Capital structure and company’s cost of capital.
Capital Structure- The mix (or proportion) of a firm’s permanent long-term financing represented by debt and equity (common stock and preferred stock)
The cost of capitalfor a firm is a weighted sum of the cost of equity and the cost of debt. Firms finance their operations by external financing, issuing stock (equity) and issuing debt, and internal financing, reinvesting prior earnings.
Cost of debt -The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; however, because interest expense is deductible, the after-tax cost is seen most often. This is one part of the company's capital structure, which also includes the cost of equity.
Cost of equity.In financial theory, the return that stockholders require for a company.
Cost of equity = Risk free rate of return + Premium expected for risk
Expected return.The expected return can be calculated as the "dividend capitalization model", which is (dividend per share / price per share) + growth rate of dividends (that is, dividend yield + growth rate of dividends).
CAPM. The CAPM gives us a precise prediction of the relationship we should observe between the risk of an asset and its expected return. This theory has the basic idea that the assets with the same systematic risk should give the same return.
CAPM has 6 assumptions:
• Perfect competition
• Myopic behavior (short-term planning)
• Universe of publicly traded securities
• No transaction costs, no taxes
• All investors are rational mean-variance optimizers (Max Er, Min Stand.Div)
• homogeneous expectations
To determine the fair risk premium for a stock, we obtain:
Beta is the calculated as: cov(rM, rStock )/ σ2M measures the contribution of stock to the variance of the market portfolio as a fraction of the total variance of the market portfolio and is called beta.
Beta measures a stock's volatility, the degree to which a stock price fluctuates in relation to the overall market.
Weighted average cost of capital
The Weighted Average Cost of Capital (WACC) is used in finance to measure a firm's cost of capital.
The total capital for a firm is the value of its equity (for a firm without outstanding warrants and options, this is the same as the company's market capitalization) plus the cost of its debt (the cost of debt should be continually updated as the cost of debt changes as a result of interest rate changes). Notice that the "equity" in the debt to equity ratio is the market value of all equity, not the shareholders' equity on the balance sheet.
WACC= E/VKe+D/VKd
Where:
· Ke - The cost of equity
· Kd - The after tax cost of debt
· D - The market value of the firm's debt, including bank loans and leases
· E - The market value of all equity
Optimal Capital Structure –because of tax benefits on debt, it will be cheaper to issue debt than new equity. Management must identify the "optimal mix" of financing – the capital structure
where the cost of capital is minimized so that the firms value can be maximized.
Modigliani-Miller theorem
If there were no tax advantages for issuing debt, and equity could be freely issued, Miller and Modigliani showed that the value of a leveraged firm and the value of an unleveraged firm should be the same.
40. Profit and profitability: definition, methods of calculation.
Profit - A financial benefit that is realized when the amount of revenue gained from a business activity exceeds the expenses, costs and taxes needed to sustain the activity.
Profitability– expected or average ratio of revenue to cost for a particular investment or trading system
The profitability ratios include: operating profit margin, net profit margin, return on assets and return on equity.
1. Return on Equity. It is the most fundamental indication of a company's ability to increase its earnings per share. It measures the return an investor receives on the capital that has been invested in the business. Shareholder equity is equal to total assets minus total liabilities. It’s what the shareholders “own”.
ROE % = Net Income/ Sharesholder’s equity
The ROE allows quickly determine if a company will generate assets or just continue to seek investment dollars to maintain operations.
2. Return on assets measures a company’s earnings in relation to all of the resources it had at its disposal (the shareholders’ capital plus short and long-term borrowed funds). Thus, it is the most stringent and excessive test of return to shareholders. If a company has no debt, it the return on assets and return on equity figures will be the same.
There are two acceptable ways to calculate return on assets.
ROA % = Net Income/ Total Assets
Note: Some investors add interest expense back into net income when performing this calculation because they'd like to use operating returns before cost of borrowing.
3. Profit Margin = (Operating Profit/ Sales)*100
It shows what % or how many pence of profit is on average generated for each $ of Sales.
The expected value of this ratio will differ quite considerably for different types of businesses. A high volume business, such as a retailer, will tend to operate on low margins that make the assets involved work very hard. By contrast a low business, such as a contractor will tend to require much greater margins.
Profit Margin % = (Profit before Taxation plus Interest Payable/ Sales)*100
Any action that will improve the profit margin % should improve the ROA %
If in comparing results with previous years or another company the profit margin % is found to be considerably lower it can be further analyzed with a view to identifying likely problem areas:
o % growth in sales
o Product mix from various activities
o Market mix for profit and sales by division and geographical area
o Expansion of activities by merger or acquisition
o Changes in selling prices ( usually only available from management accounts and not from published accounts
o Change in costs
41. Cash Flow. Methods of its estimation. Cash Flows management at the company.
Cash Flow - A revenue or expense stream that changes a cash account over a given period. Cash inflows usually arise from one of three activities - financing, operations or investing - although this also occurs as a result of donations or gifts in the case of personal finance. Cash outflows result from expenses or investments. This holds true for both business and personal finance.
The concept of cash flow is one of the central elements of financial analysis, planning, and resource allocation decisions. Cash flows are important because the financial health of а firm depends on its ability to generate sufficient amounts of cash to pay its creditors, employees, suppliers, and owners. Only cash can be spent.
The value of common stock, bonds, and preferred stock is based upon the present value of the cash flows that these securities are expected to provide to investors. Similarly, the value to а firm of а capital expenditure is equal to the present value of the cash flows that the capital expenditure is expected to produce for the firm. In addition, cash flows are central to the prosperity and survival of а firm. Therefore, it is important for managers to pay close attention to the projected cash flows associated with investment and firm expansion strategies.
For financial analysis purposes, two important definitions of cash flows are used. The two most common cash flow definitions are after-tax operating cash flow and free cash flow.
AFTER-ТАХ OPERATING CASH FLOW.The after-tax operating cash flow concept is
used primarily when estimating cash flows for capital investment analysis purposes. After-tax operating cash flow (CF) is defined as operating cash flows before tax minus tax payments.
After Tax Operating CF = (Cash Revenues-Operating Expenses)x(1-Тax Rate)+Depreciation
FREE САSH FLOW.Free Cash Flow recognizes that part of the funds generated by an ongoing enterprise must be set aside for reinvestment in the firm. Therefore, these funds are not available for distribution to the firm's owners.
FCF can be computed as:
Free Cash Flow = After-tax CF — Interest x(1 — Тax Rate) — DividendPreferred— В — Changes in WC — CapEx
Free Cash Flow = EBIT(1-T)- CapEx -WC + Depreciation
FCF represents the portion of а firm's total cash flow available to service additional debt, to make dividend payments to common stockholders, and to invest in other projects.