Finance Chapter 5 Quiz

Strategic Financial Management - Lecture 7: Risk and Return & Estimating the Cost of Capital

• Cash has a cost, the cost of capital, presented as the expected return investors demand for the funds they supply.
• Investor expectations for project returns are based on return expectations for comparable-risk investments.
• Investor return expectations are affected by the type of security (bonds or shares).
• The weighted average cost of capital (WACC) reflects the risk inherent in the capital structure.
• The capital structure's components include interest-bearing debt and equity.
• Investors of interest-bearing debt and equity expect a return on their investment.
• Free cash flow (FCF) is the cash flow available for all financial investors. WACC reflects the return for each investor.

Highlights

• Methods for estimating the cost of equity and debt capital.
• Combining these costs to calculate a project's weighted average cost of capital (WACC).
• The topic of distress and bankruptcy.

Estimating the Cost of Capital

• Value is a function of cash flows, risk, and time.
• Discounted cash flow (DCF) calculates the present value of future cash flows to determine the value of an investment.

Cost of Capital (r)

• The cost of capital is an opportunity cost, equal to the return that could be earned in alternative, similar investments.
• Investors will not invest if a more lucrative opportunity exists at the same price.

Importance of the Cost of Capital

• It is a crucial business and financial tool.
• It helps in determining company valuation and defining corporate strategy.
• Businesses use it for investment decision-making.
• Capital is the financial resources needed to run a business or pursue a project.
• Capital commitments are made upfront, expecting them to payoff.

Types of Costs

• Cost of Debt: This cost is contractually determined and relatively straightforward; interest rates vary over time and between companies.
• Cost of Equity: This is more complex, as it reflects the expectation that the return on equity will match other similar opportunities, and it takes longer to realize. This varies significantly and payments are not specified in advance.

Cost of Capital (r) - Total Cost of Capital

• The overall cost of a company's capital.
• Weighted average of the cost of debt and equity.
• Weighted according to their proportional financing.

Cost of Equity (Ke)

• Opportunity Cost: The cost of equity is determined when there is no contractual cost, therefore the investor weighs the return of the equity against other potential investments, which are in the same risk class and have a similar liquidity level.
• Expected/Required Return: The return for the investment, also considering investor risk tolerance. This is not the actual, achieved return. For risky investments, investors demand higher returns to compensate for risk. No certain returns, thus a risk-free rate of interest has to be added.
• Risk Affecting Cost of Capital: Risk averse people prefer the certain level of income; however, to accept a certain risk reward higher return must be offered. There is a correlation between risk and return.

Cost of Equity (Ke) - Risks

• Investors with diversified portfolios only need compensation for portfolio-wide risk (systematic risk)
• Specific risks aren't significant because they get diversified away in a portfolio.
• Systematic or undiversifiable risk remains.
• Risk can be evaluated through a probability distribution.

Cost of Equity (Ke) - CAPM

• CAPM estimates the cost of equity.
• Risk-free rate combined with equity return premium (EMRP)
• EMRP is a product of EMRP (average market risk) and the beta for that investment (measure of the systematic risk of that particular investment)

Cost of Equity (Ke) - Systematic and Unsystematic Risk

• Investing in various stocks help to diversify systematic risks away.
• Unsystematic risk relates to company-specific components of risk.

Cost of Equity (Ke) - Specific Risks

• Company-specific risk can be diversified away, but these risks are still essential in practice.
• Managerial competence is crucial given company-specific risks.

Cost of Equity (Ke): Summary

• Cost of equity relates to the perceived risk of the investment.
• Calculating the cost of equity is intricate.
• CAPM can be used to determine equity returns beyond a risk-free rate
• Calculating Cost of Equity is forward-looking to determine future cash flow values.

Risk-Free Rate (Rf)

• The minimum return an investor expects for investing in a risk-free asset.
• Guaranteed return.
• Time preference—attaching lower value to future money. -Expected inflation rate is also a part of risk free rates

Risk-Free Rate - Calculation

• Conversions can be done from nominal to real rates of return.

Risk-Free Rate - Examples

• Government securities (e.g., bonds) frequently used as risk-free proxy in the OECD countries.

Beta (β)

• Beta quantifies the relative volatility of a specific stock/asset compared to the market index.
• A measure of systematic risk, representing how sensitive a security's returns are to changes in the market index.
• Beta above 1.0 indicates higher volatility, and beta less than 1.0 implies lower volatility than the market.

Beta Historical Data

• Historical covariance of firm equity and market return is a good proxy for future risk.
• Regression analysis determines beta values from historical data.
• Interpreting historical beta requires caution, as it's not a perfect predictor.

Beta - Factors that Drive Beta

• Cyclicality of revenue: Degree to which a company's cash flows are affected by overall market conditions.
• Operational leverage: Degree to which fixed costs are part of total costs.
• Financial Leverage: additional risk when a portion of the company is funded by debt.

Beta - Observable Betas

• Beta incorporates operational and financial leverage impacts.
• There are different betas; asset beta relates only to operational risk.
• Company-specific risks can be mitigated through diversification.

Equity Market Risk Premium (EMRP)

• The extra return investors demand for putting money into equities of average risk.
• Calculated using historical data (arithmetic/geometric averages).
• Forward-looking approach also used in practice.

Cost of Debt

• Calculating borrowing costs for companies.
• Includes direct method (using firm data) and indirect method (examining similar companies).
• Credit ratings and default risk are significant factors in cost of debt evaluation.

Cost of Debt - Debt Margin

• Calculating the expense on borrowed funds involves using market data, like bond prices and yields, or comparing the firm to similar companies.
• The spread between the firm's bond yield and a government bond yield is considered the default risk margin.

Weighted Average Cost of Capital (WACC)

• Calculating WACC involves the cost of equity, and the percentage of equity in the capital structure, alongside the after-tax cost of debt, combined with the percentage that debt composes the capital structure.

Weighted Average Cost of Capital (WACC) - Steps

• Determine target capital structure.
• Calculate cost of debt (Kd).
• Calculate cost of equity (Ke).
• Calculate the WACC.

Capital Structure Effects

• Financing policies affect company value.
• Static trade-off between the tax shield advantage of debt and bankruptcy costs.
• Pecking order preferences among managers.

What are the major causes of business failure?

• Business failures are typically because of the combination of economic factors, industry trends, consumer habits, obsolescence of technology and demographical change, and, also economic factors such as excessive debt and unanticipated interest rate hikes
• Combining these failure reasons makes businesses unsustainable.

What Size Firm is Prone to Business Failure?

• Bankruptcy occurs more frequently in smaller firms when compared with larger ones.
• Larger companies are more likely to receive external help to avert a potential bankruptcy.

What Key Issues Must Managers Face in the Financial Distress Process?

• Identifying if the problem is temporary or permanent.
• Evaluating who bears the losses.
• Determining if it is better to liquidate the business or maintain operations.
• Identifying if bankruptcy proceedings are necessary or if informal processes might be used.
• Establishing who takes control during liquidation or reorganization.

Bankruptcy Terminology

• Voluntary Bankruptcy - A petition filed by management itself.
• Involuntary Bankruptcy - A petition filed by the company's creditors.

Typical Priority of Claims

• Secured creditors get first priority.
• Trustee and administrative costs are later.
• Worker wages, customer deposits, and taxes have priority over unsecured creditors.
• General unsecured creditors are next, followed by preferred, and then common stockholders.

What Informal Remedies Are Available to Firms in Financial Distress?

• Informal reorganization and informal liquidation.

Informal Bankruptcy Terminology

• Workout: A voluntary informal reorganization strategy.
• Restructuring: Modifying current debt terms.
• Assignment: An informal procedure for liquidating assets.

General Conclusion

• No return exists without risk.