Calculate the after-tax rate of borrowed capital. Determining the cost of borrowed capital
Almost every enterprise has two sources of financing its activities: own capital and borrowed capital. Borrowed capital becomes especially important for those enterprises that are rapidly growing and developing, but at the same time raising their own funds is not organized as quickly as the pace of production is growing. Borrowed capital also turns out to be an irreplaceable source of financing in cases where it is necessary to implement any investment program to modernize (improve) production, develop new types of products, expand its market share, or even acquire another business.
How does borrowed capital affect enterprise funds?
It often turns out that the company's borrowed capital is greater than its own. In this regard, the main functions in financial management are competent management and a clearly structured accounting system, which helps to track and record borrowed funds and borrowed capital of the organization.
Borrowed capital in an organization characterizes the entire volume of financial obligations in a particular enterprise.
The borrowed capital of an enterprise is part of the cost of property that was acquired on the basis of obligations to return funds or other valuables to the supplier or bank that will correspond to the value of this property.
The borrowed capital and assets you own may be:
- long-term - these are loans and borrowings that the organization must repay no earlier than in 12 months (debt on a tax credit, on issued bonds, on financial assistance, and so on);
- short-term - obligations whose repayment period is less than 12 months (wage arrears, mandatory payments, debts to suppliers and other types of debts). Short-term loans and borrowings and accounts payable are sources of formation of current assets.
Forms of debt capital
- funds expressed in national currency;
- funds denominated in foreign currency;
- commodity form (including deliveries made with deferred payment);
- rental of fixed assets, including intangible assets with deferred payment.
Any enterprise independently selects suitable methods and forms for attracting borrowed capital, based on its goals and the specifics of the organization’s work.
Debt capital as a method of financing: advantages and disadvantages
Debt capital is the attraction of financial resources, which for many companies is the only way to solve problems. It is important to take into account the positive and negative aspects of such operations.
Advantages of debt capital
- expanding the choice and range of opportunities of the organization;
- rapid increase in the financial potential of the company;
- accessibility and relatively low cost;
- possibility of increasing profitability.
Disadvantages of debt capital
- the risk of reducing the financial stability of the organization;
- complex registration procedure;
- dependence of costs on market conditions;
- a decrease in company income due to interest on the loan.
Main sources of borrowed capital
The formation of borrowed capital occurs by raising funds from various sources, which include the following.
Bank loans. The use of borrowed capital always involves payment of an interest rate. It is very important to understand that you should not hope for a low rate during a crisis. It is thanks to high interest rates that the bank tries to protect itself and compensate for the level of risks. No one in the market will offer you cheap money. In this regard, before you decide to visit the bank, try to analyze the financial situation at the enterprise and understand whether your organization can cope with additional fees on loan rates or not. At the same time, the size of the rate is directly affected by the amount of borrowed capital.
For the most part, interest rates on loans are acceptable for modern enterprises. Of course, profits are reduced, but this does not lead the company to bankruptcy. However, for a young company, the loan rate can be a death sentence.
In order to compensate for risks, the bank uses not only lending rates. In addition, bank employees may refuse to receive funds on terms convenient for you, adhering to a conservative policy. Of course, this is not a complete refusal to lend, but still, to increase your chances, it is better to take the following steps:
- contact several different banks;
- try to find friends who will help you;
- get to know the bank staff better - this may help you obtain additional important information;
- prepare a presentation that will demonstrate why you need these funds and whether your company is able to meet the loan rate;
- be prepared to talk about your business in a generally beautiful and competent manner;
- You can team up with some other organizations to get a joint loan. In Russian business practice, this method is used quite rarely, but abroad it is very common. If enterprises turn to the bank as a “single asset” (in connection with cross-guarantee), the chances of attracting borrowed funds increase by approximately 1.5-2 times.
The main principles for providing a loan are:
- security;
- repayment;
- payment.
At the same time, the set of such principles remains unchanged in a crisis situation. Under normal economic conditions, a bank might not pay as much attention to any aspect, but in difficult times there is always greater scrutiny.
In the modern world, in order to hope to receive a bank loan, it is not enough to simply collect the necessary documents and submit them for consideration. You need to be prepared to be able to convince the lender and prove to him that you are able to repay this loan.
Private investment. Private investments work at absolutely any stage of market development, and the crisis period is no exception. However, in today’s world there is one nuance - if previously companies could count on raising borrowed capital for 10% of shares, today almost any investor requires a controlling or at least a blocking shareholding, which means that he automatically becomes a co-owner of this business.
The main differences between investment funds and private investors lie in the amount in which borrowed capital can be expressed in the organization's balance sheet, in other words, in the monetary equivalent that can be provided by investment funds, and in the minimum amount of profit that they plan to receive. So there are two key points to know:
- individuals and funds are interested in completely different investment objects;
- For owners of small organizations that belong to medium and small businesses, it is preferable to apply for borrowed funds from private investors. In this case, the chances of receiving a small amount are high. In addition, this loan may not imply the provision of shares or a share of one's company in exchange for borrowed funds.
If an organization requires a relatively small loan (no more than a few tens or hundreds of US dollars), then it has to look for an investor on its own. It is important to consider that this requires a large amount of time.
To be able to firmly count on attracting borrowed capital from a private owner, you need to ensure that two main conditions are met.
The first is to maintain records and comply with all international financial reporting standards. If there is the slightest violation, you can not hope for a productive conversation with a potential lender.
Compliance with the second condition implies a system of soft financial modeling, that is, the investor must understand what will happen to the products in which he has invested money under various changes in market conditions.
At the same time, one must not only try to demonstrate the imposition of a strictly defined budget on optimistic and pessimistic market situations, but also work out different scenarios.
The chances of receiving a loan do not depend in any way on the industry in which the enterprise exists. Private investors are looking for promising projects to invest and increase their funds, without limiting themselves to cooperation only in the form of a private loan or the sale of a company. Other interesting forms of lending are also possible on various conditions.
There are also other sources.
- Raising money from the stock market. However, it is worth noting that nowadays raising capital by placing shares on the stock exchange is not an effective method. The main reason is the absence of investors on the market who are ready to purchase shares and bonds of companies (including very well-known ones), since not only future profits are in question, but there are also no guarantees that there will be no losses.
- Alternative sources of funds.
If it is not possible to raise funds through a bank or any investor, then you can turn to the state for help.
Lending at the expense of counterparties. You can attract borrowed capital at the expense of counterparties. At the same time, it is realistic to agree on the longest possible payment terms. This opportunity depends only on your communication skills. Lending through taxes is also possible. In case of delay in tax payments, the company must pay a penalty (1/300 of the refinancing rate of the Central Bank of the Russian Federation for each day of delay).
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Stage-by-stage attraction of borrowed capital
Analysis of the attraction and use of borrowed funds in the previous period or in practice. This action is carried out in order to identify the volume, form and composition of borrowed funds that will be attracted to the company. You also need to evaluate later the effectiveness of using these funds. The analysis includes several stages.
First stage. First, you need to study the dynamics of the total volume of funds raised for the reporting period, that is, determine the borrowed capital and compare the rate of dynamics of its attraction with the rate of growth of equity capital.
Second phase. It is necessary to determine the main forms of raising funds for a loan, while analyzing the dynamics of the share of the total amount of borrowed funds used by the company.
Third stage. It is necessary to determine the ratio of the volume of borrowed funds by the period of their attraction. To do this, borrowed funds are grouped according to this criterion and the dynamics of the organization’s long- and short-term funds are studied, their compliance with the size of current and non-current assets used by the enterprise.
Fourth stage. Within its framework, the composition of the company’s specific lenders is studied, the conditions under which various loans were provided, and then an analysis of these conditions is carried out from the perspective of the commodity and financial markets corresponding to their conditions.
Fifth stage. To complete the analysis, it is necessary to study the effectiveness of the use of borrowed funds.
The main indicators of borrowed capital in achieving this goal are indicators of turnover and profitability of borrowed capital. The first group of these indicators is compared during the analysis with the average period of equity turnover.
The results of the analysis are the basis for assessing the feasibility of raising borrowed funds in existing forms and volumes.
Determining the goals for raising borrowed funds in the coming period. The main goals of raising borrowed funds:
- replenishment of the required volume of the permanent part of current assets;
- ensuring the formation of a variable part of current assets, which is always partially or fully financed by borrowed funds, regardless of the company’s financing model;
- formation of the missing volume of investment resources, provision of social and everyday needs of its employees, as well as other temporary needs.
Determination of the maximum volume of borrowed funds. The maximum volume is determined in accordance with the following conditions:
- the marginal effect of financial leverage, that is, “financial leverage” (the ratio between debt and equity capital);
- ensuring sufficient financial stability of the enterprise.
Taking these requirements into account, the limit on the use of borrowed capital is determined. The cost of raising borrowed funds from various sources (internal and external) is assessed.
The results of this assessment are the basis for making various management decisions aimed at selecting sources of borrowed funds.
Determining the ratio of the volume of borrowed funds raised on a short- and long-term basis. The basis for the calculation is the volume of borrowed funds and the purpose of their use in the current period.
For a long-term period, funds are usually attracted to expand the volume of own resources due to the formation of the missing amount of investment funds.
For a short-term period, funds are raised for other purposes.
The full term of use of borrowed funds is the period from the beginning of the receipt of funds until the final completion of repayment of the total amount of debt.
This period is usually divided into three time periods:
- useful life (the period during which the enterprise uses borrowed funds for business activities);
- grace period, which lasts from the end of the useful use of the funds received until the start of debt repayment;
- repayment period, that is, the period during which the company fully pays the entire amount of the debt, including interest.
The full term of use of borrowed funds is usually calculated in the context of the listed elements based on the purposes of use and the established practice of the financial market in establishing the repayment period and grace period.
Determination of forms of raising borrowed funds. These forms are differentiated in the context of financial credit, commercial (commodity) credit, and other forms. The company chooses forms of raising loans, taking into account the specifics and goals of its business activities.
Determination of the composition of the main creditors. The basis for determining the composition is the forms of borrowing. Basically, creditors are regular suppliers with whom the company has established long and strong commercial relationships, or a commercial bank that provides cash and settlement services.
Formation of effective conditions for attracting loans. The most important and obligatory to comply with these conditions include:
- loan interest rate;
- credit term;
- terms of payment of the principal amount of the debt;
- terms of payment of the interest amount;
- other conditions when receiving borrowed funds.
Ensuring the effective use of loans. The main criterion is the indicators of profitability and turnover of borrowed funds.
Ensuring timely payments for received loans. If the loans are very large, then you can pre-reserve a special repayment fund. The amounts of loan payments are included in the payment calendar and are constantly monitored, while the current financial activities of the enterprise are monitored.
How to calculate the cost of debt capital
The cost of borrowed capital (discount rate) is the weighted average cost of raising financing/capital from various sources. How much does your borrowed capital cost on average? What is the formula for calculating the weighted average cost? The simplest formula looks like this: WACC = WдRд + WaRa, where Wd and Wa are the target weights for debt (d) and equity (owned by shareholders) (a) capital (W from the word weight = “weight”). It is clear that Wd + Wa = 1.0. Rd and Ra are the corresponding cost of capital (R from the word Rate = “interest rate”).
Interest payments on a company's debts are deducted from the tax base on total profits. Some sources that talk about the discount rate often use the phrase “tax shield” (literal translation from English “taxshield”). Taking into account the fact that interest on debt actually reduces the taxation of total income, the WACC formula will finally look like this: WACC = WдRд × (1 T) + WaRa, where T is the tax rate on profit, which is expressed in shares of a unit.
For example, if the Russian profit rate is 20%, then the value (1 - T) is equal to 1 - 0.2 = 0.8. At the same time, the “tax shield” effect slightly reduces the average cost of capital.
Wd is the share of debt capital in the total (sum of debt and equity) capital of the company. Accordingly, Wa represents the share of exclusively equity capital in total capital. This indicator is measured in fractions of unity.
- Wd = Debt/(Debt + Equity) – share of borrowed capital;
- Wa = Equity/(Debt + Equity) – share of equity capital.
In order to calculate the ratio of equity and debt capital, you can use the market or book value indicator. Moreover, it is expressed in rubles, and not as a percentage.
If the shares of a particular company are quoted on the market, then the market value of both equity and debt capital should be used. In this case, you need to know that:
- The market value of equity (ordinary shares) for a public company is calculated as the market price of the shares multiplied by the number of shares outstanding;
- The market value of borrowed capital in the case of bonds that are put up for auction should be calculated in the same way as the value of shares outstanding, that is, by multiplying the price by their number. If debt obligations are not traded on the market, then it is necessary to calculate the amortized cost of such financial obligation;
- if the market value of capital is used, then retained earnings do not need to be taken into account separately, since it was previously taken into account in the market value of the shares.
The authors of Western textbooks on finance advise using, whenever possible, the market value of debt and equity capital to calculate WACC. For companies whose shares are not traded on the stock market, you can take the cost of capital from the balance sheet. In this case, equity capital will also include a reserve of retained earnings. It goes without saying that more accurate values of W in this case will be obtained when using financial statements in accordance with IFRS standards.
The simplest way to determine the interest rate on debt capital is the WACC formula. Even if this formula is not spelled out in the agreement (with the bank), then you still know at least the payments associated with the debt obligation. Then you need to determine the internal rate of return (the effective interest rate on the financial instrument). It will also be Rd in the WACC formula. If a company raises funds using different debt instruments, then the interest rates on them can be completely different. In this case, when calculating the WACC formula, it will be necessary to use the weighted average interest rate on all debt obligations.
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How to calculate return on debt capital
The concept of return on borrowed capital means a parameter characterizing the efficiency (profitability, profitability) of the use of borrowed funds. This parameter reflects the real return on funds per ruble. One of the main indicators of profitability is the gearing ratio in terms of its profitability. This parameter is widely used when conducting investment and financial analysis of a company.
The return on debt capital can be calculated using a simple formula. If the parameter is calculated taking into account , then Forms No. 1 and No. 2 can be used.
The peculiarity of this indicator is expressed in the absence of standards. Profitability can only be analyzed in dynamics in relation to the parameters of other organizations that exist in similar or related industries. The greater the return on funds raised, the more effective the management of the enterprise as a whole.
The increase in dynamics reflects an increase in the quality of management of borrowed funds, which helps to increase the investment attractiveness of the organization and the market value of the enterprise (including the cost of issued securities). It is possible to analyze profitability in a comprehensive manner, while simultaneously assessing equity capital.
As an example, we can cite the indicators of the well-known organization PJSC Gazprom (the company’s indicators are in the public domain). This calculation can be made using a simple Excel program. The formula for calculating profitability is as follows: Profitability = C8/(C4 + C6).
Definition cost of borrowed capital includes calculation of the cost of a loan, bond issue and financial leasing. The required rate of return is the annual rates under the loan agreement, lease payment rates and the yield to maturity of bonds.
Cost of debt capital (Kd) calculated by the formula:
where is the standardized loan rate in accordance with tax legislation; - real cost of borrowed capital; - interest rate under the loan agreement; - income tax rate.
2. the cost of borrowed capital must be calculated at the effective interest rate, taking into account the cost of additional costs, the composition and size of which are determined in each case separately. Additional costs include fees for using a loan, issuing and placing a bond issue, for examining a loan agreement, a loan application, for processing a loan, for issuing and maintaining a loan, for opening and servicing a current account, and payments under additional agreements in favor of third parties.
Cost of financial leasing– the annual amount of leasing payments, which includes, in addition to compensation to the lessor for used borrowed funds, commissions to the lessor, payment for additional (auxiliary) services of the lessor, depreciation of property for the entire term of the contract. Since depreciation is not a direct expense of the lessee to attract leasing, it is excluded from the amount of leasing payments and the cost of leasing is calculated using the following formula:
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where is the cost of capital raised through financial leasing; - annual rate of leasing payments; - income tax rate; - rate of depreciation.
The cost of borrowed capital raised through the issue of bonds is determined by the yield to maturity at which the company was able to place bonds, minus the relative costs of placement.
Having received the current value of each source, you can calculate current value of total capital corporation, used as a discount rate when assessing the effectiveness of the company's investment decisions.
The current total market value of a commercial organization (V t) can be found using the formula:
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The above formula gives an approximate estimate; more accurate calculations require a separate assessment of the market value of equity and borrowed capital and summation of the results obtained.
The formation of a rational structure of funds is influenced by the following factors:
The growth rate of the organization's turnover, requiring increased financing due to an increase in variable and possibly fixed costs, an increase in accounts receivable, inflation and other costs;
The level and dynamics of profitability, since the most profitable organizations have a relatively low share of debt financing on average over a long period;
Asset structure. If an organization has significant general purpose assets, which by their nature can serve as collateral for loans, then the share of borrowed funds in the liability structure increases;
The severity of taxation;
Attitude of creditors to the organization;
State of the capital market.
Capital structure has a direct impact on the market value of the enterprise. The market value of a going concern is determined by estimating its future cash flows. The calculation involves choosing a discount rate based on the rate of return and assessing the expected risk.
The determination of the market value of the organization is carried out
in several stages:
At the first stage, the expected value of the company's current profit for a long period is predicted. Current earnings are earnings before interest but after taxes. This ensures independence of the size of cash flows from the structure of sources of financing the current activities of the enterprise. Then the current profit is increased by the amount of written-off depreciation of fixed capital and intangible assets and by the amount of deferred taxes, and other elements that are not reflected in cash flows are also taken into account.
At the next stage, the total amount of future capital expenditures necessary to ensure production activities and maintain the current level of profit of the organization is determined. These include the costs of purchasing machinery and equipment, conducting scientific research, and increasing working capital.
As a result, the enterprise's net cash flows are obtained, which are used in assessing its market value.
Net cash flows- the capital of an enterprise, which is at its disposal and can be used to fulfill the company’s obligations to investors (for the payment of interest, dividends, debt repayment and repurchase of its shares).
Market value of the company (V) equal to the net present value obtained by discounting the sum of the net cash flows at an acceptable rate of return. V=Dlr.
The income here is the profit before interest and taxes, reduced by the amount of income tax and other mandatory deductions from profits.
The weighted average cost of capital (W) is used as an acceptable rate of return. This is due to the fact that the enterprise annually receives the same level of income, which is used to cover the costs of servicing sources of capital formation, which include payments of dividends to shareholders and interest to creditors. If we assume that all net profit is distributed among shareholders, then the total level of company expenses for servicing sources of capital formation is equal to the weighted average cost of capital.
Borrowed capital, borrowed financial resources– these are funds and other property raised to finance the development of an enterprise on a repayable basis.
Sources of debt financing: bank loan, financial leasing, commodity (commercial) loan, bond issue and others.
Structurally, borrowed capital consists of: short-term (up to a year) – current accounts payable and long-term (more than a year) – advances, subsidies.
Efficiency of investment of borrowed capital determined by the degree of return on fixed or working capital.
Cost of borrowed funds of the enterprise.
The cost of borrowed funds (unquoted bonds or long-term loans not in the form of marketable securities) is determined by calculating the present value of the outstanding principal and interest payments. The discount factor can be found based on the actual yield of similar financial instruments traded on the market, or (in the absence of the latter) based on the average effective interest rate on newly received loans, adjusted for tax deductions.
The weighted average cost of resources attracted to finance investments depends not only on the cost of various types of resources, but also on the share of each resource source in their total volume.
Question 95. The structure of the enterprise’s own funds and their value.
Own capital structure- the amount of authorized, reserve and additional capital, as well as retained earnings and targeted financing.
Authorized capital (fund) enterprise determines the minimum amount of its property, guaranteeing the interests of its creditors. Authorized capital is the main source of enterprises' own funds. Its minimum size is determined in accordance with the legally established minimum wage (minimum wage) in the country. Minimum amount of authorized capital (fund):
open joint-stock company - 1000 times the minimum wage;
closed JSC and LLC - 100 minimum wages;
state unitary enterprise - 5000 minimum wage;
municipal unitary enterprise - 1000 minimum wage.
Extra capital is the second fund of own funds. It accumulates funds received by the company during the year, since it is impossible to include them in the authorized capital at this time. At the end of the year, additional capital should be converted into authorized capital, but this is done by a small number of enterprises.
The following funds are included in additional capital:
revaluation of fixed assets in accordance with;
share premium received from the excess of the actual placement price over the par value of shares as in the case of an initial placement;
some other amounts (exchange differences).
The following reduces additional capital:
depreciation of fixed assets;
sale, gratuitous transfer; liquidation in case of accidents, natural disasters, emergencies and write-off of fixed assets due to moral or physical wear and tear, etc.
Reserve Fund is created in the joint-stock company in accordance with the provisions of the charter, but not less than 5% of the authorized capital. It is formed from net profit through annual mandatory contributions in the amount of at least 5% of the net profit until the amount provided for by the charter is reached.
The reserve fund is intended to cover the losses of the joint-stock company, as well as to repay bonds and repurchase shares of the company in the absence of other funds.
Retained earnings. Characterizes the part of the enterprise's profit received in the previous period and not used for consumption by the owners (shareholders, shareholders) and staff. This part of the profit is intended for capitalization, i.e. for reinvestment in production development. In terms of its economic content, it is one of the forms of reserve of the enterprise’s own financial resources, ensuring its production development in the coming period.
Cost of equity – the net worth of the business (or the value of the company's total capital minus debt) at the valuation date. To determine S.s.k. methods of direct calculation of the cost of equity capital, the cost of capital assets, arbitrage pricing, etc. are used.
The modern market economy contributes to the formation of the value of the property of any organization. This indicator is created under the influence of various cash flows. In the course of its activities, the company uses its own and borrowed capital. All these cash flows flow into the organization’s funds and form its property.
WACC is an indicator of the cost of each individual source of financing the company's activities. This ensures normal execution of technological cycles. Controlling the cost of capital sources allows you to increase profits. Therefore, this important coefficient is necessarily considered by analysts. The essence of the presented method will be discussed below.
General information
Weighted average cost of capital (WACC) is a measure, which first began to be considered by analysts in the middle of the last century. It was introduced into use by the likes of Miller and Modigliani. It was they who proposed considering the weighted average cost of capital. This indicator is still defined as the price of each share of the organization’s funds.
To evaluate each source of financing, it is discounted. In this way, the level of profitability and then the profitability of the business are calculated. At the same time, the minimum amount of payment to the investor for the use of his financial resources in the process of the organization’s activities is determined.
Scope of application of the WACC indicator to of the company is determined when assessing the capital structure. Its cost is not the same for each category. That is why the price of each source of financing is determined separately. Returns are also calculated for each individual capital category. The difference between these indicators and the costs of attracting them allows you to determine the amount of cash flow. The result obtained is discounted.
Financial sources
Cost of capital WACC, examples and calculation formula which will be presented below, requires delving into the organization of financing the company’s activities. The assets managed by the organization are presented on the active side of the balance sheet. The funds that formed these funds (raw materials, equipment, real estate, etc.) are indicated in the liability. These two sides of the balance are always equal. If this is not the case, there are errors in the financial statements.
First of all, the company uses its own sources. These funds are formed at the stage of creation of the organization. In subsequent years of work, part of the profit is included here (called undistributed).
Many companies use debt capital. In many cases this is advisable. In this case, the balance model may look like this:
0.9 + 0.1 = 1, where 0.9 is equity capital, 0.1 is credit funds.
Each presented category is considered separately, determining its cost. This allows you to optimize the balance sheet structure.
Calculation
As already said, WACC is a measure of the average return on capital. To determine it, a generally accepted formula is used. In the simplest case, the calculation method looks like this:
WACC = Дс*Сс + Дз*Сз, where Дс and Дз is the percentage indicator of the share of own and borrowed capital in the overall structure, Сс and Сз is the market value of own and credit resources.
To take into account income tax, you need to supplement the above formula:
WACC = Ds*Ss(1-NP) + Dz*Sz, where NP is income tax.
It is this formula that is most often used by managers and analysts of the organization. The weighted average cost is an informative indicator, in contrast to the average cost of capital.
Discounting
Situations on the capital market. In order to be able to correlate the real state of affairs of the company with the trends existing in the business environment, a discount rate is used.
The use of each source to finance the company's work is associated with certain costs. Shareholders are paid dividends, and creditors are paid interest. This indicator can be expressed as a coefficient or in monetary terms. Most often, the cost of financing sources is presented as interest.
The cost of a bank loan, for example, will be determined by annual interest. This is the discount rate. For share capital, this indicator will be equal to the required return that security owners expect from providing their temporarily free funds for the use of the company.
Cost of own sources
WACC is a measure which primarily takes into account the cost of equity capital. Every organization has one. Shareholders buy securities and invest them in the activities of their company. At the end of the reporting period they want to make a profit. To do this, part of the net profit after tax is distributed among the participants. Another part of it is used to develop production.
The more dividends a company pays, the higher the market value of its shares will be. However, without financing its own development, the organization risks falling behind its competitors in technological development. In this case, even high dividends will not increase the value of shares on the stock exchange. Therefore, it is important to determine the optimal amount of funding for all funds.
The cost of internal sources is difficult to determine. Discounting is performed taking into account the return expected by shareholders. It should not be less than the industry average.
Aspects of analysis
Should be considered in terms of market or balance sheet indicators. If the organization does not trade its shares on the stock market, the presented indicator will be calculated using the second method. For this purpose, accounting data is used.
If an organization forms its own capital through freely traded shares, it is necessary to consider the indicator in terms of its market value. To do this, the analyst takes into account the results of the latest quotes. The number of all shares outstanding is multiplied by this figure. This is the real price of securities.
The same principle applies to all components of an organization's securities portfolio.
Example
To determine WACC indicator value, It is necessary to consider the presented methodology using an example. Let’s say a joint-stock company attracted financial sources for its work totaling 3.45 million rubles. It is necessary to calculate the capital ratio. To do this, some more data will be taken into account.
The company's own financial sources are determined in the amount of 2.5 million rubles. Their profitability (according to market quotes) is 20%.
The lender provided the company with its funds in the amount of 0.95 million rubles. The required rate of return on his investment is about 18%. Using the weighted average, the cost of capital is 0.19%.
Investment project
WACC is a measure allowing you to calculate the optimal capital structure for the company. Investors strive to invest their available funds in the most profitable projects with the lowest degree of risk. On the part of the company, financing its activities exclusively through its own resources increases stability. However, in this case, the organization loses the benefits from the use of additional sources. Therefore, some part of borrowed funds should be used by the company for stable development.
The investor evaluates the company's weighted average cost of capital to determine the appropriateness of the investment. The company must provide the most acceptable conditions for the lender. If stability indicators have deteriorated in dynamics, a large amount of debt has accumulated, the investor will not agree to finance the activities of such an organization. Therefore, choosing the optimal capital structure is an important stage in the strategic and current planning of any company.
All of the above allows us to conclude that WACC is a measure weighted average cost of financial sources. On its basis, decisions are made on the organization of the capital structure. With an optimal ratio, you can significantly increase the profit of the company's owners and investors.
The cost of borrowed capital refers to the value of current costs (in relative values - percent per annum) for servicing borrowed capital.
In general, the cost of borrowed capital is determined by the required return on borrowed capital and tax operating conditions. The yield to maturity ratio is influenced by many risk factors.
The main factors influencing the cost of borrowed capital:
The level of interest rates at the moment - with an increase in the interest rate, the cost of borrowed capital increases;
The degree of risk of non-fulfillment of obligations by the borrowing corporation - with an increase in the risk of non-fulfillment of obligations (violation of interest payment deadlines or inability to fully repay the borrowed amount), the costs of servicing such debt also increase as compensation to the lender for the greater risk. One of the methods for assessing the risk of non-fulfillment of obligations is the use of ratings (widely used for bond issues). A higher rating indicates low risk and relatively low costs of servicing borrowed capital;
Tax benefits of borrowing capital. Since the payment for borrowed capital is excluded from the tax base (in Russia, since July 1999, interest payments on the Central Bank refinancing rate, increased by 3 percentage points, are subject to withdrawal from taxation for bonds and bank loans), then the cost of borrowed capital (the cost of all elements of capital are considered taking into account tax payments, i.e. these are post-tax estimates) is a function of the income tax rate. A reduction in tax payments due to payments on borrowed capital (interest payments) leads to a reduction in the real costs of servicing borrowed capital. This advantage becomes more significant as the income tax rate increases. k d = i (1 - t), where t is the income tax rate, i is the annual interest rate on borrowed capital. For example, if a bank loan is attracted at 23% per annum, then taking into account the tax advantages of borrowed capital, the cost of this element of capital k d = 23% (1 - 0.35) = 14.95% (income tax rate - 35%).
It should be borne in mind that the cost of borrowed capital is not:
the established unchanged coupon rate on the previously placed bond issue;
interest rate on a bank loan taken out earlier.
The cost of borrowed capital reflects the current real (actual) costs associated with raising borrowed capital at the moment (not in previous years). The required return on debt capital owners can be estimated as the discount rate /, which equates the current market valuation of the loan with the current valuation of future cash flows:
where D o is the current market valuation of borrowed capital;
t I - interest payments in year f,
D t - debt payment in year t (with loan amortization);
i is the required return on borrowed capital.
If the borrowed capital is repaid at the end of the year in a single amount D, and interest is paid annually in the amount of /, then the required return i is calculated from the equation
For a bond loan, the required yield / is calculated as the discount rate from the equation (when paying coupon income once a year)
where I = N x Coupon rate;
N - bond par value;
n is the bond's circulation period;
i is the yield to maturity.
Two reasons lead to a discrepancy between the required yield and coupon rate on a bond loan:
firstly, the time factor and changes in risk. The coupon rate reflects the required yield at the time of placement (if there are no placement costs, then the par value of the bond is equal to the market price at the time of placement - the coupon rate coincides with the required yield). With a change in risk-free yield and risk assessment of the corporation issuing bonds, the required return changes. The coupon rate does not change, since it is fixed for a certain period (either until the bond matures or for the coupon period);
secondly, the costs of placing a loan. Due to placement costs, the capital raised under a bond loan is less than the nominal value of the loan (the product of the bond's face value and the number of issued bonds).
where N is the number of placed bonds;
F - placement costs per bond.
The required yield at the time of placement can be found using a simplified formula
For example, if a bond with a face value of 1 thousand dollars is placed at a price of 0.94 thousand dollars with an annual coupon rate of 8% and a period of 20 years, then / = 1000 x 0.08 = 80; H = 1000; F= 1000 - 940 = 60; i = (80 + 60/20) / (1000 +1000 - 60)/2 = 83 /970 = 8.56%.
At an income tax rate of 40%, the cost of this element of capital is equal to k d =8.56% (1 -0.4) = 5.14%.