The document discusses methods for calculating the required rate of return for companies, divisions, and projects. It describes calculating the weighted average cost of capital using costs of different sources of financing like equity, debt, and preferred stock weighted by their market values. It acknowledges limitations in assuming the weighted average cost of capital represents the true marginal cost given capital structure changes. The document also discusses approaches for determining required rates of return for divisions, including using rates of comparable public companies and adjusting debt costs for any difference in risk levels.
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The document discusses methods for calculating the required rate of return for companies, divisions, and projects. It describes calculating the weighted average cost of capital using costs of different sources of financing like equity, debt, and preferred stock weighted by their market values. It acknowledges limitations in assuming the weighted average cost of capital represents the true marginal cost given capital structure changes. The document also discusses approaches for determining required rates of return for divisions, including using rates of comparable public companies and adjusting debt costs for any difference in risk levels.
The document discusses methods for calculating the required rate of return for companies, divisions, and projects. It describes calculating the weighted average cost of capital using costs of different sources of financing like equity, debt, and preferred stock weighted by their market values. It acknowledges limitations in assuming the weighted average cost of capital represents the true marginal cost given capital structure changes. The document also discusses approaches for determining required rates of return for divisions, including using rates of comparable public companies and adjusting debt costs for any difference in risk levels.
Copyright:
Attribution Non-Commercial (BY-NC)
Available Formats
Download as PPTX, PDF, TXT or read online from Scribd
The document discusses methods for calculating the required rate of return for companies, divisions, and projects. It describes calculating the weighted average cost of capital using costs of different sources of financing like equity, debt, and preferred stock weighted by their market values. It acknowledges limitations in assuming the weighted average cost of capital represents the true marginal cost given capital structure changes. The document also discusses approaches for determining required rates of return for divisions, including using rates of comparable public companies and adjusting debt costs for any difference in risk levels.
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REQUIRED RETURNS
FOR COMPANIES, DIVISION
AND REQUISITION”
REQUIRED RETURNS FOR COMPANIES, DIVISION AND REQUISITION
Cost of Equity Capital
In theory, cost of equity capital can be defined as the minimum rate of return that a company must earn on the equity – financed portion of its investments in order to leave unchanged the market price of its stock. In measuring the cost of equity capital, we are concerned with approximating the rate of return required by investors. A market model approach, with apporpriate adjustments, is one means by which we can do this. Another way we might approach the problem of determining the required rate of return is to estimate the stream of expected future dividend per share, as perceived by investors at the margin, and then solve for the rate of discount that equates with the current market price of the stock. Cost of Preferred Stock Preferred stock – a class of ownership in a corporation that has a higher claim on the assets and earnings than common stock. Preferred stock generally has a dividend that must be paid out before dividends to common stockholders and the shares usually do not have voting rights. The cost of preferred stock is a function of its stated dividend. This dividend is not a contructual obligation of the firm but is payable at the discretion of the board of directors. Consequently, unlike debt, it does not create a risk of legal bankruptcy. To holder of common stock however, preferred stock is a security interest that takes priority over theirs. Most corporations that issue preferred stock intend to pay the stated dividend. Other Types of Financing Although equity, debt, and preferred stock are the major sources, other types of financing include leasing, convertible securities, warrants, and other options. Weighted Average Cost of Capital Common stock equity includes both common stock issues and retained earnings. In calculating proportionsw, it is important that we use market-value as opposed to book-value weights. Because we are trying to maximize the value of the firm to its shareholders, only market-value weights are consistent with the objective. Market values are used in the calculation of the costs of the various components of financing, so market-value weights should be used in determining the weighted average cost of capital. With the calculation of a weighted average cost of capital, the critical question is wether the figure represents the firm's “true” cost of capital. The answer to this question depends on how accurately we have measured the individual margin costs, on the weighting system, and on certain other assumptions. Limitations of Weighted Average Cost of Capital
Marginal Weigths : The critical assumption in any weigthing
system is that the firm will in fact raise capital in the proportions specified. Because the firm raises capital marginally to make a marginal investment in new projects, we need to work with the marginal cost of capital to the firm as a whole. This rate depends on the package of funds employed to finance investment projects. In other words, our concern is with new or incremental capital, not with capital raised in the past. In oder for the weighted average cost of capital to represent a marginal cost, the weights employed must be marginal; that is, the weights must correspond to the proportions of financing inputs the firm intends to emply. If they do not, capital is raised on a marginal basis in proportions other than those used to calculate this cost. Limitations of Weighted Average Cost of Capital
Change in Capital Structure : A problem occurs whenever the
firm wishes to change its capital structure. The costs of the component methods of financing usually are based on the existing capital structure, and these costs may differ from those that rule once the has achieved its desired capital structure. Because the firm cannot measure directly its costs at the desired capital structure, these costs must be estimated. During the period of transition from the present capital structure to one that is desired, the firm usually will rely on one type of financing until the desired capital structure is achieved. Although there may be some discrepancy, it is best to use the estimated weigthed average cost of capital based on the financing mix to be employed once the firm reaches its target capital structure. Flotation Costs : Flotation costs involved in the sale of common stock, preferred stock, or a debt instrument affect the profitability of a firm's investments. In many case, the new issue must be priced below the market price of existing financing; in addition, there are out-of-pocket flotation costs. Owing to flotations costs, the amount of funds the firm receives is less than the price at which the issue is sold. The presence of flotation costs in financing requires that an adjustment be made in the evaluation of investment proposals. Rationale for Weighted Average Cost The rationale behind the use of a weighted average cost of capital is that by financing in the proportions specified and accepting projects yielding more than the weighted required return, the firm is able to increase the market price of its stock. This increase occurs because the investment projects accepted are expected to return more on their equity- financed portions than the cost of equity capital. Once these expectations are apparent to the market-place, the market price of the stock should rise, all other things remaining the same. The firm has accepted projects that are expected to provide a return greater than that required by investors at the margin, based on the risk involved. A Pool of Financing The weighted average cost of capital approach implies that investment projects are financed out of a pool of funds, as opposed to being individually financed out of debt, preferred stock, common stock, or what you have. Using Proxy Companies As with individual investment projects and the company as a whole, we can use the capital asset pricing model to determine a required rate of return on equity for a division. We would try to indentify “pure-play” companies with publicly traded stocks that were engaged solely in the same line of business as the division. This would involve careful comparison of the products and services involved. Proportion and Cost of Debt For the cost of debt for a division, many use the company's overall borrowing cost. Even here adjustments can and should be made if a division has significantly more or less risk than the company as a whole. The notion that equity costs differ according to a division's systematic risk applies to debt costs as well. Both types of costs are determined in the capital markets according to a risk-return trade-off. The greater the risk, the greater the interest rate that will be required. Determining a Division's Overall Required Return When different divisions are allocated significantly different proportions of nonequity funds, determining the overall required return for a division is more complicated. If one division is allocated a much higher proportion of debt, it will have a lower overall required return on paper. High leverage for one division may cause the cost of debt funds for the overall company to rise. This marginal increase should not be allocated across divisions, but rather it should be pinpointed to the division responsible. If the firm's earnings should decline so that the tax deductibility of interest payments is postponed or lost, the cost of debt funds to the company overall rises dramatically. Finally, leverage for one division increases the volatility of returns to stockholders of the company, together with the possibility of insolvency and backruptcy costs on equity to compensate for the increased risk. For these reasons, the “true” cost of debt for the high leverage division may be considerably greater than originally imagined. If this is the case, some type of premium should be added to the division's required return in order to reflect more accurately the true cost of capital for the division.