Basic Concepts and Theories

Introduction

long-term investments we make today will determinevalue of our business tomorrow. In order to make long-term investments in new product lines, new equipment and other assets, managers must knowcost of obtaining funds to acquire these assets. cost associated with different sources of funds is calledcost of capital. Cost of Capital representsrate 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 isminimum acceptable rate of return for long-term investments. Ifbusiness earns more than its cost of capital, the market value ofbusiness 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 forowners of the business. Therefore, how we manage capital is extremely important to fulfilling the basic objective of increased shareholder value.

The Economics of Capital

An understanding of economics and capital can also help us understand how we should manage capital within an organization. For example, total amount of capital available is determined by the total amount of investment. 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 maintainasset base at its current size. Additional investments will cause the capital stock of an economy to grow, similar toassets of a business.

amount invested in the economy is determined byafter tax rate of return on capital. actual level of investment depends onwillingness of people to invest in assets. People invest based on the returns they expect to receive. returns to investors must be adjusted for inflation, taxes, depreciation, and risk related toinvestment. It is the after tax real rate of return that drives investment.

Overall, after tax rate will remain constant over time due to changes in investment spending. For example, ifrate 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, whenrate 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 increasecost of capital. In order to supply capital, investors must receive a minimum after tax real rate of return. users of capital not only pay investors a nominal rate of return, but they also incurcost of economic depreciation (lost values of capital assets) and related taxes on capital. These total costs representcost of capital.

Basic Considerations in Managing Capital

Now that we understandimportance of capital, let's focus on how we manage capital within an organization. overall objective is to find an "optimal" capital structure - the right mix of capital sources (debt and equity) that minimizes 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 isownership 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 atadvantages and disadvantages of 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, invested capital does not have to be repaid.
• Improves the credit worthiness of the company.

Some disadvantages to using stock are:

• Dilutesearnings 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.

Some advantages to using debt are:

• Interest payments are tax deductible.
• Does not dilute earnings per share or control withincompany.
• Cost is fixed; interest and principal do not change.
• Expected returns to investors are usually lower than stock.

Some disadvantages to using debt are:

• Fixed charges must be paid regardless of available earnings or cash flow.
• Adds more risk tobusiness.
• Has a maturity date and the capital invested must be repaid to investors.

In addition to understandingpros and cons of financial securities, we also need to recognize that several conditions will impact how we raise capital. These conditions include:

Economic Conditions: demand and supply of capital inmarketplace can impact how capital is raised. For example, expectations of inflation will influence the cost that is paid for capital. Higher rates of inflation erodevalues of investments and thus, investors will demand higher rates of return.

Market Conditions: demand for higher rates of return will increasecost of capital. For example, if we raise capital with a security that is not highly marketable, investors will require higher rates of return forincreased risk.

Operating Conditions: level of fixed costs used to operatebusiness 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: 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 onright 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 ispermanent financing of the business through the use debt and stock. total of all liabilities and equity is referred to as Financial Structure. Therefore, Capital Structure = Financial Structure - Current Liabilities.

Findingright capital structure encompasses numerous considerations - growth rates in sales, risk attitudes of management, liquidity of assets, control position ofcompany, etc. Finding the right capital structure also involves finding the right amount of financial leverage. Financial leverage isfinancing of assets with fixed obligations - debt and preferred stock. 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 coveradditional 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 thancosts of obtaining funds. In a perfect world, management would favor more leverage whenever return on capital exceedsafter tax costs of debt. However, higher returns also result in higher risk tobusiness (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 asDegree of Financial Leverage or DFL. DFL is the percentage change in earnings given a change in operating income (Earnings Before Interest & Taxes or EBIT). higher the DFL, 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 tax rate.



In addition to financial leverage, there is operating leverage. Operating leverage isuse 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 coverincreased 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 measureDegree of Operating Leverage (DOL) as the percentage change in operating income given a change in sales. 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 overother 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 totype 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 Capital

One way to understand how to manage capital is to look atvarious 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 offirm 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 andNet Income Approach.

Net Operating Income Approach: This approach to capital management concludes that it does not matter how you mixcapital structure. value of the business is not determined by how you arrange the right side of Balance Sheet. Additionally, the overall cost of capital will not change as you changemix 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 toNet 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, use of leverage will change both the cost of capital and the value of the firm. Net Income is capitalized in arriving atmarket 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 calculatefollowing 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 betweenNet Operating Income Approach and the Net Income Approach. Modigliani and Miller concluded that capital structure is not a major factor indetermination 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 resolvedanswer 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 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 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. 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 toso-called signaling effect. Additionally, the real source of values will reside in cash flows (more specifically free cash flows). Free cash flows are 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 cost of capital.