Summary - Business Finance - ثاني ثانوي

pul 340 Business Finance M SUMMARY All assets are financed using two main sources of capital: debt and equity. If the firm uses debt financing or preferred stock financing, it is financially leveraged. If the firm uses financial leverage, IL increases risk, which may increase the cost of the components of the firm's capital structure. One component of the capital structure the cost of debt-depends on the Interest rate that must be paid, and the tax saving associated with interest payments. Another component-the cost of preferred stock-depends on the dividend that is paid and the net proceeds from the sale of the preferred stock. The third component, the cost of common equity, depends on whether the firm uses retained earnings or Issues new shares of stock. New equity is more expensive because of the flotation costs associated with the sale of the new shares. The cost of common stock is an opportunity cost, as it is the return necessary to convince investors to buy the stock. This cost may be determined by adding an equity premium to the Interest rate paid to creditors (bondholders). An alternative approach to determine the cost of common stock is with the capital asset pricing model, which Incorporates the return on a risk-free security, the return on the market, and the systematic (market) risk associated with the stock. A third approach uses the expected dividend yield and expected growth to determine the cost of common stock. Management's task is to determine the best combination of debt and equity financing, that is, to determine the firm's optimal capital structure. That structure takes advantage of financial leverage without overly increasing risk. That combination of debt and equity financing minimizes the overall cost of capital and maximizes the common stock value. Once the optimal capital structure has been determined, the combination of debt and equity should be maintained. PROBLEMS 1. Describe the benefits of debt financing.

2. Explain why the cost of capital for preferred stock will usually be lower than the cost of capital for common stock. 3. What actions might be taken to estimate the risk premium for determining the cost of capital for common stock? 4. How does the weighted-average cost of capital change with additional debt? 5. Describe a situation in which a company might decide to avoid additional debt. 6. When a company takes on additional debt, how might that be viewed by stockholders? حرارة التعليم CHAPTER 8 Cost of Capital 341

M 342 Business Finance 7. Why is the optimal capital structure considered a range of debt-to-equity proportions rather than a specific combination of debt to equity? 8. If a company was planning to expand its business activities into an additional region of the world, would you recommend the use of debt or equity financing? Explain your answer. 9. Since Inflation can influence the risk associated with cost of capital, describe how higher prices might affect the required rate of return of an investor. EXERCISES 1. Calculate the after-tax cost of debt based on an interest rate of 6% with a 30% tax rate. 2. What would be the cost of capital for preferred stock with a market price of SAR 45 and a dividend of SAR 2.70? 3. A company plans to issue additional preferred stock. If they plan a preferred cost of capital of 9% and the current market price is SAR 90, what dividend amount will need to be paid?

4. Calculate the risk premium using CAPM with these amounts: beta 1.15 risk-free rate 4% average market rate 8%. 5. Using the dividend growth equation, what would be the cost of equity based on these amounts? dividend: SAR 2 growth rate: 6% market price: SAR 42 6. Based on these amounts, what would be the weighted-average cost of capital? Proportions debt: 35% common stock: 50% preferred stock: 15% Costs of capital: cost of debt: 7% cost of common stock: 10% cost of preferred stock: 8.5% 7. A company has this capital structure: SAR 120 million debr SAR 24 million preferred stock SAR 96 million common stock cost of debt: 8% preferred stock cost of capital: 11% common stock cost of capital 15% a. Calculate the capital structure proportions of debt, preferred stock, and common stock. b. Use the proportions from (a) to calculate the weighted-average cost of capital. وزارة التعليم CHAPTER 8 Cost of Capital 343

344 Business Finance ASSESSMENT QUESTIONS Choose the correct answer 1. Cost of capital is also considered the required rate of return of the lenders and investors. True/False 2. Common stockholders require a risk premium in addition to the basic return of bondholders. True/False 3. Which cost of capital has the benefit of a tax deduction? a. cost of debt. b. cost of preferred stock. c. cost of common stock. d. average weighted cost. 4. The cost of preferred stock is determined by dividing the dividend by the: a. growth rate. b. tax rate. c. beta coefficient. d. market price. 5. Which of these methods is not commonly used to determine the cost of equity? a. Capital asset pricing model. c. Current tax rate. d. Dividend growth rate model. b. Adding a risk premium. 6. Capital structure is the amount of debt and equity used by a company to finance its business activities, True/False 7. As a company's capital structure goes from no debt to some debt, the weighted average cost of capital will: a. remain constant. b. rise. c. decline d. be uncertain. 8. The optimal capital structure is the appropriate blend of debt and equity financing. True/False. 9. At the optimal capital structure: a. the value of the company is minimized. b. the value of the company is maximized. c. the weighted average cost of capital is equal to the cost of debt. d. the amount paid in taxes is rising.

10. Determining the cost of equity is easier than determining the cost of debt. True/False. KEY TERMS Match the terms listed with their definitions Write the letters of the correct definitions. a. The combination of debt and equity that results in the lowest cost of capital and maximum market value Term Your choice Definition 1. Capital structure 2. Cost of capital 3. Cost of common stock 4. Cost of debt 5. Cost of equity 6. Cost of preferred stock 7. Flotation costs 8. Optimal capital structure 9. Weighted-average cost of capital b. The required return company owners expect to earn based on the money they have invested in the company c. The relationship between the dividend from dividend paying shares in a firm and the market price d. The mean of the costs of debt, shares in a firm that pay dividends, and common stock e. Expenses associated with selling new stock f. The return required by investors to buy the shares of ownership in a firm, which is viewed as an opportunity cost g. The rate of return required by creditors h. The amount of debt and equity used by a company to finance its business activities i. Also called required rate of return, this is the rate required by lenders and investors who are letting the company use their money حرارة التعليم CHAPTER 8 Cost of Capital 345

pal 346 Business Finance W KEY FORMULAS Cost of debt Cost of preferred stock kg = 101-11 Cost of common stock-risk premium k =+ Risk premium Cost of common stock-CAPM Cost of common stock -dividend growth model D (1+g) K₁ = P Cost of new shares D₁(1 + g) P-F +9 Weighted average cost of capital kwikwak + Wik

MINI CASE B.1 Cost of Capital for Debt Borrowing allows a company to use the money of others with a lower cost of capital because of the lower risk for lenders than the expected return of stockholders. In addition, interest payments on debt are tax deductible as a business expense. Despite these benefits, debt increases the risk for stockholders since creditors are entitled to interest payments and repayment before any dividends are paid. As a telecommunications company plans to expand into new regional markets, the managers are trying to decide whether to use debt or issue additional stock. They realize that in addition to the tax benefits of debt, the following must also be considered: ⚫ The current interest rate for borrowing for a telecommunications company. ⚫ The length of the borrowing term. Short-term debt will usually have a lower interest rate than long-term debt. Task The riskiness of the firm should be evaluated based on the business risk for a telecommunications company and the current debt level of the company. 1. What factors should the company consider before taking on additional debt? 2. How might the additional debt affect the cost of capital for the company? وزارة التعليم CHAPTER 8 Cost of Capital 347

pul 3-4 Business Finance M MINI CASE 8.2 Cost of Capital for Common Stock Malak plans to buy shares of common stock in a retailing company. Evaluating the opportunity cost for an expected return of this investment, she will also consider other possible investments. The required return for an investor of common stock might be determined using one of three methods: 1. This approach starts with the interest rate paid on debt and adds a risk premium, which is estimated based on uncertainty related to economic. company, and market factors. 2. A second approach is the capital asset pricing model (CAPM) with the risk premium influenced by the firm's belo coefficient, which measures the systematic (undiversifiable) risk. 3. A third approach takes in to account the expected dividend yield plus expected growth. Task 1. Why is the required return for a common stock investment viewed as an opportunity cost? 2. Which of the three methods would provide Malak with the best approach to determine her required rate of retum for the potential retailing company stock investment? Explain your choice.

MINI CASE 8.3 Weighted Average Cost of Capital Layla is the financial manager for a construction company. Current plans include determining the company's cast of capital for upcoming building projects. This process involves calculating a cost of equity and the weighted average cost of capital for the company. Layla needs to take actions using the following data provided by the company's analysts. Task 1. Using the Dividend-Growth Model formula, calculate the k, based on these amounts: Dividend Growth rate SAR 5 4% Current stock price SAR 80 2. Calculate the weighted-average cost of capital based on thek, from (a) along with a k, of 7% and these capital structure proportions: Debt Equity 30% 70% 3. What additional actions might Layla consider in the future to reduce the cost of capital for the company? وزارة التعليم CHAPTER 8 Cost of Capital 349

CASE STUDY: COST OF CAPITAL FOR EXPANDED GLOBAL BUSINESS ACTIVITIES Companies are continually planning for new equipment, new products, new markets, and expansion strategies. These actions require funding, either through debt or equity. Managers must decide how to best finance new and expanded business activities. At the foundation of these decisions is a company's cost of capital. A food and beverage company developed a planning format for identifying its. cost of capital. This process involves two steps. Step one, a framework involves consideration of quantitative and qualitative factors in relation to: (1) the company situation, (2) the country/market situation, and (3) the proposed business project. This is a summary of the factors the company studies when selecting a cost of capital. (1) Cost of Capital Fucture Current Company Station Country Prod Project Situation Quantitive Factors. bond yield stock yield debt level ⚫inflation rate .bond yields ⚫ Gross Domestic start-up costs Qualitative Factors past success managers Product per capita incorne growth infrastructure government current markets regulations geographic factors certainly of cash flows funding availability andiales facility, teclinulogy avalubility market potential for product In step two, in addition to the quantitative and qualitative factors, the company uses these guidelines to determine a specific cost of capital when planning a project or product in an existing or new market. Cost of Capital Analysis Existing Project (or product) Home Country of Company Base rate New Mar Industializedxuntry Base plus 1-3% Me Market leveleind economy Base plus 2-5% New Project Base plus 1-3% Base plus 2-5% Base plus 4-6% (or product) pul 350 Business Finance When using this table the company starts with a base rate - Its current cost of capital. This amount is adjusted for the type of project (existing or new) and the market setting of the project (home country, Industrialized country or developing economy). The food and beverage company is planning to expand beyond its home country of Saudi Arabia. Various projects under review include production in another country and plans to sell its products outside its home country. M

Study Questions 1. For the planned business expansion, would you recommend that the Saudi company develop a new product for a new market in: (a) an industrialized country, or (b) a country with a developing economy? Explain your choice. 2. Explain how one or more quantitative and qualitative factors might affect the cost of capital for the food and beverage company: 3. Starting with a base cost of capital in Saudi Arabia of 4% and using the guidelines in the "Cost of Capital Analysis" table, choose a cost of capital for the project you recommended in Item 1 (above). Explain the factors that influenced your decision for the cost of capital you selected. Online Activity Research online methods used by Saudi companies to determine the cost of capital for linancing new business activities. Describe the process used and the current cost of capital for various companies. حرارة التعليم CHAPTER 8 Cost of Capital 351