1. The Corporate Form and the Cost of Capital
CHAPTER 17
The Corporate Form and
the Cost of Capital
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2. Economic Profit and Capital Markets
Weighted average cost of capital (WACC)
Cost of capital
Combination of its payment to the different sources
Determined in the capital markets by the interaction of buyers and sellers
WACC = [cost of debt](debt/total capital) + [cost of equity](equity/total capital)
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3. Table 17.1
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4. Table 17.2
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5. Stocks Shares, equity, or stock Preferred shares
Ownership of a piece of a company
Technically, owning a share of everything the firm owns
Share of the company’s earnings
Preferred shares
Guarantee a fixed annual payment - dividend
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6. Stocks Common stock Firm sells or issues shares of stock
May or may not provide dividend
Firm sells or issues shares of stock
The dollars raised is the firm’s capital
Once the shares are owned by investors
Can be bought and sold in the secondary market
Do not provide capital to the firm
Determines the price of stocks
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7. Business Insight Stocks
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8. Business Insight Stocks
Columns 1 and 2: 52-week high and low
Highest and lowest prices at which the stock has traded over the previous 52 weeks (one year)
Column 3: Company name and type of stock
Name of the company
Common stock: No special symbols or letters
Different classes of shares: Different symbols
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9. Business Insight Stocks
Column 4: Ticker symbol
Unique alphabetic name that identifies the stock
Column 5: Dividend per share
Annual dividend payment per share
Column 6: Dividend yield
Percentage return provided by the dividend
Annual dividends per share divided by price per share
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10. Business Insight Stocks
Column 7: Price/earnings ratio
Divide the current stock price by the earnings per share for the last four quarters
Column 8: Trading volume
Total number of shares traded for the day, in hundreds
Columns 9 and 10: High and low for the day
Price range within which the stock has traded that day
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11. Business Insight Stocks
Column 11: Close
Last trading price recorded when the market closed for the day
Column 12: Net change
Dollar value change in the stock price from the previous day’s closing price
Stock index
Measure of the price movements of a group of stocks
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12. Business Insight Stocks
Dow Jones Industrial Average (DJIA)
30 companies
Standard & Poor’s 500 (S&P 500)
500 companies
All major areas of US economy
Nasdaq Composite Index
All companies listed on the Nasdaq stock exchange
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13. Stocks Demand for stocks Return to a shareholder
Investors: individuals, mutual funds, other institutions (insurance companies)
Looking for the highest return on their funds
Return to a shareholder
Dividend the stock pays
Plus the appreciation in the price of the stock
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14. Stocks Supply of a stock Buyers and sellers
Current shareholders who want to sell their shares of stock (secondary market)
New issues of stock (primary market)
Buyers and sellers
Evaluate the firm’s stock
Comparison with comparable investments
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15. Stocks Changes in demand for and supply of a stock
Due to the expected performance of the company
Investors – expect the price of the stock to rise more
Increase in demand
Decrease in supply
Higher price
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16. Bonds Bond Fixed-income security, debt security
An IOU issued by a borrower to a lender
Buying newly issued bonds = lending money to the borrower
Buying a bond that is not a new issue
Own a portion of the debt obligation of a company
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17. Bonds Bond’s maturity date Bond’s face or par value Cupon
Specified time at which the borrower will repay your loan
Bond’s face or par value
Amount that the lender will be repaid once the bond matures
Cupon
Interest payments the borrower pays the lender until the bond matures
Fixed amount
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18. Business Insight Bonds
Column 1: Issuer
Company, state (or province), or country that issued the bond
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19. Business Insight Bonds
Column 2: Coupon
Fixed interest rate that the issuer pays to the lender
Column 3: Maturity date
Date when the borrower will pay the lenders (investors) their principal back
Column 4: Bid price
Price that someone is willing to pay for the bond
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20. Business Insight Bonds
Column 5: Yield
Annual return until the bond matures
Amount of interest paid on a bond divided by the price
Measure of the income generated by a bond
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21. Bonds Demand for bonds Supply of bonds
Investors looking for the best return on their savings
Supply of bonds
Companies, governments, and other institutions
Offering new issues of IOUs (primary market)
Investors owning previously issued bonds who want to sell (secondary market)
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22. Bonds Bond prices and interest rates
Inversely related
When interest rates rise, bond prices fall
Expectations of a firm’s performance decline
The bond price falls
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23. Capital Structure Capital structure Optimal capital structure
Ratio of debt to equity
Optimal capital structure
Specific ratio that minimizes the cost of capital while maximizing the stock price
Higher debt to equity ratio
More likely failure or bankruptcy
Lower tax payments
Reduced flexibility and increased risk
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24. CAPM Cost of capital for a firm Capital asset pricing model, CAPM
Cost of a risk-free investment + equity premium
Capital asset pricing model, CAPM
E(RA) = Rf + β[E(Rm) − Rf]
E(RA) - expected return on firm A’s stock
Rf - risk-free return
β[E(Rm) − Rf] - equity premium
E(Rm) - expected return on all investment opportunities
Β - volatility of the firm’s stock relative to the market as a whole
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25. CAPM Riskiness of a firm
How well the stock behaves relative to other stocks
Countries in which the firm does business
Rules and regulations imposed on businesses by governments
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26. Internal Use of Capital
Accept an investment proposal
If the present value of the expected future cash flows from the investment
Is greater than the present value of the cost of the investment
Net present value (NPV) of a project
Present value of revenues less the present value of costs
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27. Internal Use of Capital
Net present value approach – problems
Division managers - incentive to fiddle with cash flow projections until NPV > 0
Managers’ forecasts of future revenues
Depend on advertising and sales promotions
Costs of these promotions - not considered to be costs associated with the capital requests
Upward bias
Ignoring the cost of capital
Treating capital as if it were free
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28. The Corporate Form Corporate form Millions of individuals
Voluntarily entrust billions of dollars of personal wealth to the care of managers
Complex set of contracting relationships that define the rights of the parties involved
Stockholders take on the risk of ownership
No role in the control of the firm
Holders of common stock – minimize risk
Create their own individual portfolios
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29. The Corporate Form Trade-offs and costs
Owners have no control of the company
Problem of separation of ownership from control
Requirement: behavior of managers to be aligned with what owners want
When the governance breaks down or the architecture becomes inefficient
Cost of capital rises
Firm has to either change or exit the business
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30. Debtholders versus Equityholders
Some corporate decisions
Increase the wealth of stockholders
While reducing the wealth of bondholders
Increase the wealth of bondholders
At the expense of stockholders
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31. Debtholders versus Equityholders
Balance
Bondholders - monitor the stockholders
Ensure that the wealth of bondholders is not transferred to the stockholders
Stockholders - ensure that the optimal amount of risky projects is undertaken
Restrictions written in contracts
Bond covenants - provide some control of the bondholder–stockholder conflict
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