# Calculate the cost of common stock equity, and convert it into the cost of retained earnings and the cost of new issues of common stock.

March 29, 2019
###### balance sheet
March 29, 2019

his is the Team Assignement. This Portion of the assignement is mine. Please do in Excel and must be complete by Sunday 11.00PM (Due in 45 hours. I will also post what other member of the team has done… Tomorrow I will be on a flight all day. So cannot respond to email till Sunday morning(24hours from now)

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Resource: Principles of Managerial Finance, Ch. 9

Complete the Spreadsheet Exercise on p. 390, and The Interactive Case 4 Eco Plastics in Ch 9.

Create a spreadsheet with two tabs. Use one tab for the Spreadsheet Exercise on p. 390, and the other tab for The Interactive Case 4 Eco Plastics.

MY PORTION OF THE ASSIGNMENT:

f.

• (1) Assuming that the debt financing costs do not change, what effect would a shift to a more highly leveraged capital structure consisting of 50% long-term debt, 0% preferred stock, and 50% common stock have on the risk premium for Eco’s common stock? What would be Eco’s new cost of common equity?
• (2) What would be Eco’s new weighted average cost of capital?
• (3) Which capital structure–the original one or this one–seems better? Why

CHAPTER 9

## Learning Goals

• LG 1 Understand the basic concept and sources of capital associated with the cost of capital.
• LG 2 Explain what is meant by the marginal cost of capital.
• LG 3 Determine the cost of long-term debt, and explain why the after-tax cost of debt is the relevant cost of debt.
• LG 4 Determine the cost of preferred stock.
• LG 5 Calculate the cost of common stock equity, and convert it into the cost of retained earnings and the cost of new issues of common stock.
• LG 6 Calculate the weighted average cost of capital (WACC), and discuss alternative weighting schemes.

## Why This Chapter Matters to You

ACCOUNTING You need to understand the various sources of capital and how their costs are calculated to provide the data necessary to determine the firm’s overall cost of capital.

INFORMATION SYSTEMS You need to understand the various sources of capital and how their costs are calculated to develop systems that will estimate the costs of those sources of capital as well as the overall cost of capital.

MANAGEMENT You need to understand the cost of capital to select long-term investments after assessing their acceptability and relative rankings.

MARKETING You need to understand the firm’s cost of capital because proposed projects must earn returns in excess of it to be acceptable.

OPERATIONS You need to understand the firm’s cost of capital to assess the economic viability of investments in plant and equipment needed to improve or grow the firm’s capacity.

Knowing your personal cost of capital will allow you to make informed decisions about your personal consuming, borrowing, and investing. Managing your personal wealth is a lot like managing the wealth of a business in that you need to understand the trade-offs between consuming wealth and growing wealth and how growing wealth can be accomplished by investing your own monies or borrowed monies. Understanding the cost of capital concepts will allow you to make better long-term decisions and maximize the value of your personal wealth.

## Alcoa Falling Short of Expectations

Often listed among America’s most admired corporations, Alcoa, Inc., is the world’s largest producer of aluminum, with more than 61,000 employees in 30 countries. A quick glance at its financial statements might suggest that the company has been doing very well in recent years. Alcoa increased its total sales from \$18.4 billion in 2009 to \$23.7 billion in 2012, an annual growth rate of almost 9 percent, far exceeding overall economic growth over the same period. In each of those years, Alcoa spent more than \$1 billion on capital expenditures, expanding and upgrading its manufacturing facilities, entering new joint ventures, and making strategic acquisitions.

During that span, however, Alcoa’s stock underperformed. During the 5-year period ending in May 2013, Alcoa common stock lost almost 80 percent of its value, while the broader stock market (as measured by the Standard & Poor’s 500 Stock Composite Index) rose by about 20 percent. Why did Alcoa perform so poorly? A simple answer is that its business investments failed to earn a return sufficient to meet the expectations of investors. Despite Alcoa’s continued growth, the rate of return that it earned on the assets that it had invested was not sufficient to satisfy investors. When a firm’s operating results disappoint investors, its stock price will fall as investors sell their shares and move to a more attractive investment. According to some estimates, Alcoa’s cost of capital exceeded 12 percent, but its investments were consistently earning returns below 5 percent. That is a recipe for a declining stock price, which is precisely what Alcoa had been experiencing for several years.

For companies to succeed, their investments have to earn a rate of return that exceeds investors’ expectations. How, though, do companies know what investors expect? The answer is that companies have to measure their cost of capital. Read on to learn how firms do that.

## 9.1 Overview of the Cost of Capital

LG 1

LG 2

My Finance Lab Video

Chapter 1 established that the goal of the firm is to maximize shareholder wealth. To do so, managers must make investments that are worth more than they cost. In this chapter, you will learn about the cost of capital, which is the rate of return that financial managers use to evaluate all possible investment opportunities to determine which ones add value to the firm. The cost of capital represents the firm’s cost of financing and is the minimum rate of return that a project must earn to increase firm value. In particular, the cost of capital refers to the cost of the next dollar of financing necessary to finance a new investment opportunity. Investments with a rate of return above the cost of capital will increase the value of the firm, because these investments are worth more than they cost. In contrast, projects with a rate of return below the cost of capital will decrease firm value.

cost of capital

Represents the firm’s cost of financing and is the minimum rate of return that a project must earn to increase firm value.

The cost of capital is an extremely important financial concept. It acts as a major link between the firm’s long-term investment decisions and the wealth of the firm’s owners as determined by the market value of their shares. Financial managers are ethically bound to invest only in projects that they expect to exceed the cost of capital; see the Focus on Ethics box for more discussion of this responsibility.

## in practice focus on ETHICS: The Ethics of Profit

Business Week once referred to Peter Drucker as “The Man Who Invented Management.” In his role as writer and management consultant, Drucker stressed the importance of ethics to business leaders. He believed that it was the ethical responsibility of a business to earn a profit. In his mind, profitable businesses create opportunities, whereas unprofitable ones waste society’s resources. Drucker once said, “Profit is not the explanation, cause, or rationale of business behavior and business decisions, but rather the test of their validity. If archangels instead of businessmen sat in directors’ chairs, they would still have to be concerned with profitability, despite their total lack of personal interest in making profits.”a

But what happens when businesses abandon ethics for profits? Consider Merck’s experience with the drug, Vioxx. Introduced in 1999, Vioxx was an immediate success, quickly reaching \$2.5 billion in annual sales. However, a Merck study launched in 1999 eventually found that patients who took Vioxx suffered from an increased risk of heart attacks and strokes. Despite the risks, Merck continued to market and sell Vioxx. By the time Vioxx was withdrawn from the market, an estimated 20 million Americans had taken the drug, 88,000 had suffered Vioxxrelated heart attacks, and 38,000 had died.

News of the 2004 Vioxx withdrawal hit Merck’s stock hard. The company’s shares fell 27 percent on the day of the announcement, slashing \$27 billion off the firm’s market capitalization. Moody’s, Standard & Poor’s, and Fitch cut Merck’s credit ratings, costing the firm its coveted AAA rating. The company’s bottom line also suffered as its net income fell 21 percent in the final three months of 2004.

The recall dealt a major blow to Merck’s reputation. The company was criticized for aggressively marketing Vioxx despite the drug’s serious side effects. Questions were also raised about the research reports Merck had submitted in support of the drug. Lawsuits followed. In 2008, Merck agreed to fund a \$4.85 billion settlement to resolve approximately 50,000 Vioxxrelated lawsuits. The company had also incurred \$1.53 billion in legal costs by the time of the settlement.

The Vioxx recall increased Merck’s cost of capital. What effect would an increased cost of capital have on a firm’s future investments?

aPeter F. Drucker, The Essential Drucker (New York: Collins Business Essentials, 2001).

## THE BASIC CONCEPT

A firm’s cost of capital reflects the expected average future cost of funds over the long run, and it reflects the entirety of the firm’s financing activities. For example, a firm may raise the money it needs to build a new manufacturing facility by borrowing money (debt), by selling common stock (equity), or by doing both. Managers must take into account respective costs of both forms of capital when they estimate a firm’s cost of capital. In fact, most firms do finance their activities with a blend of equity and debt. In Chapter 13, we will explore the factors that determine what mix of debt and equity is optimal for any particular firm. For now, we will simply say that most firms have a desired mix of financing, and the cost of capital must reflect the cost of each type of financing that a firm uses. To capture all the relevant financing costs, assuming some desired mix of financing, we need to look at the overall cost of capital rather than just the cost of any single source of financing.

## Example 9.1

My Finance Lab Solution Video

A firm is currently considering two investment opportunities. Two financial analysts, working independently of each other, are evaluating these opportunities. Assume the following information about investments A and B.

Investment A

The analyst studying this investment recalls that the company recently issued bonds paying a 6% rate of return. He reasons that because the investment project earns 7% while the firm can issue debt at 6%, the project must be worth doing, so he recommends that the company undertake this investment.

Investment B

Least costly financing source available

Equity = 14%

The analyst assigned to this project knows that the firm has common stock outstanding and that investors who hold the company’s stock expect a 14% return on their investment. The analyst decides that the firm should not undertake this investment because it only produces a 12% return while the company’s shareholders expect a 14% return.

In this example, each analyst is making a mistake by focusing on one source of financing rather than on the overall financing mix. What if instead the analysts used a combined cost of financing? By weighting the cost of each source of financing by its relative proportion in the firm’s target capital structure, the firm can obtain a weighted average cost of capital. Assuming that this firm desires a 50–50 mix of debt and equity, the weighted average cost here would be 10%[(0.50 × 6% debt) + (0.50 × 14% equity)]. With this average cost of financing, the firm should reject the first opportunity (7% expected return < 10% weighted average cost) and accept the second (12% expected return > 10% weighted average cost).

## SOURCES OF LONG-TERM CAPITAL

In this chapter, our concern is only with the long-term sources of capital available to a firm because they are the sources that supply the financing necessary to support the firm’s capital budgeting activities. Capital budgeting is the process of evaluating and selecting long-term investments. This process is intended to achieve the firm’s goal of maximizing shareholders’ wealth. Although the entire capital budgeting process is discussed throughout Part 5, at this point it is sufficient to say that capital budgeting activities are chief among the responsibilities of financial managers and that they cannot be carried out without knowing the appropriate cost of capital with which to judge the firm’s investment opportunities.

There are four basic sources of long-term capital for firms: long-term debt, preferred stock, common stock, and retained earnings. All entries on the right-hand side of the balance sheet, other than current liabilities, represent these sources:

Not every firm will use all of these sources of financing. In particular, preferred stock is relatively uncommon. Even so, most firms will have some mix of funds from these sources in their capital structures. Although a firm’s existing mix of financing sources may reflect its target capital structure, it is ultimately the marginal cost of capital necessary to raise the next marginal dollar of financing that is relevant for evaluating the firm’s future investment opportunities.

## REVIEW QUESTIONS

9–1

What is the cost of capital?9–2

What role does the cost of capital play in the firm’s long-term investment decisions? How does it relate to the firm’s ability to maximize shareholder wealth?9–3

What does the firm’s capital structure represent?9–4

What are the typical sources of long-term capital available to the firm?

## 9.2 Cost of Long-Term Debt

LG 3

The cost of long-term debt is the financing cost associated with new funds raised through long-term borrowing. Typically, the funds are raised through the sale of corporate bonds.

cost of long-term debt

The financing cost associated with new funds raised through long-term borrowing.

## NET PROCEEDS

The net proceeds from the sale of a bond, or any security, are the funds that the firm receives from the sale. The total proceeds are reduced by the flotation costs, which represent the total costs of issuing and selling securities. These costs apply to all public offerings of securities: debt, preferred stock, and common stock. They include two components: (1) underwriting costs, or compensation earned by investment bankers for selling the security; and (2) administrative costs, or issuer expenses such as legal and accounting costs.

net proceeds

Funds actually received by the firm from the sale of a security.

flotation costs

The total costs of issuing and selling a security.

## Example 9.2

Duchess Corporation, a major hardware manufacturer, is contemplating selling \$10 million worth of 20-year, 9% coupon (stated annual interest rate) bonds, each with a par value of \$1,000. Because bonds with similar risk earn returns greater than 9%, the firm must sell the bonds for \$980 to compensate for the lower coupon interest rate. The flotation costs are 2% of the par value of the bond (0.02 × \$1,000), or \$20. The net proceeds to the firm from the sale of each bond are therefore \$960 (\$980 minus \$20).

## BEFORE-TAX COST OF DEBT

The before-tax cost of debt, rd, is simply the rate of return the firm must pay on new borrowing. A firm’s before-tax cost of debt for bonds can be found in any of three ways: quotation, calculation, or approximation.

## Using Market Quotations

A relatively quick method for finding the before-tax cost of debt is to observe the yield to maturity (YTM) on the firm’s existing bonds or bonds of similar risk issued by other companies. The YTM of existing bonds reflects the rate of return required by the market. For example, if the market requires a YTM of 9.7 percent for a similar-risk bond, this value can be used as the before-tax cost of debt, rd, for new bonds. Bond yields are widely reported by sources such as the Wall Street Journal.

## Calculating the Cost

This approach finds the before-tax cost of debt by calculating the YTM generated by the bond’s cash flows, given the net proceeds that the firm receives when it issues the bonds. From the issuer’s point of view, this value is the cost to maturity of the cash flows associated with the debt. The YTM can be calculated by using a financial calculator or an electronic spreadsheet. It represents the annual before-tax percentage cost of the debt.

## Example 9.3

In the preceding example, \$960 were the net proceeds of a 20-year bond with a \$1,000 par value and 9% coupon interest rate. The calculation of the annual cost is quite simple. The cash flow pattern associated with this bond’s sales consists of an initial inflow (the net proceeds) followed by a series of annual outlays (the interest payments). In the final year, when the debt is retired, an outlay representing the repayment of the principal also occurs. The cash flows associated with Duchess Corporation’s bond issue are as follows:

End of year(s)Cash flow
0 \$  960
1–20−\$   90
20− \$1,000