technical analysis n cost of capital

8/23/2019 Technical Analysis n Cost of Capital

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Technical Analysis &

The Cost of Capital


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What is Technical Analysis ???

It is trading in securities, commodities, currencymarkets, etc. based on the belief that all these itemshave a recognizable pattern in their movement

These trades follow charts

They observe prices and volumes within aCHANNEL

The BUY when it crosses the SUPPORT level andSELL when it crosses the RESISTANCE level


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Channels

Two parallel trend lines that act as areas of

support and resistance (more later) Any break through the channel is a break of the

trend, otherwise the price should stay in range


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Chart Analysis : Support


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Chart Analysis : Resistance

Price at which overwhelm consistently.When a stock makes a new high and then retraces,

sellers who missed out @ the previous peak will feelpressured to sell when price climbs back to that level.


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What is the Cost of Capital?

When we talk about the cost of capital, we aretalking about the required rate of return on investedfunds

It is also referred to as a hurdle rate because this isthe minimum acceptable rate of return

Any investment which does not cover the firms costof funds will reduce shareholder wealth (just as if

you borrowed money at 10% to make an investmentwhich earned 7% would reduce your wealth)


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The Appropriate Hurdle Rate: An Example

The managers of RMM Ltd. are considering the purchase of anew plot of land. The purchase price of the land isTk.10,000,000. RMMs capital structure is currently made up of

40% debt, 10% preferred stock, and 50% common equity. Thiscapital structure is considered to be optimal corporate strategyfor financing by RMM, so any new funds will need to be raisedin the same proportions.

Before making the decision, RMMs managers must determine

the appropriate required rate of return (k). What minimumrate of return will simultaneously satisfy all of the firms capitalproviders?


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Financing Structure of RMM

ASSUME THE FOLLOWING COST OF FUNDS FORRMM LTD.:

Currently Debt Costs: 7%

Preferred Stocks Cost : 10%

Common Stocks Cost: 12%

Note: Common Stocks costs more than any othersources of financing, based on the theory that morethe risk, more the expected return for the investor


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RMM Example (cont.)

Source ofFunds

Amount(in 000 Tk)

TakaCost

After-taxCost

Debt 4,000 280 7%

Preferred 1,000 100 10%Common 5,000 600 12%

Total 10,000 980 9.8%

Because the current capital structure is optimal, thefirm will raise funds as follows (figures in 000s)


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RMM Example (Cont.)

Rate of Return 8% 9.8% 11%

Total Funds Available 10,800 10,980 11,100Less: Debt Costs 4,280 4,280 4,280

Less: Preferred Costs 1,100 1,100 1,100

= Remainder to Common 5,420 5,600 5,720

The following table shows three possible scenarios:

Obviously, the firm must earn at least 9.8%. Any less,and the common shareholders will not be satisfied.


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The Weighted Average Cost of Capital

We now need a general way to determine theminimum required return

Recall that 40% of funds were from debt. Therefore,40% of the required return must go to satisfy thedebtholders. Similarly, 10% should go to preferredshareholders, and 50% to common shareholders

This is a weighted-average, which can be calculated

as:

WACC w k w k w k d d p p cs cs


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Calculating RMMs WACC

Using the numbers from the RMM example, we cancalculate RMMs Weighted-Average Cost of Capital(WACC) as follows:

Note that this is the same as we found earlier

WACC 0 40 0 07 010 010 0 50 012 0 098. ( . ) . ( . ) . ( . ) .


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Finding the Weights

The weights that we use to calculate the WACC willobviously affect the result

Therefore, the obvious question is: where do theweights come from?

There are two possibilities: Book-value weights

Market-value weights


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Book-value Weights

One potential source of these weights is the firmsbalance sheet, since it lists the total amount of long-term debt, preferred equity, and common equity

We can calculate the weights by simply determiningthe proportion that each source of capital is of thetotal capital


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Book-value Weights (cont.)

Source Total Book Value % of TotalLong-term Debt 400,000 40%

Preferred Equity 100,000 10%Common Equity 500,000 50%

Grand Totals 1,000,000 100%

The following table shows the calculation of thebook-value weights for RMM from balance sheet:


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Market-value Weights

The problem with book-value weights is that thebook values are historical, not current, values

The market recalculates the values of each type ofcapital on a continuous basis. Therefore, marketvalues are more appropriate

Calculation of market-value weights is very similarto the calculation of the book-value weights

The main difference is that we need to first calculatethe total market value (price times quantity) of eachtype of capital


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Calculating the Market-value Weights

Source Price per

Unit

Units Total Market

Value

% of

TotalDebt 905 400 362,000 31.15%Preferred 100 1,000 100,000 8.61%Common 70 10,000 700,000 60.24%

Totals 1,162,000 100.00%

The following table shows the current market prices ofRMMs financial instruments :

WACC 0 3115 0 07 0 0861 0 10 0 6024 0 12 0 1027 10 27%. . . . . . . .


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Market vs Book Values

It is important to note that market-values is alwayspreferred over book-value

The reason is that book-values represent thehistorical amount of securities sold, whereas market-values represent the current amount of securitiesoutstanding

For some companies, the difference can be much

more dramatic than for RMM Finally, note that RMM should use the 10.27 WACC

in its decision making process


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The Costs of Capital

As we have seen, a given firm may have more thanone provider of capital, each with its own requiredreturn

In addition to determining the weights in thecalculation of the WACC, we must determine theindividual costs of capital

To do this, we simply solve the valuation equations

for the required rates of return


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The Cost of Debt

Recall that the formula for valuing bonds is:

We cannot solve this equation directly for kd, so wemust use an iterative trial and error procedure

Note that (in real life) kd is not the appropriate cost ofdebt to use in calculating the WACC, instead weshould use the after-tax cost of debt

Nd

N

d

Bk

MVkISummationV

11


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The After-tax Cost of Debt

Recall that interest expense is tax deductible

Therefore, when a company pays interest, the actualcost is less than the expense

As an example, consider a company in the 34%marginal tax bracket that pays Tk.1000 in interest

The companys after-tax cost is only Tk.660. Theformula is:

After tax k Before tax k td d 1


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The Cost of Preferred Equity

As with debt, we calculate the cost of preferredequity (without any maturity period) by solving thevaluation equation for kP:

kD

VP P


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The Cost of Common Equity

Again, to find the cost of common equity we simplysolve the valuation equation for kCS:

kD g

Vg D

VgCS

CS CS

0 1

1

Note that common dividends are not tax-deductible,so there is no tax adjustment for the cost of common

equity


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Flotation Costs

When a company sells securities to the public, it mustuse the services of an investment banker

The investment banker provides a number of servicesfor the firm, including: Setting the price of the issue, and

Selling the issue to the public

The cost of these services are referred to as flotation

costs, and they must be accounted for in the WACC Generally, we do this by reducing the proceeds from

the issue by the amount of the flotation costs, andrecalculating the cost of capital


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The Cost of Debt with Flotation Costs

Simply subtract the flotation costs (f) from the priceof the bonds, and calculate the cost of debt as usual:

Note that we still must adjust this calculation fortaxes

NdN

d

Bk

MV

k

ISummationfV

11


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The Cost of Preferred with Flotation Costs

Simply subtract the flotation costs (f) from the priceof preferred, and calculate the cost of preferred asusual:

fV

Dk

P

P


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The Cost of Common Equity with Flotation Costs

Simply subtract the flotation costs (F) from the priceof common, and calculate the cost of common asusual:

kD g

V F

gD

V F

gCSCS CS

0 11


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A Note on Flotation Costs

The amount of flotation costs are generally quite lowfor debt and preferred stock (often 1% or less of theface value)

For common stock, flotation costs can be as high as25% for small issues, for larger issue they will bemuch lower

Note that flotation costs will always be given, but

they may be given as a dollar amount, or as apercentage of the selling price


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The Cost of Retained Earnings

The firm may choose to finance new projects usingonly internally generated funds (retained earnings)

These funds are not free because they belong to thecommon shareholders (i.e., there is an opportunitycost)

Therefore, the cost of retained earnings is exactly thesame as the cost of new common equity, except that

there are no flotation costs:

k

D g

Vg

D

VgRE

CS CS

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technical analysis n cost of capital

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