Interpreting Financial Accounting Information Chapter 11 PDF

INTERPRETING FINANCIAL AND ACCOUNTING INFORMATION CHAPTER 11: THE COST OF CAPITAL AND CAPITAL STRUCTURE THE COST OF CAPITAL AND CAPITAL STRUCTURE  THE IMPORTANCE OF COST OF CAPITAL - Cost of capital is the rate of return required by providers of finance - Equity holders receive returns...

INTERPRETING FINANCIAL AND ACCOUNTING INFORMATION CHAPTER 11: THE COST OF CAPITAL AND CAPITAL STRUCTURE THE COST OF CAPITAL AND CAPITAL STRUCTURE  THE IMPORTANCE OF COST OF CAPITAL - Cost of capital is the rate of return required by providers of finance - Equity holders receive returns in the form of dividends and capital gains - Debt providers receive fixed interest and a redemption value - Represents investors opportunity cost  COST OF EQUITY Capital asset pricing model (CAPM) Dividend growth model (DGM) CAPITAL ASSET PRICING MODEL (CAPM) - Called the risk adjusted discount rate - Incorporates risk in the calculation of Ke - Risk measures using β - Assumes the investor holds a well diversified portfolio  SYSTEMATIC AND UNSYSTEMATIC RISK Systematic Unsystematic - Also known as market risk - Risk specific to a particular company - Relates to the market and economy - Can be eliminated or diversified away - Caused by macroeconomic factors - Not impacted by political and economical factors - Affects all shares in the market ASSUMPTIONS OF CAPM CRITICISMS OF CAPM DIVIDEND VALUATION MODEL  COST OF DEBT Irredeemable debt Preference shares A perpetual debt which is never paid  COST OF DEBT Redeemable debt - Issued as repayable at premium on nominal value - Usually repaid at nominal value (par) Source: https://www.accaglobal.com/gb/en/student/exam-support-resources/foundation-level-study-resources/ffm/ffm-technical-articles/the-internal-rate-of-return.html  WEIGHTED AVERAGE COST OF CAPITAL - Commonly known as company cost of capital - Represents minimum return company must earn on asset - Represents the weighted average return paid to all providers of finance  CAPITAL STRUCTURE - The mix of equity and debt financing that shows how the business is financed - It is concerned with the balance between equity and non-current liabilities - Key objective is to maximise value of the company  CAPITAL INVESTMENT Funds invested by a business for furthering its objectives  FACTORS AFFECTING CAPITAL STRUCTURE Financial leverage or gearing Market conditions Tax exposure Control principle Other factors Growth Cost principle Risk principle RISK FACTORS AFFECTING CAPITAL STRUCTURE  FINANCIAL GEARING - The proportion of debt the company has relative to its equity - Measure of financial leverage PROBLEMS AROUND HIGH LEVELS OF GEARING  OPERATING GEARING - Measures the proportion of fixed cost the company has relative to the variable cost - In times of growth -> high proportion of fixed cost and low proportion of variable cost can be advantageous - Common method to measure operating gearing is to consider the CS ratio - The higher the operating gearing the higher the sensitivity of profit to a change in sale - The higher the operating gearing the higher the sensitivity of EBIT to a change in sale  CAPITAL STRUCTURE THEORIES Traditional approach Modigliani and Miller (without taxes) Modigliani and Miller (with taxes) TRADITIONAL APPROACH TO CAPITAL STRUCTURE LIMITATION OF TRADITIONAL VIEW MODIGLIANI AND MILLER (WITHOUT TAX) MODIGLIANI AND MILLER (WITHOUT TAX) Assumptions of the MM without tax MODIGLIANI AND MILLER (WITH TAX) CRITICISMS OF THE MM TRADE-OFF THEORY  REAL WORLD APPROACHES Pecking order theory - Outlines the order of preference for financing decisions 1. Retained earnings 2. Straight debt 3. Convertible debt 4. Preference shares 5. Equity shares Reason is that companies are risk averse and will prefer retained earnings followed by debt and lastly equity