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Financial Management

PART III - CAPITAL STRUCTURE& FINANCINGLecture No. 29

Intro to Debt, Efficient Markets,& Cost of Capital

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Recap of Financial Markets Capital Markets

Stock Exchange (listed shares , unit trusts, TFC) Money Markets (Short-term liquid debt market)

Bonds Government of Pakistan: FIB, T-Bill

Private Sector: Corporate Bonds, Debentures Call Money, Inter-bank short-term and overnight lending Loans, Leases, Insurance policies, Certificate of Deposits (CDs) Badlah (money lending against shares), Road-side money lenders

Real Assets Markets Cotton Exchange, Gold Market, Kapra Market

Property (land, house, apartment, warehouse) Computer hardware, Used Cars, Wheat, Sugar, Vegetables ,etc.

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Debt and Equity Markets Equity Markets and Institutions

Stock Exchanges

Private Placements Private Equity Investments Venture Capital Islamic Finance

Debt Markets and Institutions Bond Markets Money Markets & Call Markets Bank Loans & Certificate of Deposits (CDs)

Project Financing Running Finance or Working Capital Finance

Hypothecation and Pledge Financing for Inventory Purchase

Bridge Financing Mortgage Financing Lease Financing Insurance and Credit Card

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Efficient Markets Assumption We assume that Financial Markets are Quick and Prices are Right.

There are Lots of Rational Investors in every Financial Market. They are all well-informed and act quickly on information related to the companies operations,finances, risk and return.

So Prices of Securities like Stocks and Bonds adjust (equilibrate) quickly to newinformation . Pricing by the Market is Efficient and Accurate.

Observed Market Price are Accurate reflection of Fair Price (or Theoretical Price based on Investors NPV calculations).

All Stocks have Optimal Risk-Return Combinations , ie. All Stocks lie right ONthe SML Line !

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Securities Securities : pieces of legal contractual paper that represent claim against assets

Direct Claim Securities: Stocks : equity paper representing ownership, shareholding. Appears on

Liabilities side of Balance Sheet

Bonds: debt paper representing loan or borrowing .

When you are Issuing Bonds (ie. Borrowing money) then the Value ofBonds appears under Liabilities side (as Long Term Debt) of BalanceSheet.

If you are Investing (or buying) Bonds of other companies then theirValue appears under Assets side (as Marketable Securities) of BalanceSheet.

Value of Direct Claim Security is directly tied to the value of the underlying RealAsset .

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Why raise money through a Debt (ie. Bond) rather than through Equity (ie. Sharesor Stocks)?

If you do NOT have enough money to meet your own or your familys personal living expenses, then you approach a friend or a Bank for a PersonalLoan .

If you can NOT find friends, family, or investors who want to invest Equityinto your business venture, then you approach an Individual Lender or Bank orLeasing Company for a Business Loan .

In an Emergency or Crisis , the quickest way to get money is generally totake a Loan at a high interest rate. Countries who are short of money do thistoo.

Why Take Debt ?

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Debt vs Equity

If the Company raises money using Debt or Bonds , then it will have to pay a fixed amount of interest (or mark-up) regularly for a limitedamount of time . Of course, failure to pay interest can force company toclose down.

If the Company raises money using Equity , then it is forced to bring innew shareholders who are Owners & can interfere in themanagement and will get a share of the net profits (or dividends) foras long as the company is in operation !

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Capital Structure Most Firms keep a Mix of Both Debt and Equity Capital. In other words

most Firms raise money from both Stockholders (or Shareholders) andBondholders (and Banks).

The Mixture or Proportion of Debt Capital and Equity Capital is known asthe Capital Structure .

This Financial Policy Decision is taken by the CEO, CFO, and Board ofDirectors

Capital Structure can Change With Time depending on Firms Financingneeds and strategy.

Some Projects like Power Plants and Cement are so Capital Intensiveand large that initially the sponsors need Debt Capital

When a Running Business reaches maturity, some owners prefer to fixthe Ratio of Debt to Equity at 20/80 and only for Running Finance .

Some Muslim Businessmen use 100% Equity Capital only (No Debt).

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Theories of Capital Structure

Traditional Approach : The more you debt finance more benefit in terms ofTax shield.

Trade-off theory : Cost & Benefits of financing move parallel

Pecking Order Theory : Order of financing

1. Internal financing2. Debt financing3. Equity financing

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Modigliani and Miller's( MM) Approach : Firm Value isirrespective of its capital structure.

Assumptions of M&M:

No taxes No transaction costs No bankruptcy costs

Equivalence in borrowing costs for both companies and investors Symmetry of market information, meaning companies and investors have the same

information No effect of debt on a company's earnings before interest and taxes

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Where Do Bonds & Stocks Appear on theBalance Sheet?

Stocks & BondsPurchased asInvestment

Own Stock Issued byCompany toRaise Cash

Own Bonds

Issued byCompany toRaise Cash

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Cost of Capital Firms try to attract Debt and Equity Investors to invest their Capital (or

money).

Firms claim that they are SAFE and PROFITABLE investments.Therefore, Firms try to Get Investment Capital (or money) at theLOWEST possible Cost of Capital.

Remember that whenever you Borrow or Rent or Buy anything (cycle,house, money), it Costs You Money in the form of a Rental, Interest orMark-up, Installment, etc.

Stockholders (Equity owners) expect to receive Dividends Bondholders (Debt Holders and Banks) expect to receive Interest

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Cost of Capital & Required ROR Required ROR (or Opportunity Cost) %

CAPM Theory (SML for Efficient Markets) & NPV

Minimum ROR required to attract investor into buying a Security (ie. Stock orBond )

Opportunity Cost : Investor Sacrifices the ROR available from the 2nd bestinvestment.

Cost of Capital % Weighted Average Cost of Capital ( WACC ) Combined costs of all sources of financing used by Firm (ie. Debt and Equity) WACC is Similar to Required ROR BUT Takes into account some

Practical Factors: TAXES : Interest Payments are P/L Expenses and NOT Taxed. TRANSACTION COSTS : Brokerage, Underwriting, Legal, and

Flotation Costs incurred when a Firm issues Stocks or Bond Securities

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Security Market Line ( SML )For Market of Efficient Stocks

RequiredReturn (r*)

Beta Risk ( )M =+ 1.0

r M = 20%

r A= 30%

A =+ 2.0

r RF = 10%Risky Stock AsRisk Premium= 30-10 = 20%

r A = r RF + ( r M - r RF ) A .Stock A lies ONthe SML Line.Efficient Risk-ReturnCombination

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WACC %Weighted Average Cost of Capital

Assume that Firm markets 3 Types of Financial Products (orSecurities or Instruments) to attract Investors Capital. Bonds (Debt): Cost = Coupon Interest Common Shares (Equity): Cost = Variable Dividend Preferred Shares (Hybrid Equity): Cost = Fixed Dividend

The Firm Issues a Security or Financial Instrument to theInvestor and Receives Capital (or Money) in exchange. TheFirm has to pay a Rental Cost for using the InvestorsCapital.

WACC % = Weighted % Cost of Debt + Weighted %Cost of Common Equity + Weighted % Cost of PreferredEquity = rDxD + rExE + rPxP

WACC must take Taxes & Transaction Costs into account.