Beruflich Dokumente
Kultur Dokumente
THEMINIMUMACCEPTABLERATEOFRETURN(MARR)andtheCostof
Capital.
Capitalisanecessaryfactorofproduction,andlikeanyotherfactor,ithasacost.Thecostof
eachfinancialcomponentorinstrumentisdefinedasthecomponentcostofthatparticularfinancial
component.Thethreemajorcapitalstructurecomponentsare:debt(bondsandloans),equity(common
stock,preferredstock),retainedearnings.
TheMARRvalueusedinengineeringeconomicanalysisisoneofthemostimportantparameters
ofsuchananalysis.ThecorrectuseandthevalueusedfortheMARRisoftheutmostimportanceto
achievereliabledecisions.
ThesettingoftheMARRforanengineeringeconomicanalysisisnotanexactscience.The
financialstructureofcompanyischangingovertimeanthereforethedebttoequityratiowillchange
andthischangewillinfluencetheMARRvalue.TheMARRvaluecanalsochangebetweenprojects
becauseofchangesintheriskprofilesofprojects.ManagementmightdecidetochangetheMARRvalue
toincreasetherateofreturnorbecauseofidentifiednewrisksinprojects.
5.1.CapitalStructureofaFirm.
Thedebtpartofthecapitalstructureofafirmleveragestheequity
partbyincreasingthetotalfundsavailableforcapitalprojectsaswell
asthepotentialwealthofafirm.
5.1.1.DebtCapital:
DebtCapitalinvolvesbothshorttermandlongtermborrowingof
funds.Interestmustbepaidtothesuppliersofthecapital,anddebt
mustberepaidataspecifiedtime.
Thesuppliersofdebtdonotshareintheprofitsresultingfromtheuseofthe
capital.
Interestpaidfortheuseofborrowedfundsisataxdeductibleexpenseforthe
firm.
5.1.1.1Loans:
Loansareregardedasashorttermfinancialinstrument(n<5years)
Forsimplicityassumethatallinterestpaymentsontheloanaswellasincome
taxesarepaidbyafirmonanannualbasis.
Theaftertaxcostofcapitalforashorttermloanis:
cL iL 1 t
i L 1 t 20 1 0 . 28 14 . 4 %
5.1.1.2.Bonds.Facevalue
Fixedinterestperperiod
01n
i
Sellingpriceflotationcost
i
ieffective 1 1
m
i=interestratethatwillensureequivalencebetweenthenetsellingprice,theinterest,andthe
facevalue.
i effective
effectiveinterestrateperperiod
m=frequencyofcompoundingoftheinterestperperiod(oneyear)
t company tax rate
Aftertaxcostofabond= ieffective
1 t
Example:
Acompanyoffersbondstoinvestorstofinanceacapitalproject.Thematuritydateis30years
andthecouponratewillbe12%payablesemiannually.ThebondisofferedtoinvestorsatR1000par
value.Thetaxrateforthecompanyis28%.
i effective
0 . 12
1 1
1 0 . 1236 12 . 36 %
2
Aftertaxcostofabond= ieffective
5.1.2.EquityCapital:
Equitycapitalissuppliedandusedbyitsownersintheexpectationthat
aprofitwillbeearned.
Equitycapitalcannotbeobtained,however,unlesstheexpectedrateofreturnis
highenough,atanacceptablerisk,tobeattractivetopotentialinvestors.
5.1.2.1.CommonStock/Shares.
Theownerofashareofcommonstockinacorporationisentitled
toreceivecashdividendsdeclaredbythecompany,aswellasthe
priceofthestockatthetimeitissold.
P0
Div n
PN
Div1
Div 2
.....
2
N
1 ea 1 ea
1 ea 1 ea N
ea rateofreturnperyear(requiredbycommonstockholders(aftertaxcostofequitytothe
corporation).
P0 currentvalueofashareofcommonstock.
PN sellingpriceofashareofcommonstockattheendofNyears.
Ifwenowassumethatdividendsstayconstantoveraninfiniteperiodoftimeand P0 PN :
P0 Div( P / A, ea , )
Div
ea
Thus,ifthecurrentsellingpriceofashareofcommonstockisknownandtheannualdividend
forthepastyearisalsoknown,theaftertaxcostofequity(commonstock)isconservativelyestimated
tobe:
ea
Div
P0
Note:
1 i n 1
i
1
i
P A
Ifnthen: P
A
A
therefore i
i
P
Example:
Ifsomeoftheearningsareretained,thenthecompany`sstockholderswillincuranopportunity
costbecausetheearningscouldhavebeenpaidasdividends,inwhichcasestockholderscouldhave
reinvestedthemoney.Thefirmshouldearnonitsreinvestedearningsatleastasmuchasits
stockholderscouldearnonalternativeinvestmentsofequivalentrisk
Ifacompanywouldfinanceaprojectbyissuingcommonstockorbyretainedearningsatthe
marketpriceofR100,thecompany`scommonsharesatpresent.TheanticipateddividendisR5per
shareandtheinvestorsexpectagrowthrateof10%.TheinvestorsalsoanticipateasharepriceofR120
after3years.
P0
Div n
PN
Div1
Div 2
.....
2
N
1 ea 1 ea
1 ea 1 ea N
P0
5
51 0.1 51 0.1 120
100
1 ea 1 ea 2
1 ea 3
2
ea 11.44%
Thisresultsimpliesthatifthecompanyistofinancetheprojectbyusingretainedearningsor
sellcommonstocktoinvestors,itwillhavetorealizearateofreturnofatleast11.44%.
5.1.2.2.PreferredStock/Shares.
Because,likedebt,preferredstockcarriesafixedcommitmentonthepartofthe
corporationtomakeperiodicpayments,and,inthecaseofliquidation,theclaimsofthepreferred
stockholderstakeprecedenceoverthoseofthecommonstockholders.Preferredstockistherefore
moreriskytothefirmthancommonstock,butitislessriskythanbonds.
Becausethedividendrateisfixed,themarketvalueofsuchstockislesslikelyto
fluctuate.Thereforetheaftertaxcostofcapitalforpreferencestockcanbe
approximatedbydividingtheguaranteeddividendbytheoriginalparvalueof
thestock.
e P
Div P
PP
Example:
Thecostofpreferredstockisthepreferreddividenddividedbythenetissuingprice.
ThepreferredstockpriceisR100anditpaysdividendofR10.Ifthereisanunderwritingor
flotationcostof2.5%oftheshareprice(R250)thenthenetissuingpriceforthecompanywouldbe
R9750.Thecostofpreferredstockwouldthenbe:
e P
Div P
10
10.3%
PP
100 2.50
5.1.2.3.RetainedEarnings/Ownerscapital.
Theaftertaxcostofretainedearningsisnormallyassumedtobe
thesameasforcommonstock(therateofreturnexpectedby
commonstockholders).
Theseearnings,whichareequityfunds,donotbelongtothecorporation,but
rathertothestockholders.Theyhavebeenretainedandreinvestedinthefirm
forthepurposeofenhancingfuturegrowthandrevenuesandincreasing
stockholderswealth.Thus,thereisthesameopportunitycostforthesefundsas
wouldoccuriftheshareholdersreceivedthemoriginallyandtheninvestedthem
inadditionalcommonsharesofthecorporation.
5.2.4.EffectofLeverageontheCostofCapital.
Thehigherthelevelofdebt,thelargerthefixedchargesandthehighertheprobabilityof
notbeingabletocoverfixedcharges.Theinabilitytocoverthefixedchargesthenleadsto
ahostofnegativeimpactsandperceptionsonthecorporation.Thegreaterprobabilityof
notcoveringfixedcharges,whichalsoincreasestheprobabilitiesofbankruptcy,willcause
therelationshipbetweenleverageandtheriskmeasurestocurveupmorerapidlythan
withoutthebankruptcyclause.
Withbankruptcyclause
RequiredrateWithoutbankruptcyclause
ofreturn
Premiumforbusinessrisk
Risklessrateofreturn
Debt/equityratio
5.3.TheEffectofLeverageontheComponentCostofDebt.
Thehighertheleverageratio,thehigherthecostofdebt.Thecostofdebtcanbeexpected
toriseatanincreasingratebeyondacertainratioofdebttoequity.
Aftertax
Costofdebt
Debttoequityratio
Thecostofcapitalforacompanywillstarttoincreaseasthedebtratioincreasesifthe
companyborrowlargesumsofmoneytofinanceprojects.Ifacompanyhasonlyafew
projectsthatisnotthatcapitalintensive,itcanfinancethecapitalbudgetwithonlyequity
funds.Incasethecompanyhavealargenumberofeconomicallyviableprojects,the
managementwillhavetogotothefinancialmarkettoacquirethenecessaryfunds.
Dependingonthedebtratioandthefinancialstandingofthecompanywithinthefinancial
constituency,therequiredcostofcapitalcanincrease.AllprojectswithaNPV>0atthe
MARRvaluecanbeconsideredaslongsthebudgetlimitisnotexceeded.Underconditions
ofcapitalrationingthecompany`svaluewillnotbemaximized.Maximizationofthe
company`svaluecanonlytakeplaceifmanagementcanmovetothepointwherethe
marginalprojects`NPViszeroandthereisnocapitalrationingpresent.
5.4.WeightedAverageCostofCapital(WACC).
Theweightedaveragecostofcapital(WACC)ofthepoolisestimatedbytherelativefractionsfromdebt
andequitysources.Ifknownexactly,thesefractionsareusedtoestimatetheWACC.
WACC = (Equity fraction) (cost of equity capital)
+
(Debt fraction)(cost of debt capital)
= (Common stock fraction)(Cost of common stock capital)
+
(Preferred stock fraction)(Cost of preferred stock capital)
+
(Retained earnings fraction)(Cost of retained earnings capital)
+
(Loans fraction)(Cost of loans capital)
+
(Bonds fraction)(Cost of bonds capital)
Short term
debt
Bonds
Common
stock
Preferred
stock
Retained
earnings
Amount
R x 000
Proportion
After Tax
Cost
(Decimal)
3 600
0.0809
Weighted
Cost
(Proportion)
(After tax
cost)
0.0481
0.0039
10 000
24 600
0.2247
0.5528
0.0424
0.1000
0.0095
0.0553
2 000
0.0449
0.08000
0.0036
4 300
0.0967
0.1000
0.0097
44 500
1.0000
WACC =
0.0820
Percentage added to
compensate for the
risk involved
Expected return
Percentage added to
make it economically
viable
Minimum MARR
value
Cost of Capital
Risk adjusted rates may not work well. When MARR used in
economic analysis calculations is raised to adjust for risk or
uncertainty, greater emphasis is placed on immediate or short
term results and less emphasis on longer-term results.
Example:
0
1000
2000
3000
4000
5000
Present Value:
0%
10%
15%
20%
30%
-15000 -10652.4 -9127.55 -7897.2 -6065.8
-15000 -12093
-10985
-10049
-8550
1000
2000
3000
4000
5000
% Return on
Investment
Opportunity
Cost of investment 1 3
Not taken
WACC
1 3
5.6.2. The effective MARR can vary from one project to another
and through time because of:
Project risk
Where there is greater risk(perceived or actual) associated with
proposed projects, the tendency is to set a higher MARR. This
means that there is some concern that the project will not
realize its projected revenue requirements.
Investment Opportunities
If management is determined to expand in a certain area, the
MARR may be lowered.
Tax Structure
If corporate taxes are rising, pressure to increase the MARR is
present.
Limited Capital
As debt and equity capital become limited, the MARR is
increased. If the demand for limited capital exceeds supply, the
MARR may tend to be set even higher.
Market rate at other corporations
These variations are often based on changes in interest rates
for loans, which directly impact the cost of capital.
5.6.3.FactorsthatAffecttheWACC.
ThelevelofInterestRate.
Ifinterestratesincrease,thecostofdebtwillincreasebecause
investorswilldemandahigherrateofreturnontheir
investment.Investorswillalsoexpectincreaseddividendsand
thiswillincreasethecostsofcommonandpreferredstock.
TaxRates.
Taxratesareapplicabletocalculatetheaftertaxcostof
capital.Theinterestpayableonaloanistaxdeductibleand
wouldthereforereducethecostofcapitalforthecompany.
CapitalStructureoftheCompany.
Theaftertaxcostofcapitalislowerfordebtthanforequity.A
companycanchangeitscapitalstructurewiththe
understandingthatitwillinfluencetheproportions(weights)
ofeachfinancialinstrumentinthestructureandthereforethe
finalvalueoftheWACC.
TheDividendPolicy.
Thepercentageofearningspaidoutindividendsmayaffecta
stock`srequiredrateofreturn.
InvestmentPolicy.
Thecostofcapitalisdeterminedbythecompany`sinvestment
profile.Ifthisprofileisgoingtochangeitwillalsoaffectthe
perceivedriskofthecompanybyinvestors.Iftheinvestors
experiencethechangeasanincreaseintheriskinessofthe
company,theywilldemandhighercompensationforthe
increasedriskintheformofhigherdividendsandinterestrates
onloans.
RevisionQuestions.
1. Whatisthecostofcapital?
2. Identifythedifferentcomponentsthatthecostofcapitalcanbecomprisedof.
3. Describetheinfluenceofthedifferentfinancialcomponentsonthevalueofthecostof
capital.
4. Describetheinfluenceofthecapitalstructureonthevalueofthecostofcapital.
5. Supposethatbasicbusinessriskstoallfirmsinanygivenindustryaresimilar.
a. Wouldyouexpectallfirmsineachindustrytohaveapproximatelythesamecost
ofcapital?
b. Howwouldtheaveragesdifferamongindustries?.
6. Whatfactorsoperatetocausethecostofcapitaltoincreasewithfinancialleverage?.
7. Explaintherelationshipbetweentherequiredrateofreturnontheequity/debtratio.
8. Howwouldthevariouscomponentsofcostofcapital,andtheaveragecostofcapital,
belikelytochangeifafirmexpandsitsoperationsintoanew,moreriskyventure?.