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Finman Notes November 12, 2014

COST OF CAPITAL (Chapter 10 in the book)


Case 2: Coleman Technologies Incorporated
Balance Sheet: Accounting VS. Market Value
-becomes different depending on perspective used.
Purpose of obtaining coast of capital
1. Sources of Funds: (1) Debt and (2) Equity
Determine if you Reinvest or Give out as Dividendsopportunity cost must take into
consideration the risk. Retained earnings (RE) is not free because there is opportunity
cost
2. Get a good mixture of Risk and Stocks
3. For Capital Budgeting
COMPONENTS OF CAPITAL:
(1) Debt) (2) Preferred Stock (3) Common Equity [RE,Common Stock]
-why don't you include liabilities (they have costs too)? Its used in operation, not in
capital expenditure/budgeting
-the idea here is looking for the HURDLE RATE for decision making
*Debts are Tax Deductible
Cost of Debts are AFTER TAX COST OF DEBT.
*Debt is CHEAPER
Cost of Preferred Stock
-not tax deductible
-option not to pay dividends, cumulative tho

-Take into consideration the Flotation Rate


Retained Earnings
-has cost
-from previous operations
Common Stock VS RE
-the Flotation Cost, which should be deducted from the proceeds
*Three ways of computing Common Equity:
(1) CAPM - assumes that investors value common stock based on the risk they perceive
of the stock
-criticism: how con this be effective when it uses past data to compute Beta, when
you're looking for the future?
Limitation: Understates rest if firms stockholders aren't well diversified. Beta woulbe
incorrect
(2) Bond Yield Plus Risk Premium Approach - uses logic that firms with risky and
high interest debt also have high interest capital
Limitation: Estimation between 3-5
(3) Discounted Cash Flow - values stocks by discounting future cash flows assuming a
constant growth rate
-you apply Gordon Growth Rate formula, discounting the cash flows
What do you do? Use 3 processes.
Get the Weighted Average Cost of Capital (WACC)
-Percentage Capital Structure(%) x Cost of Capital; then add it all up.
-it measure the cost each dollar o capital takes, provided that the capital structure is
maintained.
-look at marginal cost of capital
-its the hurdle rate
Case: releasing Common Stock is more expensive, there's floatation cost to be
considered.
The Marginal Cost of Capital
-look at MCC schedule, if investment exceeds RE, cost will be higher since you have to

look at external sources which has flotation cost


In theory, each business unit in a same company will have a different hurdle rates (HR)
with respect to Cost of Capital since the risks per department should be adjusted.
-if its lower than the hurdle rate, you should accept the project. Soo you look at each
hurdle rates of departments in firm because it will have different HR for each business
unit in the firm.

Warren Buffet Lecture


-He believes in Value Investing
-never look at day to day stock valuation. Buy the business, not the stock
-buy the undervalued (underpriced) stock, hoping that it would correct itself.
CAPITAL STRUCTURE & FINANCING Lecture (see ppt slides)
Debt or Equity Permutations
Traditional EBIT/EPS Analysis
-choosing between Debt or Equity depends upon Equity Before Interest and Taxes
(EBIT)
-look for break-even point.
-after break-even point, debt will be higher than equity (Earnings per share = EPS)
Modigliani Miller (MM) Assumptions
-no taxes or other market imperfections
- fixed cap budg
-financing policy which is set
-MM Conclusions:
-splitting the total income stream between debt and equity holders cannot change
the total value of securities and hence the firm. (The partition is no important, its the size
of the pie)
-Capital Structure is irrelevant as long as the firms investment decisions are given.
MM Proposition IIL The Expected Return on Equity
-Re = Ra + (D/E)(Ra-Rd)

-the expected return on equity of a leveraged firm increases proportionately to the


increase in the debt-equity ratio
-no matter the cost of debt, WACC is constant (main point of MM!) but the return on
equity of the firm increases proportionately
-When tax is introduced (as cost o debt increases), value increases because of tax
benefit of debt
MM Recap:
-WACC is same without taxes
-with tax, value increases, WACC goes down initially because of value of debt then it
goes up (in reality)
How can MM be violated? Perfect-market assumption.
-there must be an optimal structure.
*WACC = U-shaped graph, VALUE = mountain-shaped graph
In view of this reality how can it increase stockholder value?
-reduce tax costs on costs of burdensome regulation
-reduce potential conflicts of interest among stakehodlers
-provide holders with financial assists not otherwise available to them
Explanation Observed Capital Structures
Agency Cost/Tax Shield Trade-off model
- firms trade off the tax benefits of increased debt usage against the increasingly severe
agency costs that result as debt ratios approach critical levels
-Agency cost of outside equity reduce the market value of corporate assets by (1-a)
times the expected value of entrap perquisite consumption. External debt serves as a
bonding mechanism for managers to convey their good intentions to outside
shareholders (banks won't lend to basura firm)
"Financial Distress"
-more debt financing, higher probability of future distress which brings lower sales, EBIT,
and bankruptcy costs. Lowers value of stock and bonds
-Direct Costs: Legal and admin costs
-Indirect Costs: impaired ability to conduce business etc.

"Agency Costs"
*MM model overstates value of leverage since it ignores financial distress and agency
costs.
New formula is reduced by these two factors.
Pecking Order Hypothesis (hierarchy where to source the money)
-firms prefer Internal to External
-Asymmetric Information: firms managers know more about the company than outsiders
thus act in its best interest
-Corporations retain sufficient financial slack (cash and marketable sec holdings as
well as unused risk free debt capacity)
Signaling Model of Financial Structure
-ability to get debt is a good signal
-existing shareholders invariably consider leverage increasing events to be "good news"
and leveraging decreasing events to be "bad news"
*ownership structure clearly seem to influence capital structures. more concentrated
(kayo kayo lang so you go out to borrow), the more debt it tolerates. Family-owned firms
more levered(debts). [Atomistic vs Concentrated]
*corp that are forced away from a preferred capital structure tend to return to that
structure over time (so theres an optimal structure)

Finman Notes November 14, 2014

MM: Whatever Divident policy the company adopts, you can undo it. It doesn't matter
The Rightists (High Payout View)
-in favor of liberal dividends. increased dividends, shareholders better off
-dividend in hand is worth more than capital gain in the bush
-div today are certain; toms capital gain are risky

Radical Left
-capital gains are better than receiving dividends
Theory
Irrelevance Bird in hand Tax preference -

Implications
any payout ok
lower cost of equity, higher stock price
vice versa

Theoretical Explanation for Dividends (slide 28)


*Using the residual Model to Calculate Dividends Paid
-pay what you don't need.
-problem? its pay when able system. results in variable dividends. so don't follow rigidly.
Observed Dividend Policy Patterns

Finaman Notes November 21, 2014


Report by Mich's group (get the ppt)
Difference between policies (Conservative, Aggressive etc)
Balance between level of current assets with its financing
-in theory its exclusive but in real life you can mix up (independent)
Finaman Notes November 26, 2014
Gross WC - total current assets
Net WC - current assets - cure liab
WC Policy - level and how it will be financed
WC Mngmt
MATURITY MATCHING (Moderate approach)
Permanent WC <-> Long term financing
-tends to accumulate overtime, mostly irregularly

Seasonal Financing <-> Short term Financing arrangement


Cost of Alternative ST Financing Policies
Trade off cost of restrictive policies vs flexible ones
Trade off carrying cost vs shortage cost (missed on a potential sale)
Carrying cost - cost that rise with the level of investment in current assets
opp cost
maintaining eceonomic value
storage and handling costs
insurance prop taxes sep and obsolecense
Shortage Cost - decrease when investment in current asset is increased
trading or order cost, cost of placing orders, shipping and handling costs
**Cash Cycle Time / Cash Conversion Cycle
Why hold cash when it doesn't earn?
Transactions: cash to operate
Precaution: "Safety stock"
Compensating balances: for loans and/or services
Speculation: take advantage of opportunities
How does float affect firm's cash manager?
Float is the diff between cash as shown on the firm's books and on its bank's
books
Payment float arises when checks are issued but have not cleared
Collection float arises when a check is received but has not cleared
Cash Budget: The Primary Cash Management Tool
Purpose: Forecast flows, anding cash balances. Used to plan loans needed or
funds available to invest
Timing: Daily, weekly or monthly depending upo purpose of forecast. Monthly for
annual planning, daily for actual cash management
Pledging and Factoring Receivables

Elements of Credit Policy


Terms of Sale
Credit analysis
**credit analysis example (10 pts Obi 1 case)
PV = P(R- C) - (1-P)
5Cs of Credit:
Character
Capacity
Capital
Conditions
Collateral - preferred is Real Estate Mortgage (REM)
**Question 6 of Upscale Toddler's Case
what is overall effect on change of policy (income etc check phone pic)