Determination of the average price of capital, Capital...

Determination of the average price of capital

The total price of capital is composed of the value of its individual components. The enterprise attracts additional capital to cover various investment needs: implementation of projects, development of production infrastructure, renovation of equipment, etc. Regardless of the total number of investment directions, the structure of the sources of financing for each of them should remain unchanged. Therefore, in the course of investment design, not the prices of individual sources of capital (stock, loan, etc.) are used, but the average price of the aggregate capital of a given structure. The aggregate price of all sources of capital is determined by the formula of the average yield (the average arithmetic weighted). The average amount of capital raising costs obtained in this way

where k i is the price of the corresponding source of capital; w i - the specific weight of a particular source in total capital.

This method of determining the average price of capital is quite simple. However, its application in practice is associated with a number of difficulties, for the overcoming of which additional calculations are required. Among the main problems include such as the heterogeneity of the structure of equity; an increase in the price of individual sources as their volume increases; a variety of methods for calculating the specific weights of individual sources (the weighing problem); different approaches to determining the actual value of capital - at market and book value; the need to account for depreciation.

Determining the price of capital is not the ultimate goal of financial management. Knowledge of WACC allows you to justify investment decisions and form a budget for capital investments. Investments are justified only if their expected return (taking into account the risk) is higher than the price of capital involved in financing these investments.

Capital Structure Management

The formation of the optimal structure of capital, i.e. the establishment of the most favorable balance between own and borrowed sources of financing is an important task of financial management.

By increasing the proportion of relatively less expensive sources, an enterprise can reduce the total price of capital. World practice shows that a cheaper source is debt financing, since creditors are in a more privileged position compared to the owners of the enterprise; they reserve the right to return their investments, and in case of bankruptcy of an enterprise, creditors 'claims will be satisfied much earlier than shareholders' demands.

Attracting borrowed capital creates the effect of a financial leverage (financial leverage). The financial lever characterizes the relationship between operating profit and the amount of income after paying interest on the loan:

where DEL (degree of financial leverage) - level of financial leverage; ΕΒI Τ (earnings before interests and taxes) - profit before interest and taxes; I (interests) - the amount of interest for a loan.

The effect of the financial lever acts in both directions: both towards increasing net profit per share, and in the direction of its decline. In the event that an enterprise increases its financial dependence on creditors, the owners assume additional financial risk, since the interest on the loan must be paid regardless of the results of the work. The higher the amount of interest payable, which is a constant mandatory expenditure, the lower the net profit. Additional risk leads to an increase in the required rate of return on equity. In the situation of bankruptcy of an enterprise, creditors will have advantages over shareholders in obtaining their share in its property. Owners stand last in the queue of applicants for the residual value of the liquidated enterprise. Such a significant increase in shareholders' risk is compensated by an increase in the level of return on equity that the enterprise will provide in case of a successful outcome.

For example, an enterprise that received an operating profit of 12 million rubles. and paid interest for a loan of 3 million rubles, the financial leverage will be 1.33 (12/(12 - 3)). If the degree of financial dependence of the enterprise was twice as high, i.е. he had to pay 6 million rubles. as interest for the loan, the effect of the financial leverage will be 2.0 (12/(12 - 6)). In the first case, an increase in operating profit by 1% will provide owners with an increase in net profit before tax on a per share basis by 1.33%, in the second - by 2.0%. It should be remembered that the same rate will reduce the income of owners in the event of a reduction in operating profit.

Optimizing the capital structure can bring the enterprise a real reduction in its price and make the owners of the enterprise richer. One of the most important factors of this effect is the possibility of classifying interest for a loan as a cost price, in other words - excluding these amounts from the size of the base of taxation of profits. Dividends on shares are paid out of net profit, i.е. the tax shield does not apply to them. However, when deciding to expand the share of debt financing, it is necessary to assess the degree of financial dependence of the enterprise on external creditors and the change in the level of risk.

Also We Can Offer!

Other services that we offer

If you don’t see the necessary subject, paper type, or topic in our list of available services and examples, don’t worry! We have a number of other academic disciplines to suit the needs of anyone who visits this website looking for help.

How to ...

We made your life easier with putting together a big number of articles and guidelines on how to plan and write different types of assignments (Essay, Research Paper, Dissertation etc)