WHAT IS COST OF CAPITAL?
IT IS THE AMOUNT OF RETURN OF AN INVESTOR
NEEDS TO MAKE, IN ORDER TO PROVIDE THAT NEXT
INVESTMENT FURTHER DOWN THE LINE.
So, merong 4 na factors depending dun sa amount or cost of capital
1. THE PRODUCT- which is what type of investment they are
lending, (secured loan – collateral/financial assets e.g home/car,
revenue loan-business loan/additional payment “capping”)
2. THE TERM- which is how long they are lending the money for
3. THE RISK – how likely they are to get the money back
4. THE FEES – how much it cost to make the whole deal happen or
capital project.
5. Another way to describe the cost of capital is the opportunity
cost of making an investment in a business. So, thru cost of
capital it can determine whether yung certain stock ba ay too
risky or good investment.
Additionally, we can also oversee yung amount of return na kailangan
ni investors para makapag generate siya ng new capital project, then
pwede din syang makapag purchase ng equipments or makapag
construct ng bagong building thru the means of cost of capital.
EQUITY - difference between liabilities and assets on the balance sheet.
What Is an Example of Cost of Capital?
Merong new business/startup that has a capital structure of 90% equity and
10% debt. The cost of equity, or the return that a company pays its shareholders
for investing in the firm, is 5%. Meanwhile, the cost of debt that it pays its
creditors is 15%. The cost of capital would be calculated as follows: (.9 x 5%) +
(.10 x 15%) = 6%.
EQUITY CAPITAL – ito yung mga funds na ininvest ng mga shareholders,
tinatawag natin din syang cost of equity. So, hindi siya nagrerequire ng
repayment however at some degree ng return of investment yung shareholders
pwede sila mag-expect ng return based dun sa market performance in general or
yung volatility of the stock (unpredictable/ liability to change rapidly)
DEBT CAPITAL – ito yung mga borrowed funds that must be repaid with a
timeframe. This is any form of growth capital a company raises by taking out
loans. These loans may be long-term or short-term such as overdraft protection.
SUMMARY: ADDITIONAL INFORMATION RE: SA D & E CAPITAL
Debt and equity capital both provide businesses money they need to
maintain their day-to-day operations.
Equity capital reflects ownership while debt capital reflects an obligation.
Most business owners prefer debt capital because it doesn't dilute
ownership.
WHAT IS THE USE OF COST OF CAPITAL IN INVESTMENT
DECISIONS?
How companies will finance a project or make an investment, is an important
decision, since that choice will determine a firm's capital structure. Ideally,
businesses seek a fair balance in this scenario, with enough financing to get a
project or investment done, while reducing or limiting the cost of capital.
Sobrang importante ng cost of capital sa mga companies at investors who
need capital to expand their operations at makapagpondo sa kanilang
business while keeping debts as low as possible to satisfy shareholders.
Cost of capital is a useful finance and accounting kasi isa itong tool na
pwedeng gamitin ng companies and investors to make better decisions on
how they will allocate their money.
WACC (WEIGHTED AVERAGE OF COST OF CAPITAL) – is a way to
measure the required rate of return of a company. Companies can
use it to measure the profitability of a project. Investors can use
it in something like discounted cash flow.
By changing the capital structure, a company can raise or lower
the WACC.
- WACC is one of the most important figures in assessing
company’s financial health both for internal use (in capital
budgeting) and external use (valuing companies on
investment markets).
WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))
Where:
E = market value of the firm’s equity (market cap)
D = market value of the firm’s debt
V = total value of capital (equity plus debt)
E/V = percentage of capital that is equity
D/V = percentage of capital that is debt
Re = cost of equity (required rate of return)
Rd = cost of debt (yield to maturity on e xisting debt)
T = tax rate
INTERNAL RATE OF RETURN – is used to measure an acceptable
level of return for an investment by equating a net present value rate
of zero of investment. In other words, management uses the internal rate of
return to develop a baseline or minimum rate that they will accept on any new
investments. Then they use this rate to decide what investments the company
should make. the IRR shows management what they need to receive from
any investment in order to make it worthwhile for the business to
pursue.
IT IS A TOOL IN THE CONTEXT OF CAPITAL BUDGETING AND CAPITAL
EXPENDITURES IN DECISION MAKING.
What Is Net Present Value (NPV)?
Net present value (NPV) is the difference between the present value of cash
inflows and the present value of cash outflows over a period of time. NPV is used
in capital budgeting and investment planning to analyze the profitability of a
projected investment or project.
WORKING CAPITAL MANAGEMENT
Working capital is the difference between a company’s current assets
and current liabilities. It is a financial measure, which calculates whether a
company has enough liquid assets to pay its bills that will be due within a
year. When a company has excess current assets, that amount can then be
used to spend on its day-to-day operations.
Current assets, such as cash and equivalents, inventory, accounts receivable,
and marketable securities, are resources a company owns that can be used up
or converted into cash within a year.
Current liabilities are the amount of money a company owes, such
as accounts payable, short-term loans, and accrued expenses, that are due for
payment within a year.
Positive vs negative working capital
Having positive working capital can be a good sign of the short-term financial
health of a company because it has enough liquid assets remaining to pay off
short-term bills and to internally finance the growth of its business. With a
working capital deficit, a company may have to borrow additional funds from
a bank or turn to investment bankers to raise more money.
Negative working capital means assets aren’t being used effectively and a
company may face a liquidity crisis. Even if a company has a lot invested in
fixed assets, it will face financial and operating challenges if liabilities are due.
This may lead to more borrowing, late payments to creditors and suppliers,
and, as a result, a lower corporate credit rating for the company.
OPERATING CYCLE IS A POINT OF BUYING INVENTORY TO EVENTUAL
REALIZATION (CONVERTED INTO CASH)
LETS US PROCEEDS TO THE WORKING CAPITAL POLICY, HOW MUCH CURR.
ASSETS NEED TO MAINTAIN AND HOW MUCH CURR. LIABILITIES
SEASONAL CURRENT ASSETS- temporary / are
sudden increases in A/R and inventory due to spikes
of sales
PERMANENT – is the minimum amount of current
assets a company needs to continue operations
FIXED – applies to items that the company does not
expect to consumed or sell within the accounting
period.
HEDGING APPROACH (ALSO KNOWN AS MATCHING
APPROACH)
Basically, the hedging principle is one which guides a firm’s debt maturity financing decisions. The
hedging principle states that the financing maturity should follow the cash flow characteristics of the
assets being financed. For example, as asset that is expected to provide cash flows over a period of
say, 5 years, then it should be finance with a debt having similar pattern of cash flow requirements.
The hedging approach involves matching the cash flows generating characteristics of an asset with
the maturity of the sources of financing used to finance it. AGAIN
WHAT EVER THE MATURITY OF THE ASSETS THAT SHOULD BE THE MATURITY OF THE
FUNDING. WHY IT ACTUALLY MAKE SENSE ?
EXAMPLE: IMAGINE IF YOU WILL CATER A SPECIAL ORDER WHICH WOULD REQUIRE A
INVENTORY ONLY FOR 20 DAYS ARE YOU GOING TO HAVE A 20-YEAR LOAN FOR THIS
INVENTORY LEVEL, OF COURSE NOT, WE WILL USE LOAN THAT WILL ONLY TAKES FOR 20
DAYS.
ANOTHER, IF YOU WILL PURCHASE A BUILDING, ARE YOU GOING TO TAKE A 1 MONTH
LOAN, OF COURSE NOT YOU ARE GOING TO HAVE A 10-20 YEAR LOAN.
CONSERVATIVE WORKING CAPITAL POLICY
Conservative approach is a risk-free strategy of working capital financing. A company
adopting this strategy maintains a higher level of current assets and therefore higher
working capital also.
- We have to maintain more current assets, and less current liabilities, what’s the
danger in that ? having more current assets is actually good, it will keep you safe,
anytime someone bill, you have current assets, that is liquidity. However, if we
are going to maintain too much current assets for the sake of liquidity we are also
incurring opportunity cost, we have to maintain a level of current assets that
required funding, funding can be use somewhere else where it would be
profitable but you would not do because it is trap in your current assets. Now, if
we are conservative, we will keep our liabilities low if current liabilities are low, it
is safe, however, current liabilities are cheaper than the long-term counterparts
that is why we are going to end up with more long-term financing which is more
expensive again being conservative we are going to minimize risk being liquid
however, we have to incur more cause or we may want an…
AGGRESSIVE WORKING CAPITAL POLICY
Aggressive policy if the firm decides to finance a part of the permanent working
capital by short term sources. So, the short term financing under aggressive policy
is more than the short term financing under the hedging approach. The aggressive
policy seeks to minimize excess liquidity while meeting the short term requirements.
The firm may accept even greater risk of insolvency in order to save cost of long
term financing and thus in order to earn greater return.
The aggressive approach is a high-risk strategy of working capital
financing wherein short-term finances are utilized not only to
finance the temporary working capital but also a reasonable part of
the permanent working capital.
IF WE WOULD WANT TO BE AN AGGRESSIVE, WE WOULD WANT
HIGHER LEVELS OF SHORT-TERM FUNDS IN THIS DIAGRAM , WE
CAN SEE THE SHORT-TERM FUNDS FINANCE ALL SEASONAL
ASSETS ANG HALF OF THE PERMANENT CURRENT ASSETS, WITH
LONG-TERM FUNDS FINANCING HALF THE PERMANENT CURRENT
ASSETS AND THE ENTIRE FIXED ASSETS.
SO, THESE ARE THE W.C.P THAT A MANAGERS MAY IMPLEMENT.
OTHER MEANS OF RAISING CAPITAL:
TERM LOANS – is a monetary loan that has regular
payment over a set period of time. It usually last
within 1-10 years but may last long in 30-years in
some cases. Term loans involve a non-fixed interest
rate that will add to the additional balance that will
be repaid.
EXAMPLE: SOME NEW COMPANY WILL USE THE
TERM LOAN TO BUY A COMPANY VEHICLE,
DAPAT I-CONSIDER SA TERM LOAN IF ANG
INTEREST RATE BA AY FIXED OR FLOATING
INTEREST CONSIDERING UNG FLOW NG GLOBAL
OR LOCAL ECONOMY. THE HIGHER THE TERM ,
THE HIGHER THE INTEREST.
LEASES – CONTRACT OR PART OF A CONTRACT
THAT CONVEYS THE RIGHT TO USE THE
UNDERLYING ASSET FOR A PERIOD OF TIME IN
ECHANGE FOR CONSIDERATION
PAANO NATIN MALALAMAN, NA MAY RIGHT TO
CONTROL TO USE THE ASSET NI LESSE (SIYA
LANG ANG GUMAGAMIT SI LESSE/CUSTOMER)
1. OBTAIN SUBSTANTIALLY ALL THE ECONOMIC
BENEFITS FROM THE USE OF THE IDENTIFIED
ASSETS – SIYA LANG ANG MAY CONTROL OR
RIGHT TO USE THE IDENTIFIED ASSET/ SIYA
LANG GUMAGAMIT/ SIYA LANG ANG
NAGBEBENEFIT
2. DIRECT THE USE OF THE IDENTIFIED ASSETS –
SIYA ANG NAGDEDECIDE KUNG PAANO
GAGAMITIN ANG IDENTIFIED ASSETS.
2 TYPES OF LEASE
OPERATING LEASE- THIS LEASE DOES NOT
TRANSFER SUBSTANTIALLY ALL THE RISKS
AND REWARDS TO OWNERSHIP OF
UNDERLYING ASSETS -> IBIG SABIHIN HERE,
THE OPERATING LEASE IS THE OWNER WILL
STILL BE THE LESSOR, HE’S STILL THE OWNER
OF THE PROPERTY (HINDI KASI NAPAPASA KAY
LESSE YUNG RIGHTS OF THE PROPERTY) – IT IS
JUST A RENT-TRANSACTION.
FINANCE LEASE – IS JUST A RENT-
TRANSACTION
TRANSFER SUBSTANTIALLY ALL THE RISKS AND
REWARDS OF OWNERSHIP WILL BE TRANSFER TO
THE LESSE (SALE TRANSACTION)
LEASE PAYMENTS- INSTALLMENT PAYMENTS (EX.
RENT-TO-OWN/ OR REAL ESTATE)
CONVERTIBLE DEBT EXAMPLE:
Companies typically take on convertible debt when they believe their
shares will increase in value. This allows them to reduce equity
dilution (giving up too much ownership).
For example, if a business wants to raise $1 million and its shares today
are worth $20, it would have to sell 50,000 to reach its target. With
convertible debt, it can defer (postpone) until shares are worth $50 each
and issue only 20,000.
CASH MANAGEMENT:
INVOLVES THE MAINTENANCE OF APPROPRIATE LEVEL OF CASH
TO MEET THE FIRM’S CASH REQUIREMENTS AND TO MAXIMIZE
INCOME ON IDLE FUNDS. SO HINDI HEALTHY NA MARAMING CASH
NA HINDI NAGAGAMIT, DAPAT GUMAGAMIT KA SA APPROPRIATE
LEVEL. (IT IS A SIN NA HINDI GAMITIN UNG CASH, FOR EXAMPLE
PWEDE MU GAMITIN UNG CASH SA PAG VENTURE OUT NG IBANG
PROJECT PARA LUMALAGO ANG CASH LEVEL).
OBJECTIVE: TO MINIMIZE THE AMOUNT OF CASH ON HAND WHILE
RETAINING SUFFICIENT LIQUIDITY TO SATISFY BUSINESS
REQUIREMENTS.
WHAT ARE REASONS FOR HOLDING CASH/ BAKIT HUMAHAWAK
ANG MGA TAO NG PERA/ OR MAGMAINTAIN NG PERA.
CASH FLOWS: REFERS TO THE MOVEMENT OF CASH INTO OR OUT
OF AN ACCOUNT, A BUSINESS OR AN INVESTMENT
FOR EXAMPLE :
ED’S CARPET IS RUNNING A BUSINESSCASH FLOW IS ESSENTIAL
TO THE SURVIVAL OF HIS BUSINESS AS WELL AS HIS PERSONAL
FINANCES. HAVING AN AMPLE CASH ON HAND, ED’S CAN SURE
PAY HIS EMPLOYEES AND CREDITORS AND HIMSELF ON TIME. HE
NEEDS ENOUGH CASH TO HIS PERSONAL BANK ACCOUNTS TO
PAY FOR HIS HOUSE , CAR AND OTHER PERSONAL EXPENSES.
Cash inflow is the money going into a business. That could be from sales, investments
or financing. It's the opposite of cash outflow, which is the money leaving the business.
CASH INFLOWS – WHEN CASH INFLOWS EXCEED TO CASH
OUTFLOWS, IT IS A GOOD SIGN OF GOOD FINANCIAL FLOW
