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Financial Management MGT201

Lesson 28

INTRODUCTION TO DEBT, EFFICIENT MARKETS AND COST OF CAPITAL

Learning Objectives:

After going through this lecture, you would be able to have an understanding of the following topics

· Intro to Debt, Efficient Markets & Cost of Capital

In today's lecture, we will start our discussion on capital structure and corporate financing. The first

thing which we study about the capital structure is the over view of the financial markets. We have

mentioned that there are two main sources of capital raising i.e. debt and equity. There are various

financial markets where the money is available.

Capital Markets:

Stock Exchange (listed shares, unit trusts, TFC):

In the case of capital market we have study the stock exchange where the common or preferred

stocks of companies are traded. In these we have the supply or availability of the equity capital.

Money Markets (Short-term liquid debt market):

It is the market for short term debt. and it includes the debt instruments like term finance

certificates and bonds etc. bank loans ,leases from leasing company , mortgage agreements from house

building finance corporation insurance policy , credit cards and various other things .it also includes

bank deposits certificates and inter bank short term and over night borrowing and lending Bonds

Real Assets Markets:

The real asset market where the real or tangible asset or physical asset change hand .for

example, you have cotton exchange where raw bales of cotton change hands .computer hardware and

many other examples are available. For example, Cotton Exchange, Gold Market, Kapra Market

Property (land, house, apartment, warehouse) ,Computer hardware, Used Cars, Wheat, Sugar,

Vegetables, etc.

Debt and Equity Markets:

Equity Markets and Institutions

Stock Exchanges

Private Placements

Private Equity Investments

Venture Capital

Islamic Finance

Debt Markets and Institutions

Bond Markets

Money Markets & Call Markets

Bank Loans & Certificate of Deposits (CD's)

Project Financing

Running Finance or Working Capital Finance

Hypothecation and Pledge Financing for Inventory Purchase

Bridge Financing

Mortgage Financing

Lease Financing

Insurance and Credit Card

In previous lectures we have studied about the efficient markets.

Efficient Markets" Assumption:

We assume that Financial Markets are quick and Prices are Right. There are Lots of Rational

Investors in every Financial Market. They are all well-informed and act quickly on information related

to the companies' operations, finances, risk and return. So Prices of Securities (like Stocks and Bonds)

adjust (equilibrate) quickly to new information. Pricing by the Market is Efficient and Accurate.

Observed Market Price is accurate reflection of Fair Price (or Theoretical Price based on Investors'

NPV calculations).

All Stocks have Optimal Risk-Return Combinations, i.e. All Stocks lie right ON the SML Line!

Securities:

These are pieces of legal contractual paper that represent claim against assets

Direct Claim Securities:

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Stocks: it is equity paper representing ownership, shareholding. Appears on Liabilities side of

Balance Sheet

Bonds: it is debt paper representing loan or borrowing.

When you are issuing Bonds (i.e. borrowing money) then the Value of Bonds

appears under Liabilities side (as Long Term Debt) of Balance Sheet.

If you are Investing (or buying) Bonds of other companies then their Value

appears under Assets side (as Marketable Securities) of Balance Sheet.

Value of Direct Claim Security is directly tied to the value of the underlying Real Asset.

Why Take Debt?

If you do NOT have enough money to meet your own or your family's personal living expenses,

then you approach a friend or a Bank for a Personal Loan.

If you can NOT find friends, family, or investors who want to invest Equity into your business

venture, then you approach an Individual Lender or Bank or Leasing Company for a Business Loan. In

an Emergency or Crisis, the quickest way to get money is generally to take a Loan at a high interest rate.

Countries that are short of money do this too.

Debt vs. Equity:

If the Company raises money using Debt or Bonds, then it will have to pay a fixed amount of

interest (or mark-up) regularly for a limited amount of time. Of course, failure to pay interest can

force company to close down.

If the Company raises money using Equity, then it is forced to bring in new shareholders who are

Owners & can interfere in the management and will get a share of the net profits (or dividends) for

as long as the company is in operation

Where Do Bonds & Stocks Appear on the

Balance Sheet?

Stocks & Bonds

Purchased as

Investment

Own Bonds Issued by

Company to Raise Cash

Own Stock Issued by

Company to Raise Cash

Capital Structure:

Most Firms keep a Mix of Both Debt and Equity Capital. In other words most Firms raise

money from both Stockholders (and Shareholders) and Bondholders (and Banks).

The Mixture or Proportion of Debt Capital and Equity Capital are known as the Capital Structure.

This Financial Policy Decision is taken by the CEO, CFO, and Board of Directors

Capital Structure can Change With Time depending on Firm's Financing needs and strategy. Some

Projects like Power Plants and Cement are so Capital Intensive and large that initially the sponsors need

Debt Capital When a Running Business reaches maturity, some owners prefer to fix the Ratio of Debt to

Equity at 20/80 and only for Running Finance. Some Muslim Businessmen use 100% Equity Capital

only (No Debt).

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Cost of Capital: Firms try to attract Debt and Equity Investors to invest their Capital (or money). Firms

claim that they are SAFE and PROFITABLE investments. Therefore, Firms try to Get Investment

Capital (or money) at the LOWEST possible Cost of Capital.

Remember that whenever you Borrow or Rent or Buy anything (cycle, house, money), it Costs

You Money in the form of a Rental, Interest or Mark-up, Installment, etc.

Stockholders (Equity owners) expect to receive Dividends

Bondholders (Debt Holders and Banks) expect to receive Interest

Cost of Capital & Required ROR:

Required ROR (or Opportunity Cost) %:

CAPM Theory (SML for Efficient Markets) & NPV

Minimum ROR required attracting investor into buying a Security (i.e. Stock or Bond ...)

Opportunity Cost: Investor Sacrifices the ROR available from the 2nd best investment.

Cost of Capital %:

Weighted Average Cost of Capital (WACC)

Combined costs of all sources of financing used by Firm (i.e. Debt and Equity)

WACC is Similar to Required ROR BUT Takes into account some Practical Factors:

Taxes: Interest Payments are P/L Expenses and NOT Taxed.

Transaction costs: Brokerage, Underwriting, Legal, and Flotation Costs incurred

when a Firm issues Stocks or Bond Securities

WACC

%Weighted Average Cost of Capital

Assume that Firm markets 3 Types of Financial Products (or Securities or Instruments) to attract

Investors' Capital.

Bonds (Debt):

Cost = Coupon Interest

Common Shares (Equity): Cost = Variable Dividend

Preferred Shares (Hybrid Equity): Cost = Fixed Dividend

The Firm Issues a Security or Financial Instrument to the Investor and Receives Capital (or Money)

in exchange. The Firm has to pay a "Rental Cost" for using the Investors' Capital.

WACC % = Weighted % Cost of Debt +

Weighted % Cost of Common Equity +

Weighted % Cost of Preferred Equity = rDxD + rExE + rPxP

WACC must take Taxes & Transaction Costs into account

Security Market Line (SML)

For Market of Efficient Stocks

Stock A lies

rA = rRF + (rM - rRF )

Required

ON the SML

Line. Efficient

Return (r*)

Risk-Return

rA= 30%

Combination

Security Market Line

rM= 20%

Risky Stock A's

rRF= 10%

Risk Premium

= 30-10 = 20%

A =+ 2.0

M =+ 1.0

Beta Risk (

)

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Summary of Formulas:

Total risk= market risk + company specific risk

σ 2 + β 2σ 2 + σ 2

NPV Bond Pricing Equation:

Bond Price = PV = C1/ (1+rD) + C2 (1+rD) 2 + C3 / (1+rD)3 +

..... + PAR / (1+rD)3

Gordon's Formula for Share Pricing:

rCE = (DIV 1 / Po) + g = Dividend Yield + Capital Gains Yield

SML Equation (CAPM Theory)

r = rRF + Beta (rM - rRF)

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