Chapter 7

TYPES AND COSTS OF FINANCIAL CAPITAL

1

ENTREPRENEURIAL FINANCE

Determining Cost Of Debt Capital

Interest Rate:price paid to borrow funds

Default Risk:risk that a borrower will not pay the interest and/or principal on a loan

2

Determining Cost Of Debt Capital Nominal Interest Rate (rd):

observed or stated interest rate the rate quoted in loan and deposit agreement

Real Interest Rate (RR):interest one would face in the absence of inflation, risk, illiquidity, and any other factors determining the appropriate interest Is the growth rate of purchasing power derived from an

investment. Real Interest Rate = Nominal Interest Rate – Inflation Example: Earn 4% from saving account ; inflation 3% ; Real

Interest Rate = 4% - 3% = 1% Risk-free Interest Rate (rf):

interest rate on debt that is virtually free of default risk Inflation:

Rising prices not offset by increasing quality of the goods or services being purchased

A rate at which the general level of prices for goods and services is rising but purchasing power is falling

Every dollar will buy smaller percentage of good 3

Determining Cost Of Debt Capital

Inflation Premium (IP):average expected inflation rate over the life of a risk-free loan

Default Risk Premium (DRP): additional interest rate premium required to compensate

the lender for the probability that a borrower will default on a loan

the higher the quality of the loan, the lower the DRP, thus, lower nominal interest rate

Liquidity Premium (LP):charged when a debt instrument cannot be converted to cash quickly at its existing value

Maturity Premium (MP):premium to reflect increased uncertainty associated with long-term debt

4

Interest Rate Relationships

rf = RR + IPfor debt by effectively default-free borrowers (e.g. U.S. government)

rd = RR + IP + DRP +LP +MPmore generally, for more complicated risky debt securities at various maturities and liquidities

rd = rf + DRP + LP + MP

5

Determining Market Interest Rates

rd = RR + IP + DRP +LP +MP Suppose:

Real interest rate = 3% Inflation expectation = 3% Default risk = 5% Liquidity premium = 3% Maturity premium = 2%

Then: rd = 3% + 3% + 5% + 3% + 2% = 16%

6

The Cost of Equity

Dividend Growth Model Approach

7

Do x (1 + g ) D1Re - g Po

D1Re - g

WherePo = price per share of the stockDo = dividend just paid

g = growthD1 = dividend next periodRe = required return of the stock

Po =

Po =

Re = + g

The Cost of Equity

8

Example:

Po = 60 $Do = 4 $

g = 6%D1 = ?Re = ?

D1 = Do x (1 + g)= 4 x 1.06= 4.24

Re = D1 / Po + g= 4.24 / 60 + 0.06= 13.07%

So the cost of equity is 13.07%

The Cost of Equity

9

Estimating g

Year Dividend ($)2005 1.12006 1.22007 1.352008 1.42009 1.55

Year Dividend ($) $ Change % of Change2005 1.1 02006 1.2 0.1 9.09%2007 1.35 0.15 12.50%2008 1.4 0.05 3.70%2009 1.55 0.15 10.71%

9.0%Average g

The Cost of Equity

The Security Market Line Approach Depends on three things

▪ The risk free rate, rf▪ The market risk premium, E(Rm) – rf▪ The systematic risk of the asset relative to

average, which called Beta Coefficient, β E(Re) = rf +βe x (E(Rm) – rf)

▪ Example: rf : 0.2% ; βe : 1.1 ; market premium : 7%

▪ E(Re) = 0.2% x 1.1 (7%) = 7.9%

10

The Cost of Equity

11

Assume the previous example in SML: Do = $0.05 g = 9.45% Po = $2.41

With Dividend Growth Model: D1 = Do (1+g) = 0.05 (1+0.0945) = 0.0547 Re = D1 / Po + g = 0.0547 + 0.0945 =

11.72% Average cost of equity (SML and dividend

approach) Re average = (7.9% + 11.72% ) / 2 = 9.81%

Weighted Average Cost of Capital (WACC)

WACC:weighted average cost of the individual components of interest-bearing debt and common equity capital

V = E + D E = Equity ; D = Debt

100% = E / V + D / V WACC = (E/V) x Re + (D/V) x Rd x (1 – Tc)

Tc = Tax Rate

12

Weighted Average Cost of Capital (WACC)

Example: E = $7.152 million ; D = $2.516 million V = 7.152 + 2.516 = 9.668 E / V = 7.152 / 9.668 = 0.7398 D / V = 2.156 / 9.668 = 0.2602 Re = 7.06% Rd = 3.43% Tc = 18% WACC = 0.7398 (7.06%) + 0.2602 (3.43%) (1-

0.18) = 5.22% + 0.73% = 5.95% WACC for the company is 5.95% 13

Weighted Average Cost of Capital (WACC) If more than 1 debt / cost of debt

E/V = 0.83 D/V = 0.17 Tc = 18% Re = 10.43% Rd = 1.65% WACC = 0.83 (10.43%) + 0.17 (1.65%)(1-

0.18) = 8.66% + 0.23% = 8.89% 14

Bank Term Loan 1,975,800,000 78.356% 1% 0.78356%Convertible Bonds 545,716,000 21.642% 4% 0.86568%Obligation Under Finance Lease 40,000 0.002% 6% 0.00010%

Total 2,521,556,000 1.64934%

Weighted Average Interest Rate

Interest Rate%Amount $Long Term Debt

End

15