Online Financial Courses - The Management of CapitalProvided by : Matt H. Evans
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Course 3: The Management of Capital
Chapter 3: The Financing DecisionWe have an understanding of what capital is (Chapter 1) and we understand how to calculate the cost of capital (Chapter 2). The remainder of this course will focus on how to arrange financing; i.e. how do we actually raise capital. The financing decision must consider several factors. Some of these factors include:
- Flexibility - Today's financing decisions will influence tomorrow's financing decisions. If the business expects to raise capital in the future, it can not maximize its use of debt today. We need to provide a cushion so we can have flexibility with future financing decisions.
- Risk - Financing with the use of debt will increase risk. There is a limit to how much debt we can use to finance our business. Too much debt can ultimately lead to bankruptcy.
- Income - Financing can influence earnings and thus affect return on equity. If we are concerned about returns to equity shareholders, then our financing decision will need to be adjusted. Income is also influenced by our ability to take advantage of tax deductions for interest on debt.
- Control - If we have concerns about control over the organization, then we have to consider how financing will change control. Financing decisions are connected to either ownership (equity) or creditors (debt).
- Timing - Financing decisions need to be timed to take advantage of the marketplace. What type of securities should be sold? When should they be sold? What length of maturity should be used for debt financing?
Refinancing RiskOne of the objectives within the financing decision is to match the maturity of liabilities with the life expectancy of assets. This allows liabilities to be self-liquidating. If the maturity of liabilities is less than the life expectancy of assets, then you face refinancing risk since you have to raise new capital to pay off liabilities. If the maturity of liabilities is longer than the life expectancy of assets, then there will be plenty of assets around to pay off debts. However, these surplus assets may not earn enough to increase the market value of the firm.
The mismatching of liabilities with assets can occur if financing is not available. For example, suppose long-term financing is not available. Short-term sources of financing may have to be used. Mismatching can also be intentional. For example, suppose you expect long-term interest rates to fall. You may want to finance assets with short-term maturities since you can refinance in a few years at much lower rates.
InflationAnother factor to consider in the financing decision is inflation. By using debt financing during periods of high inflation, you will repay the debt with dollars that are worth less. As expectations of inflation increase, the rate of borrowing will increase since creditors must be compensated for a loss in value. Since inflation is a major driving force behind interest rates, the financing decision should be cognizant of inflationary trends.
Floatation CostEquity sources of capital will cost more than debt sources of capital. One reason is due to higher risk to investors. Whenever investors incur more risk, they demand higher rates of return; i.e. risk return tradeoff. Additionally, the actual out-of-pocket cost associated with equity financing is higher than debt financing. These costs are referred to as floatation costs. Floatation costs include all costs of issuing the securities, such as banker's fees, legal fees, filing costs, etc.
Marginal Cost of CapitalA basic consideration within the financing decision is how much money do we need to raise? If we assume that all projects have the same average level of risk, then we can establish an optimal capital budget by plotting the Marginal Cost of Capital. The relationship between cost of capital and required financing is referred to as the Marginal Cost of Capital. The Marginal Cost of Capital Rate is the discount rate used for capital budgeting analysis. Marginal Cost of Capital is calculated as follows:
1. Determine the cost and percentage of financing needed for each source of capital - debt, stock, retained earnings.
2. Calculate breaking points where the weighted average cost of capital begins to increase under different financing plans. The break point can be calculated as: Maximum Amount of Lowest Source of Capital / Percent of Financing Provided by this Specific Source of Capital.
3. Calculate the weighted average cost of capital over the range of financing between the break points.
4. A graph can be used to show the range of cost of capital in relation to total financing. If a project's internal rate of return is greater than the marginal cost of capital, then the project should be accepted.
At $ 2.8 million, the cost of capital jumps from 9.8% to 12.3%. If we compare this graph to our proposed projects, we will select projects A and B since they have an internal rate of return greater than the marginal cost of capital (9.8% up to $ 2.8 million and 12.3% above $ 2.8 million). The total investment amount of projects A and B is $ 3.5 million ($ 1.8 for project A + $ 1.7 for project B). Therefore, the optimal capital budget for Bishop Corporation is $ 3.5 million.
EBIT / EPS ComparisonIn the previous example, we selected a 50 / 50 mix for financing capital projects. One of the objectives of capital management is to find the right mix of capital. A comparison of Earnings Before Interest Taxes (EBIT) with Earnings per Share (EPS) under different financing plans can help determine which type of financing is most advantageous - debt financing or equity financing. Since debt has little effect on EBIT, we start our analysis with EBIT. We simply want to calculate what EPS will be under each financing plan. Both the debt and stock financing plans are plotted on a graph. Depending upon what we expect EBIT to be, the graph can tell us which financing plan will give us the highest EPS. The following graph plots EBIT and EPS under debt and stock financing:
At a level of $ 2 million EBIT, EPS is the same under either the stock or debt financing plan. If we expect EBIT to be below $ 2 million, then we would favor the stock plan since it yields a higher EPS. If we expect EBIT to be above $ 2 million, then debt would be preferred over stock after considering the increased risk.
In the above example, it is quite clear that Atco can benefit from the use of more debt. However, suppose Atco expects EBIT to fall dramatically over the next few years. Atco should graph the two financing plans under different levels of EBIT. In order to prepare a graph, we need to determine three points:
1. The minimum level of EBIT needed to cover fixed financing charges (debt and preferred stock) under 100% Stock Plan.
2. The minimum level of EBIT needed to cover fixed financing charges (debt and preferred stock) under 100% Bond Plan.
3. The Indifference Point where EPS is the same under the 100% Stock Plan and the 100% Bond Plan. The following formula can be used to calculate the Indifference Point:
EPS = ((EBIT - I) (1 - TR) - PD) / number of shares outstanding
EPS: Earnings per Share EBIT: Earnings Before Interest Taxes TR: Tax Rate
PD: Preferred Dividends
Now that we have calculated all three points per Example 13, we can summarize our analysis on the following graph:
At an EBIT of $ 760,000, we have an EPS of $ 1.10.
Assessing RiskOnce returns have been analyzed under different financing plans with EBIT / EPS comparisons, it is necessary to assess risk. Coverage ratios are commonly used to assess the risk associated with different financing plans. Coverage ratios show the additional risk associated with higher levels of debt financing. Examples of coverage ratios include:
- Debt to Total Assets Ratio = Total Long-term Liabilities / Total Assets
- Times Interest Earned Ratio = EBIT / Interest Expense
- Times Burden Earned Ratio = EBIT / Interest Expense + (Principal Repayment / (1 - TR))
Targeted Debt LevelsOne approach to establishing the right mix of capital is to follow a targeted debt level. Since some level of debt is desirable for maintaining higher returns, many managers will establish a target debt level for their capital structures (such as 40% of capital should be debt). Therefore, financing decisions should sometimes take into account a targeted set of coverage ratios. One of the principal concerns with using more debt is the ability to cover the additional fixed charges. As we just discussed in the previous segment, coverage ratios are used to monitor debt levels.
Another concern with the use of more debt is financial flexibility. As we increase debt, we risk the possibility of closing off this source of financing in the future. If we expect more and more financing in the future, then we need to make sure we have the flexibility to tap into debt financing over the long-term.
The Overall ProcessThe basic process for making financing decisions often boils down to three steps:
1. Measuring the returns under different financing plans. A comparison of EBIT / EPS under different financing plans can help. You also need to understand how much earnings will grow in the future. If you expect EBIT to decline in the future, then you will favor stock over debt. If you expect strong growth in earnings, then you have the ability to service higher debt loads and thus you will lean towards debt over equity.
2. Assessing the risk of each plan. The objective is to grow the business with some use of leverage and avoid excessive loads of equity. Coverage ratios (as previously discussed) are widely used to monitor risk. Under ideal circumstances, you want to grow the business according to a desired growth rate (G). A desired growth rate can be calculated as follows: G = P x R x A x T where P is Profit Margin, R is Retention Ratio, A is Asset Turnover, and T is Financial Leverage.
If the actual growth rate exceeds the desired growth rate, then you need to make sure you don't borrow too heavily since you need to maintain borrowing capacity. Higher debt loads for fast growing companies can hold back values. If there is low growth, financing with debt may be preferred since steady cash flows are available to service debt financing. Slow growing companies need to aggressively pursue investment opportunities for increased growth.
3. Recognizing the need for financial flexibility. Selecting a financing plan that allows for future flexibility can be critical to future success. You must be able to make competitive investments in the future to maintain or improve market share.
Chapter 3 pointsRefinancing Risk
Marginal Cost of Capital
EBIT / EPS Comparison
Targeted Debt Levels
The Overall Process