PowerPoint Slides prepared by: Andreea CHIRITESCU

Eastern Illinois University

The Corporate Form andthe Cost of Capital

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CHAPTER 17

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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Table 17.1

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Table 17.2

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Stocks• Shares, equity, or stock

– 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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Stocks• Common 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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Business InsightStocks

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Business InsightStocks

• 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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Business InsightStocks

• 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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Business InsightStocks

• 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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Business InsightStocks

• 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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Business InsightStocks

• 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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Stocks• Demand for stocks

– 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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Stocks• Supply of a stock

– 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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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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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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Bonds• Bond’s maturity date

– 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 17

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Business InsightBonds

• Column 1: Issuer• Company, state (or province), or country that

issued the bond

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Business InsightBonds

• 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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Business InsightBonds

• 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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Bonds• Demand for 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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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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Capital Structure• 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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CAPM• Cost of capital for a firm

• 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 whole24

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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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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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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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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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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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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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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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