BUS601: Financial Management

5a. Calculate the firm's cost of capital (debt and equity) 

• What is the capital structure of a firm?
• What is a firm's cost of capital?
• How do you calculate the weighted average cost of capital?

Part of preparing to decide whether to invest depends on the availability of capital to provide the necessary funds. You have already learned that a firm's capital comes from different sources that generally fall into two buckets: debt financing and equity financing. A question to be answered is how much of the investment should come from each bucket? The firm's capital structure is represented by the mix (how much) of debt financing and equity financing the firm will use. This is an important decision to make. We know that leverage (debt) will increase the return on equity by using borrowed funds. However, too much leverage and the risk of default increases, which means that the expected returns will also increase. The task is to find the optimum capital structure.

Once the capital structure has been established (which can change over time), the company can calculate its cost of capital. Remember that we need to know this cost as we consider the various ways to evaluate potential investments. As the capital structure is composed of different sources of cash, each has its own particular cost. To determine the actual cost of capital, you will need to calculate a weighted cost that will accurately identify the different costs of capital in proportion to the total capital committed.

Once you have identified the component costs for each item in the capital plan, you can use the following formula to calculate the weighted average cost of capital (WACC).

$WACC = w_dr_d(1-T) + w_{ps}r_{ps} + w_sr_s$

Where:

• $w_d$ = weight (%) of debt used
• $r_d$ = interest rate on debt
• $r_d(1-T)$ = after tax cost of debt (recognizes the tax shield on using debt financing)
• $w_{ps}$ = weight (%) of preferred stock used (equity)
• $r_{ps}$ = expected return on preferred stock
• $w_s$ = weight (%) of common stock used (equity)
• $r_s$ = expected return on common stock

To review, see:

• Raising Capital and Capital Structure
• Weighted Average Cost of Capital

5b. Evaluate the cost of capital to potential returns 

• How is WACC applied to a firm's investment analysis?
• What is the optimal capital structure?

Once the firm's weighted average cost of capital (WACC) has been determined, the company can evaluate each potential investment to determine if the expected return will be sufficient to cover the costs of the investment and generate an acceptable return for the stakeholders. This is the basic purpose of the net present value (NPV). Simply stated, if the firm's cost of capital is 8% and the expected return on the project is 11%, the firm should invest. If it is less than 8%, the firm should pass on the investment.

The firm has many ways to raise capital for an investment. As you saw in calculating the weighted average cost of capital (WACC), depending on exactly how much debt and equity is used, the cost of the capital can be higher or lower. The firm will look to find the optimum capital structure, which means varying the mix of debt and equity that will result in the lowest WACC.

To review, see:

• Raising Capital and Capital Structure
• Cost of Debt, Preferred Stock, and Common Stock
• Weighted Average Cost of Capital

5c. Determine the cash flow of a project

• Why is cash flow important to a business?
• What are the categories of cash flow?

Cash flow (CF) is a relatively easy calculation: cash revenues minus cash expenditures over a stated period. Every business requires sufficient cash to meet expected operating needs. This is one method for evaluating the business's liquidity, or its ability to access sufficient cash to meet its obligations. This is one to determine how solvent the business is.
 
One of the statements in a company's financial package is the Statement of Cash Flows. This statement specifically records the three main sources of cash for the business and changes that have occurred in these accounts. It allows an investor to evaluate if the results are positive and are trending in the right direction. The three categories of cash flow represented on this statement include:

1. Cash from Operations;
2. Cash from Investing; and
3. Cash from Financing.

This is followed by a summary account called the Net Increase or Decrease in Cash.
 
To review, see Interpreting Overall Cash Flow.

5d. Discuss the importance of generating free cash flow (FCF) to create value 

• Why is it important for a firm to create free cash flow (FCF)?
• What are the four methods for calculating free cash flow (FCF), and how are they used?

The executives of a firm should be committed to creating value for all of their stakeholders, and you have learned of several actions that they can take to accomplish this goal. These include creating and executing a comprehensive strategic plan, developing a corporate culture conducive to an effective and efficient operation, producing quality products and services, and making investments that will maintain and grow the business. One method for evaluating the firm's success with these objectives is to look at the free cash flow (FCF) generated. Free cash flow results from taking the net income generated by the business, adding any value from depreciation and amortization, and accounting for changes in working capital and capital expenditures. Free cash flow represents the amount of funds the company has after meeting all of its operating expenses and taxes and making investments in capital projects. These funds are not required to operate the business and can be used to pay dividends, reduce debt, etc. The greater the free cash flow, the better the firm is doing.
 
Depending on the complexities of the firm's finances, and the availability of certain values, there are four general approaches to calculating free cash flow. They consist of:

1. FCF = EBIT × (1-T) + depreciation + amortization – changes in working capital – capital expenditures
2. FCF = net profit + interest expense – net capital expenditures – net change in working capital – tax shield on interest expense
3. FCF = profit after tax – changes in capital expenditures × (1-d) + depreciation + amortization × (1-d) – changes in working capital × (1-d) [d = debt/equity ratio]
4. FCF = cash flows from operations – capital expenditures

To review, see Free Cash Flow.

Unit 5 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

• calculating free cash flow
• capital structure
• cash flow
• categories of cash flows
• cost of capital
• free cash flow
• optimum capital structure
• weighted average cost of capital