Weighted Cost of Capital

September 25, 2013

Sources of Funds

You have a brilliant idea for

a money-making project.

Where do you get the

start-up funds?

Bonds

These are promises to pay a specified amount – the `par value’ –at a specified date in the future.

They may or may not bear interest.

Often used to fund public-sector projects, or by large corporations.(why not by small corporations?)

There is trading in partially matured bonds.

Selling Stock

Common Stock Preferred Stock

No dividend

Lowest Priority

Vote

Dividend

Higher Priority

No Vote

Stock may be publically traded, e.g. on the TSE or VSE.

Preferred Stock may be callable

-- company can buy it back at a fixed price

and convertible-- can be turned to common stock at a fixedratio

Why would anyone want common stock?

-- to get a vote

-- to get income as capital gains

Cost of Capital Raised by Selling Equity:

1. If a share of stock costs $P, and pays an average annual dividend $D, the effective interest rate on this capital is

k = D/P

2. This estimate errs on the low side, since people may choose to invest in a company that doesn’t pay dividends. A better estimate might be:

k = D/P + growth rate

The Wonders of Leverage

The Wonders of Leverage

Scenario 1: I sell $1 000 000’s worth of shares in my company and buy $100 000 worth of these shares myself. In one year’s time, the company is worth $2 000 000. How much do I have?

Scenario 2: I borrow $900 000 at 10% interest and put up $100 000 of my own to start a company. In one year’s time, the company is worth $2 000 000. How much do I have?

Compound Leverage

Value of shares in the Goldman Sachs TradingCorporation:

1928 1932

$104/share $1.75/share

Capital Structure

Industry Debt Equity Other

Oil 17.6 79.0 3.4

Steel 27.2 67.2 5.6

Utility 44.2 52.6 3.2

Chemicals 5.2 82.9 11.9

Manufacturing 2.7 93.0 4.3

Mortgages

These are fixed-term loans, secured by a lienor title on some tangible property.

Usually used by larger companies (though theprincipals of small start-up companies mayraise money by mortgaging their personalproperty.)

Small-Business Loans

Some governments set aside funds to financesmall start-up companies.

(e.g.,Western Economic Development, SBIR’s,…)

Weighted Cost of Capital

If a company obtains funds Xi at an interest rateAi, the weighted cost of capital for the company is

Σi XiAi

This sets a lower bound on the MARR.

Σi Xi

Capital rationing

$

i Project 1Project 2

Project 3

MARR

Limit of cash

Capital Inventory

$

i Project 1Project 2

Project 3

MARR

Project 4

(Don’t fund)

Capital Budgetting: Other Factors

•Are the chosen projects the best fit to available capital?

•How do the projects interact?

•Are they equally risky?

•Are there intangibles to consider?

•Are some projects mandatory? (E.g. pollution controls)

•Are there relevant political factors?

Business Organization

The Three Kinds of Organization

Single Proprietorship

Partnership

Corporation

Most businesses are small.

But most business is done by big businesses.

Most small businesses fail within their firstfive years.

John Kenneth Galbraith claimed that NorthAmerican business is characterised by oligopolyrather than competition.

Time Warner, Disney, Murdoch, Bertlemann and Viacom(formerly CBS)

Detecting Oligopoly: the `four-firm concentration’:

UK supermarkets: 74.4%UK brewers: 85%US music: 80%US breakfast cereals: 80-90%US auto top three: 60%US computers: 65%

Counterexample: Internet porn

The Single Proprietorship

Advantages: Simple

Total Control

Can use money as you like

Disadvantages: Can lose all you own

Limited capital

Limited expertise

The Single Proprietorship

Advantages: Simple

Total Control

Can use money as you like

Disadvantages: Can lose all you own

Limited capital

Limited expertise

Cash Flow Problems

You have an idea that can make $150 000 in the firstyear, for an investment of $80 000.

But you have to get the $80 000 first. How?

i)Buy on credit

Can do this explicitly, or just pay bills late.Either way costs about 25% plus loss of goodwill. Many suppliers offer a 2% discount forprompt payment.

Cash Flow Problems

You have an idea that can make $150 000 in the firstyear, for an investment of $80 000.

But you have to get the $80 000 first. How?

i)Buy on creditii)Talk to the bank

Bank will ask, ``What’s the collateral?’’

Mortgageable property? Track record?If not, they charge a risk premium.

Cash Flow Problems

You have an idea that can make $150 000 in the firstyear, for an investment of $80 000.

But you have to get the $80 000 first. How?

i)Buy on creditii)Talk to the bankiii)Government help

Bureaucratic overhead, may not be worth it.

Partnership

Advantages Disadvantages

More capital

Easier Credit

More Talent

Retain ValuableEmployees

Liable for debts

Limited Credit

Arguments

Frozen Investment

Liability for Debts

The general partners are jointly and severally liablefor the debts of the partnership.

The only way to get out of this is to be a limited partner.

The partnership may include the names of the generalpartners in the firm’s name, but not the word `Limited’

A partnership must be registered according to the law in the province.

Incorporating

Advantages Disadvantages

Limited liability

More capital

Professional management

Costs money

Corporate Tax

Lack of privacy

Loss of Control

Registration

In BC, you have to submit a Memorandum of Associationto the Registrar of Joint Stock Companies. This specifieswho is applying, the amount of share capital, and theresponsibility for debt. (If the shareholders’ liability islimited, the word `Limited’ must be the last word in thecompany name.

Some provinces have a slightly different system, theletters patent.

The Corporation

A corporation is a business which is legally distinct fromits shareholders; that is, a corporation can owe money without its shareholders being responsible for the debt.

Corporations are of two kinds, public and private.

A private corporation has between 3 and 50 shareholders,and shares can be transferred only with the approval of the Board of Directors. The public must not be invitedto buy shares.

A public corporation can have as many shareholdersas it likes and can sell shares to anyone.

Tax Advantages and Disadvantages

Once you are incorporated, that part of the firm’s income that comes to you gets taxed twice – onceat the corporate rate, once as it goes from thecorporation to your pocket.

Nevertheless, you can use incorporation to reducethe tax you pay….

Tax Advantages and Disadvantages

Company(Pre-tax)

Company(After-tax)

You

25%

25%

Tax Advantages and Disadvantages

Company(pays wages)

You

60%

Tax Advantages and Disadvantages

Company

You

Selling Shares

Once you’re a corporation, how do you actually go aboutselling stock?

For a small company, you usually have an investment banking firm act as an intermediary. They will marketyour shares and take a cut – perhaps 25% -- to pay for their efforts.

If you’re a big company, the investment banker may underwrite the stock, that is, guarantee to buy all you want to sell.

How much stock can you reserve for yourself?

Accounting

A company needs to monitor its internal cash flows so itcan diagnose its state of health.

The two most important monitoring documents are theIncome Statement and the Balance Sheet.

These must be available to be checked by independentauditors, and made available to potential investors.

Several diagnostic instruments can be applied to theaccounting data.

Current Assets Fixed Assets

Current Liability

Long-Term Liability

Owed this year

Owed in the more distant future

Diagnostics

Current ratio = Total Current Assets

Total Current Liabilities

Working capital = Current Assets – Current Liabilities

Diagnostics

Acid-test ratio = Cash & Accounts Receivable

Total Current Liabilities

(After-Tax) MARR = After-Tax Profits

Total Assets

A Paradox?

The Fundamental Equation of Accounting is:

Equity = Assets – Debts

so the value of one share should be

Share Value = Equity/Number of Shares

So how can the stock market crash?

After a long period of unemployment, Jamal signs a contract to work in the distant nation of Placidia. The job requires him to be away from home for two years, and the majority of his pay is held back until he has completed the contract. If he leaves before this, he gets nothing. He receives an immediate signing bonus of Rs 70 000, but he has to spend Rs 30 000 of this on an air ticket to Placidia. The rest he gives to his family. Once in Placidia, he is provided with food and board, but after working for a year, there are unexpected difficulties in renewing his work permit. Eventually he has to pay Rs 150 000 in fees and bribes, for which he has to re-mortgage his house back home. At the end of his second year he is paid Rs 170 000. Air fares have gone up in the meantime, so he spends another Rs 35 000 on an air ticket and flies home. Regarding the entire trip as a business investment, what was Jamal’s IRR? If there are multiple solutions, you should also calculate his approximate and his exact ERR. You should assume that he can invest his funds at 12.5%.

Yan invests $10 000 000 to build a casino in Macao. In the first year he makes a profit of $20 000 000. But in the second year, a syndicate of card-counters infiltrate his casino, and he loses $15 000 000. In the third year he is able to eliminate the card-counters, and makes a profit of $50 000 000. Assume that his income and his losses occur continuously throughout each year, and that they are all continuously compounded. What is his IRR?

Any money he does not invest in the casino, he can put in his cousin’s banking business, where he can earn 15%. What is his approximate ERR?

The heating system in Jacob’s building has worn out and he has to get a new one. All the alternatives are gas-fired furnaces, but they vary in efficiency. Model A is leased at $500/year. It has installation charges of $500, and saves $200 a year compared with his previous system. Model B is purchased for $3600, including installation. After 10 years it will have a salvage value of $1000. It saves $500 a year compared with the old system. Model C is purchased at a total cost of $8000, half paid now, half paid in two years time. It has a salvage value of $1000 after ten years, and saves $1000/year compared with the current system. Assuming an MARR of 12% and using the IRR method, which furnace should Jacob get?