CHAPTER 14
Why Cost of Capital Important:(1) ROA depends on risk of
those assets (2) Return to investor is same as cost to company
(3) Provides us with indication of how market views risk of
our assets (4) Knowing it can help determine required return
for capital budgeting projects
Cost of Equity
• Return required by equity investors given the risk of the
cash flows from the firm (two methods to find this)
1. Dividend Growth Model
Advantages: easy to understand/use Disadvantages:(1) only
for companies who are giving out
dividends (2) cant apply if dividends
aren't growing at reasonably constant
rate (3) very sensitive to the estimated
growth rate an increase of g in 1%
increases the cost of equity by 1% (4)
does not explicitly consider risk
2. SML OR CAPM
Advantages:(1) explicitly adjusts for systematic risk (2)
applicable for all companies along as beta is computed
Disadvantages:(1) have to estimate the expected market risk
premium which does vary over
time (2) have to estimate beta
which also vary over time (3)
relying on past to predict
future which isn't always
reliable
Alternative Approach to Measuring Growth
Cost of Debt
• the required return on ours company’s debt, best estimated
by computing yield to maturity on the existing debt, may
also use current rates based on bond rating we expect when
we issue a new debt, cost of debt is not the coupon rate
Cost of Preferred Stock
• generally pays a constant dividend every period, dividends
are expected to be paid every period forever
Weighted Average Cost of Capital (WACC)
• (1) we can use individual cost of capital that we have
computed to get our average cost of capital for the firm (2)
this average is the required return on our assets, based on
markets perception of the risk of those assets (3) weights
are determined by how much of each type of financing we
use
Capital Structure Weights:
Impact of Taxes:(1)interest expense reduces our tax liability,
this reduction in taxes reduces our cost of debt (2) divides
aren't tax deductible so there is no impact on cost of equity
Weighted Average Cost of Capital (WACC)
E = Market Value of Equity, D = Market Value of Debt, RE =
cost of new equity (dividend discount model/CAPM), RD = cost
of new debt (YTM)
Example:
Divisional And Project Costs of Capital:(1)Divisions, where
company is involved in different lines of business, often
require separate discount rates because they have different
levels of risk
(Solution) Pure Play Approach: (1)Use of a WACC that is
unique to a particular project (2)Find one or more companies
that specialize in product or service that we are considering
(3)Compute the beta for each company (4)Use that beta
along with the CAPM to find appropriate return for a project
of that risk
Company Valuation Using WACC Adjusted Taxes = (EBIT x Tc)
If the CFA is expected to grow at a
constant rate, g, forever, (use on left)
Weighted Average Flotation Costs
CHAPTER 16
Capital Structure Question - Pie Theory: if goal of firm
management is to make firm max valuable then firm should
pick Debt-Equity Ratio that makes pie as big as possible
Maxing Firm Value/Stockholder Interest: (1)why should
stockholders care about maxing firm value? (2)what is ratio
of debt-equity that maxes shareholder value (3)changes in
capital structure benefit stockholders IF value of firm goes
up Capital Restructuring: (1)changing amount of leverage
firm has without changing firm’s assets (2)increase
leverage by issuing debt and repurchasing outstanding
shares (3)decrease leverage by issuing new shares and
retiring outstanding debt Choosing Capital Structure:
(1)primary goal of financial managers-max stockholder
wealth (2)choose structure that will max stockholder
wealth (3)can max stockholder wealth by maxing cashflow
to firm or minimizing WACC The Effect of Leverage: How
does leverage affect EPS/ROE of firm? (1)When we increase
amount of debt financing, we increase fixed interest
expense (2)If we have really good year, then we pay our
fixed cost and have more left over for stockholders (3)If we
have really bad year, we still have pay our fixed costs and
have less left over for stockholders (4)Leverage amplifies
variation in both EPS/ROE Break Even EBIT: (1)If we
expect EBIT to be greater than break-even point, then
leverage is beneficial to stockholders (2)If we expect EBIT
to be less than the break-even point, then leverage is
detrimental to our stockholders Static Theory Of Capital
Structure: (1)firm borrows up to point where tax benefit
from an extra dollar in debt is
exactly equal to the cost that
comes from increased
probability of financial distress (2)This is the point where
the firm’s WACC is minimized Shortcoming of the Static
Theory: Many large, profitable firms use little debt. Why?
Selling securities is expensive and time consuming. If a firm
is very profitable, it might never need external financing
Pecking Order Theory: (1)Firms will use internal financing
first. (2)They will issue debt if necessary. (3)Equity is sold
as a last resort. (4)Managers are sensitive to the signals
that they send with the issue of new securities.
Implications of the Pecking Order: (1)Firms don’t have a
target capital structure (2)Profitable firms use less debt–
they have greater internal cash flow and need less external
financing (3)Companies want financial slack and stockpile
internally generated cash as a result Managerial
Recommendations: (1)tax benefit is only important if firm
has a large tax liability (2)Risk of financial distress (3)
greater the risk of financial distress, the less debt will be
optimal for firm (4) cost of financial distress varies across
firms and industries. (5)As a manager you need to
understand the cost for your industry
Degree of Financial Leverage:
For levered firm: Value = debt + equity
NI = (EBIT- Interest) - ((EBIT - Interest) x Tc)
EPS = NI /# of shares outstanding
ROE = EPS / Share price
ROA = NI / Total Assets
(1)Value of equity in an unlevered firm is equal to
the value of the firm (2)Changes in structure benefit
shareholders only if value of firm ↑ (3)↑leverage by issuing
debt, repurchasing old shares, decrease vicever. (4)max
shareholder wealth by maximizing cash flows /minimizing
WACC (5)*variability in ROE and EPS increases when
leverage increases
Levered firm: Unlevered firm:
M&M Theory: Value of firm = CFs + risk of assets
Restrictive assumptions: Perpetual CFs, Perfect capital
markets (no tax, no transaction costs, perfect competition,
all have access to same info)
Rate of return:
dividend yield
Dividends received =
NI (% owned of total
shares)
Bankruptcy: value of
assets equals the value
of the debt.
Pv alive= cash flows/
discount rate. if pv
alive > costs then
don’t liq Ex. Find the
breakeven discount
rate to be indifferent
between reorganizing
or liquidating by
solving for r:
possible cash flows/r =
liquidation value
Direct bankruptcy
costs: directly
associated w
bankruptcy ie. legal
Indirect bankruptcy
costs: difficulties
caused by financial
distress.
CHAPTER 15
Venture capital: (1)private financing for relatively new
businesses in exchange for stock. Usually entails some
hands-on guidance. (2)Provided by specialized venture
capital firms, financial and investment institutions, and
government agencies. Venture capitalists are investors who
are prepared to back an untried company in return for
share of profits Angel Investor: a wealthy individual who
invests in early-stage ventures.Typically, restrictions are
placed on the management and venture capitalists advance
the funding to the firm in stages, rather than upfront.
Venture Capital Companies: specialist companies that
provide capital to new innovative companies. Types of
Venture Capital Companies: (1)Private independent firms
(2)Labour-sponsored funds (3)Corporate venture capital
funds (4)Government run funds (5)Institutional funds –
pension funds, insurance companies. Stages of company
development: seed stage, start-up stage, expansion stage,
acquisition/buyout stage, turnaround stage Choosing a
Venture Capitalist: (1)Look for financial strength (2)Choose
a VC that has a management style compatible with your
own (3)Obtain and check references (4)What contacts does
the VC have? (5)What is the exit strategy? Public issue: (1)
creation and sale of securities that are intended to be
traded on public markets (2)All companies on Toronto Stock
Exchange come under Ontario Securities Commission’s
jurisdiction Underwriter: Investment dealers that help the
company sell their securities to public to raise capital.
Flotation Costs: (1)costs incurred when a firm issues new
securities to the public (2)Includes commissions, legal,
accounting and other administrative costs. Selling
Securities to the Public: (1)Management must obtain
permission from Board of Directors (2)Firm must prepare
and distribute copies of preliminary prospectus (red
herring) to OSC and to potential investors. A prospectus is a
formal summary that provides information on an issue of
securities.One key functions of a prospectus is to warn
investors about risks involved in investment in firm. (3)OSC
studies preliminary prospectus and notifies company of
required changes (usually 2 weeks) (4)When prospectus is
approved, price is determined and security dealers can
begin selling the new issue Alternative Issue Methods:
(1)General Cash Offer: New securities offered for sale to
general public on a cash basis. (2)Rights Offer: New
securities are first offered to existing shareholders (pre-
emptive rights). These are more common outside North
America IPO: Initial Public Offering (or unseasoned new
issue) A company’s first equity issue made available to
public SEO: Seasoned Equity Offering A new issue for a
company that has previously issued securities to public.
Firm Commitment Underwriting: Also called a “bought
deal” where issuer sells entire issue to underwriting
syndicate Best Efforts Underwriting: Underwriter must
make their “best effort” to sell the securities at an agreed-
upon offering price Dutch Auction Underwriting:
Underwriter conducts an auction and investors bid for
shares, most common with bonds Overallotment Option/
Green Shoe Provision: Allows syndicate to purchase an
additional 15% of the issue from the issuerAllows the issue
to be oversubscribedProvides some protection for the lead
underwriter Lockup Agreement: Number of days insiders
(issuing company owners and management) must wait after
an IPO before they can sell stock usually 180 days Quiet
Period: Period where communications with the public must
be limited to ordinary announcements and other purely
factual matters after a new issue usually 40 days after IPO
Standby underwriting: underwriter agrees to buy any
shares that are not purchased through rights offering
Oversubscription Privilege: allows shareholders to
purchase any unsold shares at subscription price.