BUS601: Financial Management

The capital structure of a firm consists of the amount of debt and the amount of equity that the company will use to operate the business, invest in future projects, and increase firm value. One of the most important financial decisions that a firm makes is determining its optimal capital structure, or how to minimize the cost of capital while maximizing the creation of value. The cost is represented by determining the Weighted Average Cost of Capital (WACC), which we will review in more detail in section 5.2.

There is a basic financial rule that recognizes that there is a cost to using money. We know that there is a debt cost, which is the interest charge. The interest rate is different for the various forms of debt, such as short-term, long-term, notes, and so on. Chances are that you have paid this charge already on credit cards, student loans, mortgages, or lines of credit.

There is also a charge when a company uses equity (the money received from owners/shareholders who have invested in the business). This cost is the expected rate of return that those investors have.

In this section, we will continue our discussion on the cost of capital. Specifically, we will look at the cost of debt, as well as the costs incurred from the use of preferred stock and common stock. There are differences between preferred stock and common stock that are worth noting here.

Preferred stock has the advantage of having the dividend payment actually specified at purchase. In addition, the firm can not pay any dividends for common stock if they haven't paid the preferred dividend. However, preferred stockholders do not have any voting rights. Common stock provides the shareholders with voting rights for corporate governance but does not provide a guaranteed dividend.

Earlier in this unit, we discussed the cost of capital and its importance in determining a firm's optimal capital structure. A general view in finance is that a capital structure with the lowest cost of capital appropriate to the capital required will produce the highest level of corporate value. You have also learned how a company uses debt and equity sources to source the capital it requires to operate and grow the business.

One issue faced by companies in calculating their weighted average cost of capital is determining the cost of equity. Remember that equity funding comes from shareholders who have invested money and expect some return. But how do we determine what that expectation is?

The Capital Asset Pricing Model (CAPM) assumes that the required rate of return (shareholder expectation) on a stock equals the risk-free rate that shareholders can get in the market, plus a risk premium. It sounds simple enough, but this calculation requires some research. The risk-free rate of return is what an investor can earn in the marketplace with zero risk. Typically, we will use a U.S. Treasury Bill, which is guaranteed to be repaid by the U.S. government with a specified interest rate, less the current rate of inflation. Although there is no actual investment that carries zero risk, this investment carries a very small risk of default. An investor will buy stock if they believe that they can earn the risk-free rate, plus something more for taking a risk, which is the risk premium.

The idea of discounted cash flow seems more complex than it is. Let's see if we can simplify this concept. It is an essential requirement for considering any investment you make today with some expectation of future returns.

Remember the rule "a dollar today is worth more than a dollar received a year from today". Why? Because you can take that dollar today, invest it for a year, and earn interest on it. So, when we consider cash that you will receive at some point in the future, we need to take from it any interest that we could have earned by investing that money today.

This process is referred to as discounted cash flow, and it helps us understand the current value of an amount of money we will receive in the future. It is the basis for evaluating investment decisions.

Capital budgeting requires a business to forecast future requirements for investing in the plants and equipment necessary to support profitable business growth. Part of this budgeting process involves determining how much debt and equity will be involved in investment. This is referred to as the debt to equity (D/E) ratio.

One of the critical financial decisions a business will make is using debt and equity to fund investments for future business growth. The use of debt, or leverage, has a positive effect on shareholders' Return on Equity (ROE). You are using "other people's" money to fund your investment.

However, too much debt increases the risk of default (bankruptcy). As debt increases, your shareholder's expectation of return also increases. The greater the risk, the greater the expected rate of return. As a rule of thumb, a D/E ratio of 40/60 is common.

Every business must access a certain amount of cash to fund day-to-day operations. You must plan for payroll, rent, marketing, supplies, etc. To succeed, your business should not wait to see if there is enough cash to meet the business requirements on a week-by-week basis. You will need to have a cash budget, which provides a forecast of money coming in, money going out, and when these transactions will occur. This budget can help you plan for cash shortfalls that are budgeted to happen in the future, perhaps by setting up a line of credit with your bank.

Remember, banks will not usually give you a loan because you can't meet the payroll this week. You must be able to support the need with a cash budget that is prepared in advance and shared with your bank. It is the difference between showing that you understand your business, and have planned for cash needs, as opposed to being surprised that you have a problem.

Free Cash Flow (FCF) is not the same as cash flow. On the surface, it can appear to be a bit complicated. But understanding free cash flow is at the heart of realizing just how well you are doing today and is key in forecasting future value. In many executive compensation contracts, creating free cash flow is the basis for incentives.

This study session is an excellent way to review what you've learned so far and is presented by the professor who created the course. Watch this as you work through the unit and prepare for the final exam.