Financial Management for Analysts

•  The cost of capital to a company is the minimum rate of return that it must earn on its investments in order to satisy the various categories of investors who have made investments in the form of shares, debentures or term loans.
• A company's cost of capital is nothing  but the weighted arithmetic average of the cost of the various sources of finance that have been used by it.
• The use of this measure for appraising new investments will depend upon two important assumptions: a. risk characterizing the new project under consideration is not significantly different from the risk characterizing the existing investments of the firm, (b) the firm will continue to pursue the same financing policies.
• For calculating the cost of capital of the firm, you have to first define the cost of various sources of finance used by it.
• The sources of finance that are typically tapped by a firm are: (a) debentures (b) term loans (c) preference capital (d) equity capital and (e) retained earnings.
• According to the dividend forecast approach, the intrinsic value of an equity stock is equal to the sum of the present values of the dividends associated with it.
• Realized Yield Approach: According to this approach, the past returns on a security are taken as a proxy for the return required in the future by the investors.
• Bond Yield Plus Risk Premium Approach: The logic behind this approach is that the return required by the investors is directly based on the risk profile of a company.
• Earnings Price Ratio Approach: According to this approach, the cost of equity can be calculted as E₁/P where, E₁ = expected EPS for the next year, P = current market price per share, E₁ can be arrived at by multiplying the current EPS by (1 + Growth rate).
• The use of fixed charges sources of funds such as preference shares, debentures and term loans along with equity capital structure is described as financial leverage or trading on equity.
• The term trading on equity is used because it is the equity that is used as a basis for raising debt.
• Profitability, Flexbility, Control and Solvency are the features of an optimal capital structure.
• Net Income Approach: According to this approach, the cost of equity capital (k_e) and the cost of debt capital (k_d) remain unchanged when B/S, the degree of leverage varies.
• Net Operating Income Approach: According to the net operating income approach, the overall capitalization rate and the cost of debt remain constant for all degrees of leverage.
• The traditional approach has the following propositions:

i.  The cost of debt capital, k_d, remains more or less constant up to a certain degree of leverage but rises thereafter at an increasing rate.

ii.  The cost of equity capital, k_e, remains more or less constant or rises only gradually up to a certain degree of leverage and rises sharply thereafter.

iii.  The average cost of capital, k_o, as a consequence of the  above behavior of k_e  and k_d (a) decreases up to a certain point; (b) remains more or less unchanged for m oderate increases in leverage thereafter and (c) rises beyond a certain point.

• Modigliani and Miller have stated that the relationship between leverage and the cost of capital is explained by the net operating income approach in terms of three basic propositions. They argur against the traditional approach by offering behavioural justification for having the cost of capital, k_o, remains constant throughout all degrees of leverage.