Finance Class 12 Capital structure part c of syllabus, overviewing c1-c5 2 main points of focus, financial analysis within the

corporation, and looking in from the outside. (Each of these is equally important to the investor) Definition of capital- raising new money for long term investment projects. Cost of capital is how much it will cost the corporation to get the funds it needs. Capital budgeting which projects should be undertaken once the cost of capital has been established. Capital structure is looking at the mix of capital the company will use to fund projects. Capital sources are debt (D), Preferred stock (PS), Common stock (CS), and Retained Earnings (RE). Looking at the Microdrive balance sheet- Capital structure uses all 4 types of capital financing Relevant debt is long term-------754/1690----45% Preferred stock---------------------40/1690------2% Common stock----------------------130/1690 Retained Earnings------------------766+130/1690---53% Calculate an average cost of capital Retained earnings and common stock are grouped together because we think they are the same because common stock is the money that the owners have given the company to use and retained earnings is money that the owners are allowing the company to continue to use. How does the company decide on the capital structure it wants to implement? When we look at corporate finance we look at the business side and the finance side. The interest we pay depends on the capital structure. Net income can go to common stock dividends or to retained earnings. This decision is called dividend policy. Preferred dividends and common dividends are not tax deductible. Where does the company get the capital? Investors Investors formulate their required rate of return , and the corporation will have to pay the investors rate of return, which becomes the cost of capital to the firm.

Debt has the most certain cash flows, followed by preferred stock, and then common stock.

Above- The company looks at this and looks at their own risk. This company is using all types of debt in its capital structure. We would think firms would want to have the lowest cost of capital through debt, but it is also the most risky. The company faces a tradeoff between cost of capital and risk. Therefore the capital structure must be done using risk analysis. Debt clearly is a cost. Return on common equity is 12%, which is both common stock and retained earnings, because investors required rate of return is 12%. If the retained earnings were yielding less they would want to have those funds to invest elsewhere. The corporation uses this ROR, which is calculated by the investor, as a constraint for investment decisions. WACC- Weight of debt*rate of debt(1-tax rate)+Weight of preferred stock* rate of preferred stock+ weight of common equity*rate of common equity. If the rate of return on retained earnings produces capital gains the investors wont want dividends because the company is obtaining a greater rate of return than they could get elsewhere. For any financial security we know that it is valued by discounting the value of future cash flows. Suppose we own a financial security, the rate of return = the discount rate. We know that the relevant discount rate is our next best opportunity so value and ROR must be inversely related. Rate of Return perspectives. a)Debt- if there are existing bonds out in the market we can view our yield to maturity, but since the company would be taking on more debt there would need to be an additional risk premium added. b) Suppose there are no existing bonds. We would identify the risk free rate and add the appropriate determinants of market interest rates seen in the handout. The thinking of the company is the same as the investor. The price of preferred stock is derived in the same way by dividend per share/price per share.

The common equity cost is the yield on debt + the risk premium of the individual stock. It is calculated through CAPM or discounted cash flows. We have not yet incorporated the administrative costs of raising capital. a) Bank debt has administration costs. b) New securities (bonds and stocks) have floatation costs aka underwriting fees. c) Retained earnings have no floatation costs, so the risk is the same as common stock, but have a lower cost.

At any moment of time we know the weights of our capital structure. Since there is a no floatation costs we should all retained earnings before issuing new common stock. How much capital do we want to raise? The more debt we take on the greater the default risk premium. Debt risk Common Equity

With the common equity the intercept has to be higher than debt because debt is the cheapest. The required rate of return begins to increase as the amount of common stock issued begins to dilute the voting rights of existing common stock. Example- A single company has 1000 in total assets and have 200 shares outstanding. They issue 20 more shares at 5 dollars per share, which increase assets to 1100. Each share price stays the same but the voting power of each share has been diluted. WACC Maintaining target weights

They are simultaneously using all three in the same proportions as before, but the more money they raise the more expensive it becomes. It is important that we compare the WACC to accounting profit in order to realize that there are opportunity costs to using these funds. The amount left over after incorporating these opportunity costs can be seen as residual income.