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  • Jerry Taylor

    By Jerry Taylor, Full-Time Faculty, Kaplan University  
    Published October 2016

    In some way, shape, or form (as they say) the time value of money is at the heart of all things financial. First I would defend this by saying if you are talking finance you are talking money or what money has or will buy. Our entire accounting system measures the activity of a business by representing the activity with money. All those numbers on all those financial statements are almost always money. Sometimes they will have a word or two about "units" (e.g., 500,000 widgets) but soon thereafter they will convert those units into money by multiplying by the selling price or cost.

    Travel the world-dollars, pounds, yen-it is all the same, we measure activity and even success with money. One must also keep in mind that other important variable: time!

    Now all the fuss about this money is based on this concern we have with time and risk. We are now becoming familiar with one of the terms used to define this time value of money known as the Cost of Capital (or COC).

    For a company, COC may be loosely defined as the percentage cost of long-term funds employed in the business, that is, the percentage cost of the firm's capital structure. The term capital structure refers to the mix of long-term debt and equity employed by the company for its long-term (some say permanent, which I do not prefer as I do not see anything in the firm as permanent) financing needs.

    The COC structure is critical in making capital budgeting decisions. Medium to large size companies (and small companies that use capital equipment [for instance, long lasting machinery that normally is key to the production process of their product]) are constantly making capital decisions, such as:

    • Replacement or major repair to equipment
    • Expansion of capacity
    • New product lines requiring new equipment
    • New technology
    • New cars and computers (support technology)
    • Acquisitions
    • Etc.

    I am sure in your specific organizations you can think of several specific items.

    There are many COC measurements companies use. The Average COC (ACC) is defined as the weighted average after-tax cost of new capital raised in a given year. The Marginal COC (MCC) is the weighted average after-tax cost of the last dollar of new capital raised in a given year. The MCC is the ACC at the margin. These and other measures of COC are used to make capital budgeting decisions (like those listed above) and in capital structure management.

    Capital structure management requires the selection of the mix of debt and equity that will minimize the companies COC. That must be done in a financial world that does not forgive extremely high leverage, meaning you cannot fund yourself completely with cheaper debt. Lenders require the comfort of equity, they require a substantial investment by owners before they will risk their money on loans. Remember junk bonds? Those are associated with what are called "highly leveraged firms,"-companies whose capital is primarily provided by debt. When you get highly levered (too much debt) the cost of debt will be very high.

    By the way, why is debt normally thought of as cheaper? First, because interest expense is tax deductible dividend are not. Also to maintain an attractive stock price requires continuing interest in a stock-a $50 stock does not sell for $50 if no one will pay $50 for it. So investors must see gain over the long run either through aggressive dividends or an increasing stock price. Equity holders over the long run require a higher return than debt holders, as they take more risk. Hence equity is more expensive than debt. Investors must choose in which financial assets they will invest. They set the prices for these financial instruments that make up a company's capital structure and hence the market creates a firm's COC. The "price" is a function of time and risk…sounds familiar?

    The value of financial asset is the present value of the expected future cash flows from that asset. The appropriate discount rate, or capitalization rate, is the minimum rate of return necessary to induce investors to buy or hold assets. According to the capital asset pricing theory, the higher the risk involved in investing in an asset, the higher will be the appropriate discount rate.

    The appropriate discount (capitalization) rate is the risk-free (Rf) rate of return plus a risk premium (Rp) (K= Rf + Rp, use whatever alphabet characters you like, it does not matter ). Graphically this would be a line sloping up from the Y axis where the Y intercept would be the Risk Free Rate (U.S. Government Securities) and the line would rise over the X axis as the risk level increased. The slope and intercept of the capital market line shift as a result of shifts in investor expectations for inflation, future economic uncertainty, and attitudes toward risk.

    Draw the line I am describing:

    • Y axis consists of interest rate beginning at zero at the Y/X intercept and rising to whatever and the X axis some measure of degree of risk, again starting at zero and growing.

    Now, change the line as Rf interest rates rise and fall and change the slope of the line as investors' perception of market risk changes (Rp). As you watch the daily news you see that interest rates can change a little every day and so too will the performance of the stock market. This line can be quite mobile. But unless you are very active in the capital markets this activity does not warrant constant attention when measuring a firm's COC.

    The value of a bond is the present value of future interest payments plus the present value of the par value (the amount) paid at maturity. The value of a share of preferred stock is the value of the constant annual dividend payments divided by the discount (capitalization) rate. The value of a share of common stock is the present value of all the expected future dividends, assumed to be growing at some rate. The efficient market hypothesis maintains that the market prices of financial assets are normally in equilibrium.

    Now if that does not get me some questions I do not know what will.

     

    Jerry Taylor is a full-time faculty member at Kaplan University. The views expressed in this article are solely those of the author and do not represent the view of Kaplan University.

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