CHAPTER 17

The Corporate Form and

the Cost of Capital

PowerPoint Slides prepared by:

Andreea CHIRITESCU
Eastern Illinois University
2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with
a certain product or service or otherwise on a password-protected website for classroom use.

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)
2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected website for classroom use.

Table 17.1

2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected website for classroom use.

Table 17.2

2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected website for classroom use.

Stocks
Shares, equity, or stock
Ownership of a piece of a company
Technically, owning a share of everything the

firm owns
Share of the companys 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 firms 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 Insight
Stocks

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certain product or service or otherwise on a password-protected website for classroom use.

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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certain product or service or otherwise on a password-protected website for classroom use.

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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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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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 days closing price

Stock index
Measure of the price movements of a
group of stocks
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Business Insight
Stocks
Dow Jones Industrial Average (DJIA)
30 companies

Standard & Poors 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 firms 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
Bonds maturity date
Specified time at which the borrower will
repay your loan

Bonds 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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Business Insight
Bonds

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

issued the bond

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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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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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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 firms 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 + [E(Rm) Rf]
E(RA) - expected return on firm As stock
Rf - risk-free return
[E(Rm) Rf] - equity premium
E(Rm) - expected return on all investment

opportunities
- volatility of the firms stock relative to the market
as a whole
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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

bondholderstockholder conflict
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