mac2602Topic 5 - Capital structure and cost of capital.pdf - 100 TOPIC 5 Capital structure and the cost of capital Study unit 12 Capital structure

mac2602Topic 5 - Capital structure and cost of capital.pdf...

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100 MAC2602 © Edge Business School uni0054uni004Funi0050uni0049uni0043uni0009uni0035uni003A Capital structure and the cost of capital Study unit 12 - Capital structure theory Capital structure Statement of financial position ASSETS Non-current assets Property, plant and equipment xxx Investments xxx Current assets Inventory xxx Bank xxx Accounts receivable xxx TOTAL ASSETS XXX EQUITY AND LIABILITES Capital and reserves Share capital xxx Retained income xxx Non distributable reserve xxx Ordinary equity xxx Cost = div (not tax deductible) % Preference share capital xxx Cost = div (not tax deductible) % Non-current liabilities Debentures xxx Cost = int (tax deductible) % Long term loan xxx Cost = int (tax deductible) % Current liabilities Accounts payable xxx Cost = int (tax deductible) % TOTAL EQUITY AND LIABILITIES XXX Mix of cost of debt & equity = WACC Think of the statement of financial position like a management accountant instead of a financial accountant. The reason why total assets = total equity & liabilities is because: This statement shows us how the company has financed its assets The mix of debt and equity used to finance the assets is known as the capital structure
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101 MAC2602 © Edge Business School Financial leverage First it is important to understand that the cost of debt is lower than the cost of equity. There are two reasons for this: The cost of debt (interest)is deductible for tax purposes The debt provider’s required rate of return of debt instruments is low. The reason for this is due to the fact that the risk of a debt instrument is lower than the risk of equity because: o The repayment of a debt instrument is more secure. Therefore using debt instead of equity (using the cheaper funding) will lead to an increase in the ROE. This is called the leverage effect. But too much debt will increase the financial risk of the company; this will lead to a higher required rate of return (to compensate the lender for the higher risk taken). When this happens the increase in the cost of debt will offset the benefit. RETURN ON ASSETS (ROA) ROA = g2889g2911g2928g2924g2919g2924g2917g2929uni0009g2912g2915g2916g2925g2928g2915uni0009g2919g2924g2930g2915g2928g2915g2929g2930uni0009g2911g2924g2914uni0009g2930g2911g2934g2915g2929uni0009g4666g2889g2886g2893g2904g4667 g2904g2925g2930g2911g2922uni0009g2885g2929g2929g2915g2930g2929 RETURN ON EQUITY (ROE) ROE = g2898g2915g2930uni0009g2900g2928g2925g2916g2919g2930 g2904g2925g2930g2911g2922uni0009g2889g2927g2931g2919g2930g2935 The debt/equity provider’s required rate of return = The organisation’s cost of capital
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102 MAC2602 © Edge Business School Separation of the investing and financing decision Remember the objective of financial management as per Topic 2 = Maximising long term sustainable wealth = Creating s/h wealth = Return on investments > Cost of financing = Only invest in project where the return > cost of the financing But the investment decision and financing decision should be kept separate for the following two reasons: The way an asset is financed will not influence the assets performance o Example: I bought a Ferrari cash, and you bought your Ferrari on credit. That does not mean that my Ferrari is faster than yours. No - because the way the asset is financed will not influence the performance of the asset
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