Advances in Finance and Accounting. Dynamic Model WACC

Transcription

1 Dynamic Model IRENA HONKOVÁ Department of Business Economics and Management University of Pardubice Studentská 67, Pardubice CZECH REPUBLIC Abstract: - This article shows the weighted average capital cost being dynamically modeled. The model includes entry independent variables that can be freely modeled (inflation, financial stability, Central Bank rate, expected profitability of banks, tax rate, risk-free interest rate, beta coefficient) as well as dependent ones (cost of foreign capital, cost of equity, corporate and sectorial risk). The model was created within the program VENSIM. The contribution of this model lies in its dynamics. Examples were used to simulate a regular increase/decrease in equity, which reflected an increase/decrease in. Thus, these examples demonstrate the fact that the cost of equity is more expensive than the cost of foreign capital. Key Words: - weighted average capital cost, cost of equity, cost of foreign capital, dynamic model, VENSIM eventually other tangible cost such as the interest paid on corporate bonds. 1 Introduction The article focuses on the calculation of the weighted average capital cost emphasizing the calculation of own cost as its determination can be too complicated for many financial managers to deal with. Many of them wrongly neglect the cost of capital, which may lead to some incorrect financial decisions. The outcome of this study consists in a calculation model of the weighted average capital cost that should help with the orientation in the variables influencing the and relations between them. If the financial manager went in his considerations only this direction, the equity would seem to be for free. This initial incorrect assumption is one of many reasons why firms prefer internal financing: In most industrialized countries, the crucial sources for financing investment of non-financial corporations appear to consist in internal sources. Their share exceeds 50% of investment volume on a long-term basis. [10, s. 22] 2 Problem Formulations The financial management should follow these three main goals: [3, s. 110] a) to ensure an economically reasoned amount of capital budget for investments expected by the company while meeting a required rate of return, b) to achieve the lowest cost, c) not to disturb the financial stability (not to increase significantly the financial risk of the firm), for example by disproportionate involvement of a foreign long-term capital in investment financing. In other words, while selecting the needed capital, each financial manager should try to minimize the capital cost, provided that the financial stability will be complied. Furthermore, it is necessary to realize that the capital cost is not only the interest on bank loans, In 2000, internally generated sources participated in a total investment of non-financial companies in the USA more than 76%. [1, s. 378] Another reason why firms prefer equity to a foreign capital can be a kind of comport of financial managers who choose the easy use of the internal capital and the fact, that this way is also popular with other companies, supports such a decision. Sometimes the reason can consists in the inadequate information system. [7, s. 81] The approach, that is not based on rational considerations, does not reflect an economic development. Not only the cost and equity are not of a zero value but they are even higher than the cost of foreign capital! ISBN:

2 Therefore, it is necessary to include both cost of equity and foreign capital in the calculation, which is counted as follows: where: (1) represents the weighted average cost of capital, R D is the cost of foreign capital, t is a tax rate on corporate income tax, D is a foreign capital, E is equity R E is the cost of equity. 2.1 Cost of equity The cost of equity can be evaluated in an alternative way. Its objective essence consists in the use of so called opportunity cost (the cost of missed opportunities). Generally, the cost of equity can be determined either on the basis of market approaches or methods and models based on accounting data. The basic methods for estimating the cost of equity are: [2, s. 110] - Capital Asset Pricing Model CAPM, - Arbitrage Pricing Model, - Devident Growth Model, - Stable Models. In this study, a combination of methods CAPM and APM was used, based on a so called risk premium: (2) where: r is the required rate of return, r f is a minimum required rate of return with a zero risk, such as a profit of government bonds, β is the change in profitability of company shares, if the profitability of the entire capital market changes, it will reflect the business risk, r m is the required profitability of the market. The risk-free rate and risk premium together generate the cost of company capital. [4, s. 167] A macroeconomic factor of inflation, microeconomic factors of debt and overall financial stability were taken from the method APM. Dividend model was not suitable for modeling since it is based on regular dividend payments. However, only few businesses can be currently found, in the conditions of the Czech Republic, regularly paying dividends. Furthermore, the amount of paid dividends fully reflects the requirements of shareholders for capital appreciation and they no longer expect, except of dividend payment, any increase in a stock exchange. [10, s. 119] Nevertheless, no modular method for the calculation of equity cost, based on accounting data, was selected as the existing methodology is very lengthy and the purpose of this study is mainly to find a quick and easy way to calculate. For those interested, a detailed procedure is described in [5, s. 325] 2.1 The cost of foreign capital The cost of foreign capital can be substituted with an average interest rate determined on the basis of the size and price of individual loans accepted by the company. This work, however, analyzes this common bank rate to reflect the above mentioned company financial stability, inflation and also the situation on the capital market (by the rate of Czech National Bank). 3 Problem Solution The cost of equity (in a model called expected return of R E ) is the sum of rates representing particular risks: Re = risk-free rate + additional charge for corporate risk + additional charge for sectorial risk (3) while the corporate risk was counted as a product of the coefficient of financial stability and the beta coefficient and the sectorial risk is consistent with the beta coefficient. The cost of foreign capital (in the model called the nominal interest rate R D ) was considered to be ISBN:

3 the rate of bank interest calculated as the sum of real interest rate and inflation, while the real interest rate was the sum of the Czech National Bank rate (CNB rate) and the expected profit of the bank weighted by the financial stability of the company: R d = financial stability of the company * (CNB rate + expected profitability of the bank) (4) A calculation model of weighted capital cost was created (fig. 1,2,3) and the contribution of this model consists in its dynamics, i.e. it models in time depending on the change of capital structure (fig.4,5). The model was created in the program VENSIM. Fig. 1 Causes tree () t i m e The CNB rate, expected profitability of the bank, financial stability of the company, risk-free rate, beta coefficient and the tax rate act as independent variables in the model of inflation. The values of all independent variables in the program can be increased or decreased with arrows to observe the development of, which is beneficial for making financial decisions. Dependent variables in the program represent the cost of foreign capital, real interest rate, cost of equity, corporate risk and the sectorial risk. Simulations of the given model were carried out at displayed values corresponding with today s economic reality, while the coefficient of the company financial stability with the value of 1 means maximum financial health of the company. With the increasing risk, this coefficient would increase and its level would be a subject to expert estimates. The sectorial risk was determined by the value of 0,2 that corresponds with the good economic situation of the company/industry. The output of the model consists in the expected increase in due to the involvement of equity by 10% in regular period, while during the initial period, the ratio of the foreign capital and equity was balanced. Under these assumptions, it is possible to say that the involvement of equity increases the price of the total weighted capital cost (fig. 4). If the share of foreign resources increased, the cost of capital would reduce as shown in fig Conclusion The contribution of the article lies in a model that can simulate the average weighted capital cost. A financial manager can get an idea about how much the capital will cost. Determination of the capital cost, especially the cost of equity, meant a very complicated calculation until now. Thus, the summary of current theoretical knowledge contributed to creating a model in the program Vensim that would remove such a problem. Independent variables in the model that are, as mentioned above, the inflation rate, CNB rate, expected profitability of the bank, financial stability of the company, risk-free rate, beta coefficient and the tax rate, can be freely changed according to the varying conditions on the market or by simple simulations of expected scenarios. That enables to observe various changes reflecting the resulting cost of capital and allows the manager to make a correct decision on the choice of capital. The greatest advantage lies in its dynamics, which means that any variable in the model can be simulated in time. The above examples (figure 4 and 5) were simulated by changing the proportion of the total equity capital in each period by 10%. This led to a gradual increase in the average weighted capital cost (fig.4) in the case of increasing the equity and reducing average cost while reducing the equity share (fig. 5). The reality, that the involvement of equity makes the total capital more expensive, is a well-known fact and a sufficient proof of the model correctness. Monitoring the capital cost is very important for the company as the amount shows the efficiency of capital structure choice. Therefore, every company should choose the cheapest capital combination not to increase the cost of financing their needs. References: ISBN:

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5 Appendix Fig. 2 The initial model (the same ratio of equity and foreign capital) ISBN:

6 Fig. 3 Running model (initial state) ISBN:

7 Fig. 4 The progress of in involving the equity t i m e 1 Fig. 5 The progress of in involving the foreign capital t i m e 1 ISBN: