as follows:
1. Internal sources of capital - retained earnings / cash
2. External sources of capital - debt
3. External sources of capital - convertible securities
4. External sources of capital - preferred stock
5. External sources of capital - common stock
Consequently, capital structures can impact valuations due to the so-called signaling effect. Additionally, the real source of values will reside in cash flows (more specifically free cash flows). Free cash flows are the excess cash that can be withdrawn from a business after paying everything off. And in order to generate free cash flows, management must generate returns in excess of the cost of capital.
Chapter 1 pointsIntroduction
The Economics of Capital
Basic Considerations in Managing Capital
Approaches to Managing Capital