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.