Course Level: Beginner to Intermediate - No prior knowledge of capital management is required although some understanding of capital management will be helpful. Recommended for 2.0 hours of CPE. Course Method: Inter-active self study with audio clips, self-grading exam, and certificate of completion.

Basic Concepts and Theories

Introduction

how to manage the capital to make the best decision long-term investments we make today will determineconcepts and theories to understand the management of capitalvalue of our business tomorrow. In order to make long-term investments in new product lines, new equipment and other assets, managers must knowconcepts and theories to understand the management of capitalcost of obtaining funds to acquire these assets. how to manage the capital to make the best decisioncost associated with different sources of funds is calledconcepts and theories to understand the management of capitalcost of capital. Cost of Capital representsconcepts and theories to understand the management of capitalrate 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 isconcepts and theories to understand the management of capitalminimum acceptable rate of return for long-term investments. Ifconcepts and theories to understand the management of capitalbusiness earns more than its cost of capital, the market value ofconcepts and theories to understand the management of capitalbusiness 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 forconcepts and theories to understand the management of capitalowners 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, concepts and theories to understand the management of capitaltotal amount of capital available is determined by the total amount of investment. how to manage the capital to make the best decisionoverall 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 maintainconcepts and theories to understand the management of capitalasset base at its current size. Additional investments will cause the capital stock of an economy to grow, similar toconcepts and theories to understand the management of capitalassets of a business.

how to manage the capital to make the best decisionamount invested in the economy is determined byconcepts and theories to understand the management of capitalafter tax rate of return on capital. how to manage the capital to make the best decisionactual level of investment depends onconcepts and theories to understand the management of capitalwillingness of people to invest in assets. People invest based on the returns they expect to receive. how to manage the capital to make the best decisionreturns to investors must be adjusted for inflation, taxes, depreciation, and risk related toconcepts and theories to understand the management of capitalinvestment. It is the after tax real rate of return that drives investment.

Overall, concepts and theories to understand the management of capitalafter tax rate will remain constant over time due to changes in investment spending. For example, ifconcepts and theories to understand the management of capitalrate 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, whenconcepts and theories to understand the management of capitalrate 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 increaseconcepts and theories to understand the management of capitalcost of capital. In order to supply capital, investors must receive a minimum after tax real rate of return. how to manage the capital to make the best decisionusers of capital not only pay investors a nominal rate of return, but they also incurconcepts and theories to understand the management of capitalcost of economic depreciation (lost values of capital assets) and related taxes on capital. These total costs representconcepts and theories to understand the management of capitalcost of capital.

Basic Considerations in Managing Capital

Now that we understandconcepts and theories to understand the management of capitalimportance of capital, let's focus on how we manage capital within an organization. how to manage the capital to make the best decisionoverall objective is to find an "optimal" capital structure - the right mix of capital sources (debt and equity) that minimizes concepts and theories to understand the management of capitaloverall 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 isconcepts and theories to understand the management of capitalownership 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 atconcepts and theories to understand the management of capitaladvantages and disadvantages of concepts and theories to understand the management of capitaltwo 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, concepts and theories to understand the management of capitalinvested capital does not have to be repaid.
  • Improves the credit worthiness of the company.
Some disadvantages to using stock are:
  • Dilutesconcepts and theories to understand the management of capitalearnings 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 withinconcepts and theories to understand the management of capitalcompany.
  • 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 toconcepts and theories to understand the management of capitalbusiness.
  • Has a maturity date and the capital invested must be repaid to investors.
In addition to understandingconcepts and theories to understand the management of capitalpros and cons of financial securities, we also need to recognize that several conditions will impact how we raise capital. These conditions include:

Economic Conditions: how to manage the capital to make the best decisiondemand and supply of capital inconcepts and theories to understand the management of capitalmarketplace can impact how capital is raised. For example, expectations of inflation will influence the cost that is paid for capital. Higher rates of inflation erodeconcepts and theories to understand the management of capitalvalues of investments and thus, investors will demand higher rates of return.

Market Conditions: how to manage the capital to make the best decisiondemand for higher rates of return will increaseconcepts and theories to understand the management of capitalcost of capital. For example, if we raise capital with a security that is not highly marketable, investors will require higher rates of return forconcepts and theories to understand the management of capitalincreased risk.

Operating Conditions: how to manage the capital to make the best decisionlevel of fixed costs used to operateconcepts and theories to understand the management of capitalbusiness 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: how to manage the capital to make the best decisionexisting 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 onconcepts and theories to understand the management of capitalright 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 isconcepts and theories to understand the management of capitalpermanent financing of the business through the use debt and stock. how to manage the capital to make the best decisiontotal of all liabilities and equity is referred to as Financial Structure. Therefore, Capital Structure = Financial Structure - Current Liabilities.

Findingconcepts and theories to understand the management of capitalright capital structure encompasses numerous considerations - growth rates in sales, risk attitudes of management, liquidity of assets, control position ofconcepts and theories to understand the management of capitalcompany, etc. Finding the right capital structure also involves finding the right amount of financial leverage. Financial leverage isconcepts and theories to understand the management of capitalfinancing of assets with fixed obligations - debt and preferred stock. how to manage the capital to make the best decisionuse 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 coverconcepts and theories to understand the management of capitaladditional 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 thanconcepts and theories to understand the management of capitalcosts of obtaining funds. In a perfect world, management would favor more leverage whenever return on capital exceedsconcepts and theories to understand the management of capitalafter tax costs of debt. However, higher returns also result in higher risk toconcepts and theories to understand the management of capitalbusiness (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 asconcepts and theories to understand the management of capitalDegree of Financial Leverage or DFL. DFL is the percentage change in earnings given a change in operating income (Earnings Before Interest & Taxes or EBIT). how to manage the capital to make the best decisionhigher the DFL, concepts and theories to understand the management of capitalriskier 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 concepts and theories to understand the management of capitaltax rate.



In addition to financial leverage, there is operating leverage. Operating leverage isconcepts and theories to understand the management of capitaluse 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 coverconcepts and theories to understand the management of capitalincreased 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 measureconcepts and theories to understand the management of capitalDegree of Operating Leverage (DOL) as the percentage change in operating income given a change in sales. how to manage the capital to make the best decisionfollowing 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 overconcepts and theories to understand the management of capitalother 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 toconcepts and theories to understand the management of capitaltype 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 atconcepts and theories to understand the management of capitalvarious 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 ofconcepts and theories to understand the management of capitalfirm 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 andconcepts and theories to understand the management of capitalNet Income Approach.

Net Operating Income Approach: This approach to capital management concludes that it does not matter how you mixconcepts and theories to understand the management of capitalcapital structure. how to manage the capital to make the best decisionvalue of the business is not determined by how you arrange the right side of concepts and theories to understand the management of capitalBalance Sheet. Additionally, the overall cost of capital will not change as you changeconcepts and theories to understand the management of capitalmix 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 toconcepts and theories to understand the management of capitalNet 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, concepts and theories to understand the management of capitaluse of leverage will change both the cost of capital and the value of the firm. Net Income is capitalized in arriving atconcepts and theories to understand the management of capitalmarket 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 calculateconcepts and theories to understand the management of capitalfollowing 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 betweenconcepts and theories to understand the management of capitalNet Operating Income Approach and the Net Income Approach. Modigliani and Miller concluded that capital structure is not a major factor inconcepts and theories to understand the management of capitaldetermination 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 resolvedconcepts and theories to understand the management of capitalanswer 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 toconcepts and theories to understand the management of capital 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 minimizeconcepts and theories to understand the management of capital 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. how to manage the capital to make the best decisionspecific 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 toconcepts and theories to understand the management of capitalso-called signaling effect. Additionally, the real source of values will reside in cash flows (more specifically free cash flows). Free cash flows are concepts and theories to understand the management of capitalexcess 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 concepts and theories to understand the management of capitalcost of capital.

1 comment:

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