Factors Affecting Cost Of Capital - Term Paper Example

Factors Affecting Cost Of Capital Table Of Content Factors Affecting Cost Of Capital 1 Table Of Content 1 1. Theories behind capital structure and firm value 2 Net Operating Income (NOI) approach 2 Net Income (NI) approach 3 MM hypothesis without tax: Proposition 1 3 MM hypothesis with tax: 3 Trade-off theory: costs and benefits of leverage 3 2. Factors Affecting Cost of Capital 4 3. Relationship between Capital Structure and other Variables 6 4. Weighted Cost Of Capital 14 Reference: 16 Bibliography: 16 1. Theories behind capital structure and firm value The term capital structure is used to represent the proportionate relationship between debt and equity of a company. Of course capital structure is not just about ‘debt versus equity ‘.The firm can choose distinct securities in countless combinations from bundle of different types of debts, bonds and equities to maximize the overall market share of the firm.(Brealey,et al.,2007) Firm value is calculated as the sum of the debt and equity; V=D+E; Now every finance manager look for the optimum combination to maximize the firm’s value. There are different capital structure theories. The brief discussion for each of them is shown below. Net Operating Income (NOI) approach According to NOI approach, in a market where taxes are absent, the value of the firm as well as the average cost of capital is same irrespective of their capital structure. Net Income (NI) approach According to NI approach both the cost of debt and cost of equity are the same regardless of the debt amount used by the firm. Hence with increase in debt, the cost of capital declines and the firm value increases. As per this approach the optimal capital structure should be of 100% debt financing which is quite impossible in real approach. MM hypothesis without tax: Proposition 1 As per the Modigliani and Miller concept, in a perfect market any combination of securities is as good as another. The value of the firm is independent of its choice of capital structure.(B& M, 2007). MM hypothesis with tax: In most of the countries the interest payment is calculated after deducting taxes. So in a levered firm that’s an added amount to its cash flows. As per the thesis the value of the levered firm is equal to unlevered firm, i.e. if all financed by equity, plus the interest tax shield. Trade-off theory: costs and benefits of leverage Financial managers often look at the debt equity decision as the trade off between interest tax shields and cost of financial distress. According to the trade off theory of capital structure, the aimed debt ration for any firm can vary based on case to case basis. Companies with safe and stable cash flow can afford to have high target ratio, while risky firms with unstable cash flow prefer to have a lower target ratio. If no cost were charged to adjust debt ratio at its optimum, every firm would have the same .This theory avoids extreme debt amount and prefers to have moderate debt ratios. 2. Factors Affecting Cost of Capital There are many internal as well as external factors affecting the cost of capital, hence affecting the capital structure is mentioned below. Growth: The rapidly growing firms need more capital. As the suggestive cost for debt is much lesser, these kinds of firms go for debt financing. But at the same time they are often uncertain to use debt as they are not pretty sure about their growth stability. Firms conditioned with more stable growth can go for debt servicing as they will be able to pay out the fixed charges. Profitability: Companies with high return on investment tend to have low debt level, as they prefer doing their financing with their retained earnings. If return on investment is greater than the fixed cost of funds, the firm can look for funding having a fixed cost. It will increase their earning per share. Cash Flow A firm with stable cash flow can look for more than moderate debt financing as their cash flows would be stable enough to carry out their debt repayment. Control: Change in control can change the structure of firm’s capital. Selling the common stock of company will bring new voting investors into it, making the control difficult. To maintain control lied with limited members, a company can use more amount of debt or preferred stock as they have no management right. If the firm the management right to be diversified enough, it can go for equity financing. Cost of Debt: High cost of debt makes borrowing hard to go with. Hence equity capital is preferable having least cost of funding attached with it. Interest Rates: Cost of debt as well as cost of equity is affected by the change in interest rates. For example, when interest rates increase the cost of debt increases, which increases the cost of capital. Tax rate: After tax cost of debt is affected by the tax rate. If a capital structure is more debt oriented, the firm saves a considerable amount in tax payment as interest is deducted while calculating for tax amount. Agency cost: While shaping on capital structure a firm should keep agency cost in mind. Funding with the least agency cost would be preferred to lessen the cost of funds. Size of the firm: Capital structure is also determined by the size of the company. Small firms find debt financing a costly one, because investors find them less informationally efficient to invest in. So they prefer equity capital to finance. Investors find large companies less risky and, thus, these firms can issue common shares, preference shares and debentures to the public to catch on capital. Type of the industry: Nature of the industry is also a determinant of the model capital structure .Investors may find some industries risky for investment. An example of such a business can be restaurant business. In this kind of business the dependence lie with equity capital as cost of funding from market would be less favorable. Industries like banking tend to be more leveraged. There are many other factors like government regulations, capital market conditions etc affect capital structure in one or the other way. 3. Relationship between Capital Structure and other Variables The relationship between capital structure and various variables such as profitability, volatility of income, tax and asset structure have explained above theoretically .Now to support that I have used five companies’ financial ratios. Chosen industry is IT industry and the companies taken are Wipro InfoTech, Ingram Micro, Oracle, SAP and Infosys. Five years’ data starting from 2005 have been used for this analysis. To comment on profitability, the ratio, profit margin was used. It’s known as profitability ratio I corporate finance and calculated as Net income divided by revenue. Volatility of earnings per share can be looked at as volatility of earning. The amount earning can be biased of the size of the company. In that case the comparison between companies as well as companies in different periods would be predisposed. So a ratio of earning to the respective stock has been preferred for better analysis. EPS=Net Income / No of outstanding shares. There is no direct ratio to explain the affect of taxation on capital structure .To put the affect of tax rates in front, two ratios have been compared: Before tax return on equity and After tax return on equity .If a company is more levered than any other company, the Post Tax ROE would be greater than the pre tax ROE for the first one. Pre Tax ROE = Earnings before Tax/Average Equity Post Tax ROE= Earnings after Tax/ Average Equity Market value of the firm can explain the size of the company up to a certain level. And Price Earning Ratio is a good measurement of Market Value of any company. It can be measured as Stock Price per EPS. P/E Ratio= Stock Price /Earning Per Share. Asset structure in any company is consists of current and fixed assets .Thereafter Current assets can consist of cash, marketable securities, receivables and certain other assets .Three ratios have been introduced to take care of this , Current Ratio , quick ratio and Cash Ratio. Current ratio is calculated as. Current ratio= Current Assets / Current liabilities This ratio let us know how much of the asset a firm can use to payback its current liabilities. Some assets are more liquid than others .In the trouble they can be a good back up as the market will not pay true value every time .Thus it’s better to have an account of those assets so that in distress the firm doesn’t get distressed. Such a quick ratio and calculated as Quick ratio= (Cash + Marketable Securities + Receivables)/Current Liabilities Sometimes the receivables may not be available to pay back the liabilities. Hence comes the third ratio, the cash ratio. It’s the best measurement of company’s most liquid asset. Cash ratio= (Cash + Marketable Securities)/ Current Liabilities There is always two important components of any capital structure ,equity and debt .To know about the capital structure of any firm irrespective of their size, we need to compare the way of their financing. Leverage ratios as Debt equity ratio is used for the same purpose and let us how much long term debt has been used against equity. Having more debt can make a firm risky while having less debt make the firm to loose on their tax shield. The above mentioned ratios are shown in tabular as well as chart form for Oracle .We can see that as their debt ratio has fell off from 2008 to 2009, their return on equity after tax has also shown the same trend in those two years .Looking at the three liquidity ratios, current, quick and cash ratios, it seems like Oracle feels comfortable to hold a good amount of liquid cash, cash equivalents and marketable securities in its current assets .In case of financing Oracle rely less on debt and prefers to have low debt ratio all over those years ,though in 2006 and 2008 they might have increased their debt value by a little amount .Low debt value results in lower tax deductions from interest for this company. Looking at the SAP financials certain things have come up. Like their previous counter party Sap is also more inclined to equity financing, keeping their debt level low, even lower than Oracle. But such policy definitely refrain them to use benefit of tax deductions from interest part. From the liquidity ratios it seems that they have more amounts of receivables in their current assets. For them quick ratio was very high in 2005, most probably after that they felt to keep their current assets low by investing more in fixed assets .Even looking at the cash ratio tell the same story. Following is the representation of financial data for Ingram Micro in tabular as well as chart form. Like other companies in this industry even Ingram Micro also prefers to keep their debt equity ratio at low level, even from 19% in 2005 they have come lessening their debt over equity for most of the periods. Cash ratio is very low in this case For the 2009 fiscal year if we look at their pre tax ROE and post tax ROE one can be very clear about the tax shield .Unlike most of the cases cited here Ingram Micro has higher post tax ROE than the pre tax one . They got the advantage of tax shield as they have made losses in this particular year. Infosys has maintained a very low debt equity ratio. One good thing about Infosys is consistently they believe having liquid assets in their portfolio. Wipro has beaten all its counterpart having zero debt in year 2006.If we look at their profit margin, their profit margin has been decreased with the increase in their debt level. But at the same time Wipro has kept a low level of cash amount in their portfolio. (NASDAQ, 2009) In this industry most of companies prefer to have low debt .That means they mostly rely on equity to finance their companies. 4. Weighted Cost Of Capital In general weighted average cost of capital equals to the sum of weighted rewards to company’s capital providers and can be calculated as WACC= ((Debt/ (Debt +Equity))*Cost of Debt + ((Equity/ (Debt +Equity))*Cost of Equity Suppose the value of company assets at any time is V and debt and equity values are D and E respectively .As per Merton model the debt holders will be paid first and then the rest will be paid to equity holders. That means equity value =max(V-D,0).So if any time the amount V is less than the value of debt repayable it’s reasonable to consider that the firm will default on its debt. Now if a firm will only have retained earnings with no debt the net income would be summation of its retained earnings plus its dividend .In such a case if the firm is not able to find a profitable project it would distribute the retained earnings to their shareholders. But if there is awaiting any profitable investment, it would be financed with the retained earning .In this case the cost of capital of unlevered firm would be equal to its cost of capital. If investors’ money is retained with the company, the company itself is liable to reward the investor. To an investor the minimum reward is equals to required rate of return while it’s known as cost of capital to the company. In other case if the company is all debt company i.e. the company (example of such a firm can be a project finance company) is financed by 100% debt, the cost of capital would be equal to its cost of debt which includes the interest expenses paid to the debt holders. Reference: Brealey,A.R.,Myers,C.S.,Allen,F.& Mohanty,P.,2007,Principles Of Corporate Finance, New Delhi: Tata McGraw-Hill Publishing Company Limited. NASDAQ.2009.Financials.[Online] (Updated 10 Dec,2009) Available at http://www.nasdaq.com/asp/ExtendFund.asp?symbol=WIT&selected=WIT [Accessed 10 Dec,2009] Bibliography: NASDAQ.2009.NASDAQ Securities.[Online] (Updated 10 Dec,2009) Available at http://www.nasdaq.com/asp/symbols.asp?exchange=Q [Accessed 10 Dec,2009] Read More