Financial structure and cost of capital

Prof Dr Catherine Ho13.1

Components of Capital

Permanent Short-Term Debt

Long-Term Debt And Leases

13.2

And Leases

Preferred Stock

Common Stock

Table 13.1

Summarized Balance SheetDecember 31, 2005 - $ Millions

Current Assets $1,409 Current Liabilities* $1,518

Net, Plant, Property, & Equipment 1,659 Long-Term Debt 943

Goodwill 487 Deferred Taxes 400

Other Assets 740 Other LT Liabilities 413

13.3

Other Assets 740 Other LT Liabilities 413

Stockholders’ Equity 1,021

Total Assets $4,295 Total Liabilities and Stockholders’ Equity $4,295

* Current Liabilities includes a total of $819 million of permanent short-term debt.

Cost of Capital Overview

Weight X Cost = WACC

Debt WD% KD% WD KD Preferred Stock WPS% KPS% WPS KPS

13.4

Preferred Stock WPS% KPS% WPS KPS Common Stock WCS% KCS% WCS KCS

Total 100% WACC

Cost of Capital Topics

• Cost of Individual Components

– Cost of Debt

– Cost of Preferred Stock

– Cost of Equity

• Weighting Approaches

13.5

• Weighting Approaches

– Book vs. Market Weights

– Current vs. Target

• Weighted Average Cost of Capital

• Capital Structure Theory

• Hurdle Rates

Cost of DebtAfter-Tax

Cost of Debt=

Before Tax

Cost of DebtX (1 – Tax Rate)

Financial Structures

Debt No Debt

Debt $1,000 $0

Interest Rate 10% 10%

Interest $100 $0

Sales $1,000 $1,000

Cost of Goods Sold 800 800

13.6

Cost of Goods Sold 800 800

Operating Income 200 200

Interest Expense 100 0

Pre-Tax Income 100 200

Income Taxes 40 80

Net Income $ 60 $ 120

Pre-Tax Cost of Debt = $100

After-Tax Cost of Debt = 60

After-Tax

Cost of Debt= 10% X (1- 40%)

= 6%

� Historical or Book Cost of Debt◦ Cost of existing debt the company has

outstanding

� Current or Market Cost of Specific Debt◦ Current yield on specific debt◦ Current yield on specific debt

◦ But many bonds do not trade regularly or at all

� Current or Market Cost of Similar Debt◦ Today’s interest rates only similarly rated debt

� Of course, any of the costs must be after-tax

13.7

Table 13.6

Hershey's Cost of Debt

Historical Technique

Balance Interest Weighted12/31/05 Weight Rate Cost

$819.1 46.49% 4.30% 2.00%

Due 2021 100.0 5.68% 8.80% 0.50%

Due 2027 250.0 14.19% 7.20% 1.02%

$ Millions

Short-Term Debt

Debentures

13.8

Due 2007 151.2 8.58% 6.95% 0.60%

Due 2012 150.0 8.51% 6.95% 0.59%

Due 2015 250.0 14.19% 4.85% 0.69%

41.6 2.36% 6.70% 0.16%

$1,761.9 100.00% 5.55%

63.8%

3.54%

Notes

Other

X (1 – Tax Rate)

After-Tax Cost of Debt

Table 13.4

Current Market Cost of Debt

PV

Yr 0

13.9

($1,070) $72

= 6.60%

Where: X% = Current or Market Cost of Debt

$72

$1,000

$1,070 X% X% X% X% X%

$72 $72

Yr 21

$72

…. …..

Yr 1 Yr 2 Yr 3 Yr 12

Yr 0

Table 13.5

Current Market Interest Rates Yield Comparisons Based on Merrill Lynch Bond Indexes, priced as of midafternoon ET.

52-week

5/15 5/12 High Low

Treasury 1-10 Yr 5.03 5.06 5.06 3.57 10+ Yr 5.35 5.40 5.40 4.18 Agency

13.10

Agency 1-10 Yr 5.34 5.37 5.37 3.84 10+ Yr 5.71 5.76 5.76 4.49 Corporate 1-10 yr High Quality 5.61 5.64 5.64 4.21 Medium Quality 5.91 5.95 5.95 4.62 10+ yr High Quality 6.29 6.33 6.33 5.08 Medium Quality 6.61 6.64 6.64 5.48 High Yield Corporate 8.09 8.08 8.51 7.47

Source: Wall Street Journal, May 16, 2006, p. C-8

Cost of Debt Issues

• Book (or Historical) vs. Market Cost of Debt

• Market Cost of Debt

– Specific cost of a bond vs. general market cost

– Often bonds do not trade regularly or trade at all

• Recommendation is Market (or Current) Cost of

13.11

• Recommendation is Market (or Current) Cost of Debt

– When specifics are not available, use general rates

• Summary: Cost of Debt

Pre-Tax After Tax

Historical 5.55% 3.54%

Market - Specific 6.60% 4.21%

Market - General 6.29% 4.01%

Preferred Stock

• Special form of ownership that has a fixed periodic dividend payment which must be paid before any payment of common stock dividends

• Hybrid Security

– Characteristics of Debt, but

13.12

– Considered Equity

• Limited Participation in the Growth of the Firm

• Dividends Are Not Tax Deductible

– Unlike Tax Deductible Interest

• Popular with Utility Companies or Start-Up Companies

Cost of Preferred Stock

Cost of

Preferred Stock=

Preferred Stock Dividend

Price of Preferred Stock

13.13

Figure 13.2

Cost of Preferred Stock

Yr 0

Yr 1 Yr 2 Yr 3 Yr 50 Yr 100

PV

13.14

= 8.33%

Where: X% = Cost of Equity

$4.00

$48.00 X% X% X% X% X%

….

($48.00) $4.00 $4.00 $4.00 $4.00

….

Preferred Stock Issues• What Price for the Preferred Shares?

– Par Value

• “Value” When Issued

• Related to Book (or Historical) Value

• Related to Book (or Historical) Cost of Preferred

13.15

• Related to Book (or Historical) Cost of Preferred Stock

– Market Value

• Current “Value” in the Market

• Related to Market Value

• Related to Market Cost of Preferred Stock

• Our recommendation: Market Value

Cost of Equity

• Cost of Equity Includes:

– All Stockholder Equity Components• Common Stock

• Paid in Excess

• Retained Earnings

• Miscellaneous

13.16

• Miscellaneous

• Shareholders’ Required Return

• Three Techniques

– Gordon Dividend Growth Model

– Capital Asset Pricing Model• William Sharpe Won Part of a Nobel Prize

– Arbitrage Pricing Theory

� Dividend Growth Model uses the concepts of a “no growth” perpetuity and solves for the discount rate.

� D0 = D1 = D2 = DKNY

Gordon Dividend Growth Model

13.17

R equir ed R e tu r n = C ost o f E qu ity

R equ ir ed R e tu r n = D iv id end Y ie ld + G row th

D iv id end 1=

Stock P r ice 0+ G row th

Table 13.8

Interpretation of Gordon

Dividend Growth Model

PV

Yr 0

Yr 1 Yr 2 Yr 3 Yr 100

… .

($55.25) $0.93 $1.00 $1.07 $26.80

…

$827

Yr 50

13.18

Note: Dividends are assumed to grow at 7.1% annually. This is our assumption .

Do NOT buy stock in Hershey based upon this illustrative growth rate.

The stock price in December 2005 was $55.25.

($55.25) $0.93 $1.00 $1.07 $26.80 $827

$55.25 X% X% X% X% X%

Where: X% = Cost of Equity

= 8.8%

Cost of Hershey’s Equity:Dividend Growth Model

Dividend1 Cost of Equity

= Stock Price0

+ Growth

$0.93A

=

$55.25B + 7.1%C

= 1.7% + 7.1%

13.19

= 8.8%

A - Projected dividend assuming 7.1% growth from current dividend of $0.8650.

B - December 2005 Stock Price.

C - The expected growth of dividends is the anticipated growth rate of future dividends and can be ascertained from the strategic plan. The growth rate of 7.1% is only a representative rate for illustrative purposes. Do NOT buy Hershey stock based on this example.

Dividend Growth Model Issues

• For most effective use, company needs to pay dividend with steady stable growth

• Can be used for zero dividend companies by estimating first dividend payment (when and

13.20

estimating first dividend payment (when and how much) and the subsequent growth rate

• Difficulty in defining growth

– Long-term, perpetual growth rate

Capital Asset Pricing Model (CAPM)

Graphical Overview

0%

50%

100%

150%

200%

Stock Excess Return

13.21

-200%

-150%

-100%

-50%

0%

-200% -150% -100% -50% 0% 50% 100% 150% 200%

Market Excess Return

Stock Excess Return

Stock Return = Risk-Free Rate + Beta (Excess Market Return)

Excess Return = Capital Appreciation + Dividend Yield - Risk Free Rate

CAPMThree Different Stocks

-100%

0%

100%

200%

300%

400%

-200% -150% -100% -50% 0% 50% 100% 150% 200%

Stock Excess Return

Beta = 1.0

Stock C

Beta = 2.0

Beta = 0.5

13.22

-400%

-300%

-200%

-100%-200% -150% -100% -50% 0% 50% 100% 150% 200%

Market Excess Return

Stock Excess Return

Stock A

Stock B

Stock Alpha Beta

A 0.0 2.0

B 0.0 1.0

C 0.0 0.5

CAPM: Application

Kcs = Rf + β (Km - Rf) (13.6A)

Rf = 5.35% (May 15, 2006, from above)

β = 0.70 (Value Line, December 2005) (K - R) = 4.89% (Trend since 1926)

13.23

(Km - Rf) = 4.89% (Trend since 1926)

K cs = 5.35% + 0.70 (4.89%) K cs = 8.77%

Figure 13.4

CAPM: Hershey Foods vs. Market

The Hershey Company Beta Analysis

5%

10%

13.24

R2 in this example is about 0.22. Rarely does the R2 exceed 0.25.

y = 0.4551x + 0.0127

R2 = 0.2218

-10%

-5%

0%

-10% -5% 0% 5% 10%

Market Returns

Hershey

Returns

Note: Beta is 0.4551 in this specific calculation.

Market Risk Premium

Excess Returns (Large Company Stocks less )

Bonds Bills

Average CAGR Average CAGR

1926-2005 6.46% 4.89% 8.55% 6.65%

13.25

1926-2005 6.46% 4.89% 8.55% 6.65% 1976-2005 3.69% 3.23% 7.73% 6.67% 1986-2005 2.91% 2.19% 8.55% 7.33% 1996-2005 2.76% 1.48% 7.09% 5.45%

CAPM Issues

• Maintains its conceptual appeal, butJ.

• Portfolio technique with limited statistical properties for single company application

• Determining market risk premium

• Specific CAPM calculation:

13.26

• Specific CAPM calculation:

– Monthly, weekly, daily

– One year, three years, five years

• CAPM rejected theoretically:

– Alpha term ≠ 0

– Other things explain return

• Lead to Arbitrage Pricing Theory

Arbitrage Pricing Theory

• Multiple Regression Model

• Factors May Include

– Inflation

– GNP Growth

13.27

– Interest Rates• Difference Between Long and Short-Term Rates

• Difference Between High Quality (AA) and Lower Quality (BB) Rates

– Others

• Focussed on Surprise in the Factors

Cost of Equity Issues

• Three Techniques - With Limitations

– Dividend Growth Model

– Capital Asset Pricing Model


13.28


• Systematic Estimation

• Largest Cost Component

• Not Tax Deductible

• Our recommendation: CAPM

Cost of Capital Components

• Cost of Debt

– Historical vs. Marginal

• Cost of Preferred Stock

– Par Value vs. Current Market Price

13.29

– Par Value vs. Current Market Price

• Cost of Equity

– Dividend Growth

– Capital Asset Pricing Model


Table 13.6

Hershey’s Cost of Capital

Market Based Weights

% of After-Tax Weighted

Total Cost Cost

Debt A

$1,762 B

11.70% 4.01% 0.47%

13.30

Equity B

$13,288

Total 100.00% 8.21%

A - The market value of the debt is assumed to be the same as the

book value of the debt.

B - The market value of the equity is calculated as $55.25 (price per

share December 31, 2005) times 240.5 million shares outstanding.

88.30% 8.77% 7.74%

Hershey’s Cost of Capital

Book Based Weights

% of After-Tax Weighted

Total Cost Cost

Debt

$1,762

Equity

63.31% 4.01% 2.54%

13.31

Equity$1,021

Total 100.00% 5.76%

This approach understates the proportion of equity and results

in a significantly lower cost of capital.

36.69% 8.77% 3.22%

This is offered for comparison only. It is not an appropriate weighting technique.

� Based on: ◦ “Best Practices in Estimating the Cost of Capital:

Survey and Synthesis,” Bruner, Robert F., Kenneth M. Evades, Robert S. Harris, and Robert C. Higgins, Financial Practice and Education, Volume 8, Number 1, Spring/Summer 1998.8, Number 1, Spring/Summer 1998.

� Selected topics:◦ Cost of Debt

◦ Cost of Equity

◦ Capital Weights

13.32

Percent of respondents in using each approach.

Financial Corporations Advisors

13.33

Corporations Advisors

Cost of Debt Market 52 60 Current (or historical) 37 30 Other 11 10



Cost of Equity CAPM 81 80 Other 19 20

Risk free rate

Strategic

13.34

Risk free rate 90-day T-bill 4 10 3 to 7-year treasury 7 10 10 to 30-year treasury 70 70 Other 23 10

Equity risk premium Fixed rate of 4% to 5% 11 10 Fixed rate of 5% to 6% 37 0 Fixed rate of 7% to 7.4% 0 50 Other (9 techniques) 52 40



Weights

13.35

Weights Market 59 90 Book 15 10 Other 23 10 Weights Target 52 90 Current 15 10 Other 23 10

� Weighting Basis◦ Book Basis

◦ Market Basis (Recommended)

� Time Focus◦ Historical◦ Historical

◦ Current (Partially Recommended)

◦ Projected (Partially Recommended)

� Related Topics◦ Capital Structure

◦ Hurdle Rates

13.36

15%

20%

25%

After-Tax Cost of Capital Cost of Equity

Cost of Capital

13.38

0%

5%

10%

0% 10% 20% 30% 40% 50% 60%

Debt / Capital

After-Tax Cost of Capital

Cost of Debt

% of Total

After-Tax Cost

Weighted Cost

Structure 1 Debt 0% 4.0% 0.0% Equity 100% 11.0% 11.0% Capital 100% 11.0%

Structure 2 Structure 2 Debt 35% 4.5% 1.6% Equity 65% 13.0% 8.4% Capital 100% 10.0%

Structure 3 Debt 50% 6.0% 3.0% Equity 50% 18.0% 9.0% Capital 100% 12.0%

13.39

� All organizations employ cost management programs to moderate all expenses.

� Capital is the most used commodity, and many firms are to the left of the minimum many firms are to the left of the minimum cost of capital.

� By reducing the cost of capital, the firm increases its value:◦ Recall the examples from Chapter 12

13.40

8%

10%

12%

Cost of Capital

Cost of Capital

Cost of Equity

0%

2%

4%

6%

0% 10% 20% 30% 40% 50%

Current Market - Debt % of Total Capital

Cost of Capital

Cost of Debt

13.41

y = -0.0552x + 0.09842

10%

11%

Cost of Capital

Cost of Capital

R2 = 0.7517

7%

8%

9%

0% 10% 20% 30% 40% 50%

Current Market - Debt % of Total Capital

Cost of Capital

13.42

Hershey

� Hershey can reduce its cost of capital by taking on more debt.

� By taking on a moderate amount of debt, the value of the Hershey should increase.

13.43

� Consider Risk vs. Return

� Analogous to mutual fund “scoring”

� Cost of capital based

� Aligned to project classifications

� Integral to capital investment process� Integral to capital investment process

� Similar to discussions in chapter 6

13.44

� Financing a Business◦ Sources of Capital

◦ Direct Investment

� Role of the Investment Banker

� Long-Term and Short-Term Debt� Long-Term and Short-Term Debt

� Preferred Equity

� Common Equity

14.46

Table 14.1

Financing Sources Through a Firm’s Development

Financing Sources Personal Savings Going Public Internal FinancingInternal Financing

Growth to Maturity MaturityOrganization Development Stage Start-Up Rapid Growth

Organization Life

14.47

Personal Loans Bank Credit Money Market Debt Repayment

Governmental Venture Capital Capital Market Share Repurchase

Agencies

Financing Sources Personal Savings Going Public Internal FinancingInternal Financing

Life Cycle Stage Financing Type Major Sources

Development Seed Financing Entrepreneur

Family and Friends

Start Up Start Up Financing Entrepreneur

Family and Friends

Business Angels

Venture Capitalists

Survival First Round Financing Operations

Venture Capitalists

Government

Commercial Banks

Rapid Growth Second Round Financing Operations

Commercial Banks

Investment Banks

14.48

� Direct Financing

� Venture Capital

� Staged Capital Commitment

� Going Public & Initial Public Offerings (IPOs)Offerings (IPOs)◦ Investment Banking

◦ Firm Commitment

◦ Best Efforts

14.49

� Direct financing is raising funds directly from an “investor” such as a commercial bank.

� Advantages

� Disadvantages◦ Interest may be higher.◦ Cash drain is large.

Required to make payments that include interest and principal.� Advantages

◦ Facilitates short-term seasonal borrowing◦ No SEC costs◦ Requires less time◦ May be able to modify loan

agreement

principal.◦ Long-term loans are

restricted to only high quality companies.◦ Long-term loan has

restrictions that commercial paper would not.◦ Investigation costs can be

high.

14.50

� Underwriting

� Distributing

� Advice & Counsel

� Operations◦ Pre-Underwriting Consultation◦ Pre-Underwriting Consultation

◦ Registration Statement

� Including Pricing

� Investment Banking Syndicate

14.51

Table 14.2

Investment Banking Syndicate

ManagingInvestment Banker

Security IssuerBusiness Firm

Underwriting Syndicate: Manager plus 10-60

Strategic Financial Management: Applications of Corporate Finance

Samuel C. Weaver and J. Fred Weston

14.52

Investment Banker Investment Banker Investment Banker Investment Bankers

Ultimate Investors

� Advantages◦ Raise additional funds

◦ Easier to raise next “round”

◦ Public price is established

� Also for tax purposes

� Disadvantages◦ Loss of control

◦ Cost

◦ Disclosure of activities

◦ More formal reporting� Also for tax purposes

◦ Increased liquidity

◦ More formal reporting

◦ May have inactive stock market

◦ Outsiders push for short-term results

◦ Disclosures may contain competitive information

◦ Cost to service stockholders

◦ Can not act as quickly

14.53

� Secured◦ Mortgage� Similar to Home

Mortgage or Car Loan

� Applied to business

� Unsecured◦ Debenture� Credit Card Debt, as a

personal example

◦ Subordinated ◦ Provisions� Priority of Claims

� Right to Issue Additional Securities

� Scope of Lean – Specific vs. Blanket

◦ Subordinated Debentures

� Other Types◦ Income Bonds

◦ Zero Coupon Bonds

◦ Floating Rate Notes

14.54

� Debt Characteristics◦ Sinking Fund

◦ Callable◦ Convertible

� Protection to Creditors◦ Trustee� certifies issue of bond,

� polices firm’s behavior,

� takes action on behalf of ◦ Convertible� Usually Equity

� Can be Commodity

◦ Indexed Bond

� takes action on behalf of the bondholders

◦ Indenture� Restricts new debt

� Restricts dividends

� Restricts M&A

� Restricts disposition of assets

Strategic Financial Management: Applications

14.55

� Advantages◦ Limited cost

◦ Lower required return

◦ No sharing of control

◦ Interest is tax deductible

◦ Flexibility is increased by

� Disadvantages◦ Fixed charges

◦ Non-payment is default

◦ Higher leverage, higher cost of equity

◦ Fixed maturity◦ Flexibility is increased by inserting a call feature

◦ Fixed maturity

◦ Long-term risk

◦ Stringent indenture Provisions

◦ Limited amount of funds

Strategic

14.56

� Personal home mortgage refinancing:◦ Went from 25 years @6.25% to 15 years @4.5%

◦ Payments from $1400 to $1600 a month

◦ Total payments for life of loanOld: 25 Years X $1400/month = $420,000� Old: 25 Years X $1400/month = $420,000

� New: 15 Years X $1600/month = $288,000

� Savings = $132,000…….Right??

� Need to include cost of refinancing, tax impact, and time value of money (@ new rate, 4.5% after tax).

14.57

� Existing Bond◦ $200 million, 15-year bond five years ago at 8.00%◦ Cost of issuing: $6.0 million◦ Discount: $0.3 million

New Bond◦ Discount: $0.3 million

� New Bond◦ $200.0 million at 6.50% for ten years◦ Cost of issuing: $6.0 million (3%)◦ Discount: None

� Cost to Refinance◦ Call premium: 5.0% or $10 million

� Tax Rate: 40.0%

14.58

� The question is simply: should the company incur the $16.0 million of cost to reduce its interest expense by $3.0 million each year?

� The analysis can best be framed by comparing the present value of the savings versus the the present value of the savings versus the present value of the cost.

� If savings exceed the cost, the original bond should be called and refinanced.

� But as with any analysis, important details need to be examined and after-tax cash flow amounts considered.

14.59

Table 14.5

Bond Refinancing Analysis($000's)

A. Initial Cost (or Benefit) - Year 0Year 0 Impact

New or Pre-Tax After TaxExisting Cost Tax Cost After TaxBond Item (Savings) Consequence (Savings) Calculation (40% Tax Rate)

1. New Refinancing or Floatation Cost 6,000.0$ Tax savings over bond's life. 6,000.0$ No Immediate Tax Impact

14.60

1. New Refinancing or Floatation Cost 6,000.0$ Tax savings over bond's life. 6,000.0$ No Immediate Tax Impact

2. Existing Call Premium 10,000.0 Immediately tax deductible. 6,000.0 $10,000 (1-Tax Rate)

3. Existing Tax Savings on Existing Bond's: Floatation Cost: Unamortized Portion: $4,000 ($6,000 X 2/3) Immediate tax savings. (1,600.0) $4,000 (Tax Rate)

Existing Bond Price Discount: Unamortized Portion: $200 ($300 X 2/3) Immediate tax savings. (80.0) $200 (Tax Rate)

Total After-Tax Year 0 Investment Amount 10,320.0$

Table 14.5

Bond Refinancing Analysis($000's)

B. On-Going Benefit (or Cost) - Years 1-10Years 1 - 10 Impact

New or Pre-Tax After TaxExisting Cost Tax Cost After TaxBond Item (Savings) Consequence (Savings) Calculation (40% Tax Rate)

1. Interest PaymentsExisting 8.00% Interest on $200,000.0 16,000.0$ Deductible when paid. 9,600.0$ $16,000 (1-Tax Rate)

14.61

Existing 8.00% Interest on $200,000.0 16,000.0$ Deductible when paid. 9,600.0$ $16,000 (1-Tax Rate)

New 6.50% Interest on $200,000.0 (13,000.0) Deductible when paid. (7,800.0) $13,000 (1-Tax Rate)

Net Savings 3,000.0 1,800.0

2. Tax Shield from Refinancing Costs Paid in Initial YearExisting Amortization of $6,000 over 15 years = $400/yr (160.0) $400 (Tax Rate)

New Amortization of $6,000 over 10 years = $600/yr 240.0 $600 (Tax Rate)

80.0 3. Tax Shield from Bond Discount Incurred in Initial Year

Existing Amortization of $300 over 15 years = $20/yr (8.0) $20 (Tax Rate)

New None Anticipated so no Amortization Expense - $0 (Tax Rate)

(8.0)

Total After-Tax Savings - Years 1-10 1,872.0$

Table 14.6

Net Present Value of Bond Refinancing($000s)

Value Present

14.62

Value Present

Period After Tax Impact (Table 14.5) Value*

Years 1-10 Annual After-Tax Impact (Cash Flow) 1,872.0$ 15,259.5$

Year 0 Initial Year After-Tax Investment (Cash Flow) (10,320.0) (10,320.0)

Net Present Value of Bond Refinancing 4,939.5$

* The present value is calculated at the after tax cost of the new debt or 3.9% (6.5% * 0.60).

Refinance the bond.

� Hybrid security that pays a “fixed” dividend similar to debt, but it is classified as equity.

� Perpetuity with claims and rights with priority ahead of common stock but behind all bonds.

� Typical feature is “cumulative dividends”◦ If a dividend is skipped, must repay all skipped ◦ If a dividend is skipped, must repay all skipped

dividends before a common dividend.

� Often convertible to common equity.



14.63

� Preferred stock can have creative features� On occasion those features can include:◦ Voting rights

◦ Participating

◦ Sinking fund◦ Sinking fund

◦ Maturity

◦ Call provisions

◦ Adjustable rate preferred stock

◦ Auction-rate preferred stock



14.64

� Advantages◦ Could miss a dividend

payment

◦ Limited return to holders

◦ No participation in

� Disadvantages◦ Higher yield than bonds

◦ Dividends are not tax deductible

◦ After tax cost is therefore ◦ No participation in earnings

◦ No sharing control via voting

◦ Conserves mortgageable assets

◦ No maturity and no sinking fund provided for greater flexibility than debt

◦ After tax cost is therefore the full portion

14.65

� Collective Rights◦ Amend the charter

◦ Amend bylaws

◦ Elect directors

◦ Authorize sale of fixed assets

� Voting rights and proxies◦ Absentee voting

mechanism

� Cumulative voting◦ A stockholder can pool all assets

◦ Authorize mergers

◦ Right to change amount of authorized common stock

◦ Right to issue preferred stock, bonds, and other securities

◦ A stockholder can pool all of their votes for one board member

� Preemptive rights◦ Before issuing new shares,

existing shareholders must be given the offer to purchase proportionally.

14.66

� Advantages◦ No fixed charges

◦ No maturity

◦ Increase creditworthiness

◦ Can, at times, be sold

� Disadvantages◦ Dilution of control

◦ Dilution of earnings vs. fixed cost of debt

◦ Costs of issuing usually ◦ Can, at times, be sold more easily than debt

◦ Returns from common stock, in the form of capital gains, may be taxed preferentially

◦ Employee stock programs can be effective alignment mechanisms

◦ Costs of issuing usually higher than debt

◦ Cost of equity higher than debt or preferred stock

◦ Common dividends are not tax deductible

14.67

Financial structure and cost of capital

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