MGF 301 Chapter Notes - Chapter 1: Legal Personality, Limited Partnership, Professional Corporation

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orchidcockroach288

19 Dec 2016

School

University at Buffalo

Department

Management Finance

Course

MGF 301

Professor

Derek Mohr

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Document Summary

Chapter 1 goals and governance of the corporation. = capital expenditure (capex) decision: decision to invest in tangible or intangible assets. Investors receive shares of stock and become share-holders, part-owners of the corporation; investors are equity investors, who contribute equity financing. The form and amount of financing of a firm"s investments. Investors are lenders, debt investors, who one day must be paid, debt financing. Capital = the firm"s sources of long-term financing. A firm that is seeking to raise long-term financing is said to be (cid:532)raising capital(cid:533) Invest: acquire real assets (assets used to produce goods and services) Finance: finance its investment in real assets by issuing financial assets (financial claims to the income generated by the firm"s real assets) to investors. Securities: shares of stock and other financial assets that can be purchased and traded by investors. A business organized as a separate legal entity owned (legally distinct from) by stockholders.

Related Questions

Take a look at and read this article that discusses the cost of capital. What are your thoughts? Elaborate and Explain

Capital for a small business is simply money. It is the financing for the small business or the money used to operate and buy assets. Cost of capital is the cost of obtaining that money or financing for the small business. The cost of capital is also called the hurdle rate.

Should very small businesses even worry about their cost of capital? The answer to that is absolutely yes! Even very small businesses need money to operate and that money is going to cost something. Companies want that cost to be as low as possible.

What is Capital?

Capital is the money businesses use for financing their operations. The cost of capital is simply the rent, or interest rate, it costs the business to obtain financing. In order to understand cost of capital, you must first understand the concept of capital. Capital for very small businesses may just be the supplier credit they rely on. For larger businesses, capital may be the supplier credit and longer term debt or liabilities, which are the firm's liabilities.

If a company is public or takes on investors, then capital will also include equity capital or common stock. Other equity accounts will be retained earnings, paid-in capital, perhaps preferred stock.

Why is Capital Important?

In order to build new plants, buy new equipment, develop new products, and upgrade informationtechnology, businesses have to have money or capital. For every decision like this, a business owner or Chief Financial Officer (CFO) has to decide if the return on the investment is greater than the cost of capital or the cost of the money it takes to invest in the project.

Business owners do not usually invest in new projects unless the return on the capital they invest in these projects is greater than or at least equal to the cost of the capital they have to use to finance these projects. Cost of capital is the key to all business decisions.

What is the Cost of Capital?

A company's cost of capital is simply the cost of money the company uses for financing. If a company only uses current liabilities and long-term debt to finance its operations, then it uses debt and the cost of capital is usually the interest rate on that debt.

If a company is public and has investors, then cost of capital gets more complicated. If the company only uses funds provided by investors, then the cost of capital is the cost of equity. Usually, this type of company has debt but it also finances with equity financing or money that investors supply. In this case, the cost of capital is the cost of debt and the cost of equity.

The combination of debt and equity financing for a company is the company's capital structure.

What is Return on Capital?

Return on capital is the amount of profit you earn out of a business or project as compared to the amount of capital you invested. The key to cost of capital for a company is that a company's return on capital must always equal or exceed the cost of capital for any project in which the firm wants to invest. In other words, the company's investment rate of return (return on capital) must equal or exceed their financing rate of return (cost of capital) in order for the firm to be profitable.

What Composes the Cost of Capital

One component of the cost of capital is the cost of debt financing. For larger businesses, debt usually means large loans or bonds. For very small companies, the debt can mean trade credit. For either, the cost of debt is the interest rate the company pays on debt.

Another component of the cost of capital is the cost of equity financing if your company is a public company; in other words, if you have investors in your company who provide money in exchange for an ownership stake in the company.

There are several components of the cost of equity capital. First, there is the cost of retained earnings or the money that the company invests back into the company, instead of paying outdividends. Next, there is the cost of new common stock or stock that the company issues to raise money. Last, the company may even issue preferred stock to raise money.

For very small firms, the cost of capital may be much simpler. There are advantages and disadvantages to both debt and equity financing, including cost, that any business owner must consider before adding them to the capital structure of the company. Very small firms may just useshort term debt, in which case we have to establish a cost for this capital component.

The Company's Weighted Average Cost of Capital

Once the business owner understands the concepts of capital and cost of capital, the next step is to understand weighted average cost of capital. Each capital component is a certain percentage of the company's capital structure. In order to arrive at the true cost of capital for a business firm, the owner must multiply the percentage of the company's capital structure for each component by the cost of that component and sum them.

Summary of Cost of Capital

Before a company can engage in buying assets or obtaining financing for its operations, it must make some determination of its cost of capital -- what it really costs the firm for the money it has to have to for all its financing. That cost of financing must never exceed its return on capital. Here is a cost of capital video series that you may find helpful. It helps put the return on capital and cost of capital in real world terms for you.

The 2015 financial statements for Growth Industries are presented below:

INCOME STATEMENT, 2015
Sales		$	370,000
Costs			235,000

EBIT		$	135,000
Interest expense			27,000

Taxable income		$	108,000
Taxes (at 35%)			37,800

Net income		$	70,200

Dividends	$ 42,120
Addition to retained earnings	28,080

BALANCE SHEET, YEAR-END, 2015
Assets			Liabilities
Current assets			Current liabilities
Cash	$	6,000	Accounts payable	$	13,000

Accounts receivable		11,000	Total current liabilities	$	13,000
Inventories		33,000	Long-term debt		270,000

Total current assets	$	50,000	Stockholdersâ equity
Net plant and equipment		310,000	Common stock plus additional paid-in capital		15,000
			Retained earnings		62,000

Total assets	$	360,000	Total liabilities and stockholdersâ equity	$	360,000

Sales and costs in 2016 are projected to be 20% higher than in 2015. Both current assets and accounts payable are projected to rise in proportion to sales. The fixed assets of Growth Industries are operating at only 75% of capacity. Interest expense in 2016 will equal 10% of long-term debt outstanding at the start of the year. The firm will maintain a dividend payout ratio of .60.

What is the required external financing over the next year?

Even if sales increase by 20%, the firm still has more than enough fixed assets to meet production. Only working capital will increase. Net working capital of the firm in 2015 was $. The increase in net working capital will be $, which is less than the increase in the retained earnings. Thus required external financing is $. A negative external financing value indicates the firm will generate more cash than it needs to finance the projected growth. This extra cash can be used to reduce debt, repurchase shares, increase cash reserves, or fund future growth. This extra cash was primarily due to the firm's excess production capacity.

The 2015 financial statements for Growth Industries are presented below:

INCOME STATEMENT, 2015
Sales		$	250,000
Costs			175,000

EBIT		$	75,000
Interest expense			15,000

Taxable income		$	60,000
Taxes (at 35%)			21,000

Net income		$	39,000

Dividends	$ 23,400
Addition to retained earnings	15,600

BALANCE SHEET, YEAR-END, 2015
Assets			Liabilities
Current assets			Current liabilities
Cash	$	8,000	Accounts payable	$	15,000

Accounts receivable		13,000	Total current liabilities	$	15,000
Inventories		29,000	Long-term debt		150,000

Total current assets	$	50,000	Stockholdersâ equity
Net plant and equipment		190,000	Common stock plus additional paid-in capital		15,000
			Retained earnings		60,000

Total assets	$	240,000	Total liabilities and stockholdersâ equity	$	240,000

Sales and costs in 2016 are projected to be 40% higher than in 2015. Both current assets and accounts payable are projected to rise in proportion to sales. The fixed assets of Growth Industries are operating at only 70% of capacity. Interest expense in 2016 will equal 10% of long-term debt outstanding at the start of the year. The firm will maintain a dividend payout ratio of .60.

What is the required external financing over the next year?

Answer:

Even if sales increase by 40%, the firm still has more than enough fixed assets to meet production. Only working capital will increase. Net working capital of the firm in 2015 was $_______ . The increase in net working capital will be $________ , which is less than the increase in the retained earnings. Thus required external financing is $________ . A negative external financing value indicates the firm will generate more cash than it needs to finance the projected growth. This extra cash can be used to reduce debt, repurchase shares, increase cash reserves, or fund future growth. This extra cash was primarily due to the firm's excess production capacity.

MGF 301 Chapter Notes - Chapter 1: Legal Personality, Limited Partnership, Professional Corporation

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