A1 Risk and the Cost of Capital

There are two main forms of investment in a company, debt and equity. Investors in a company's debt are lending money to the company. The loans are contracts that give lenders rights to repayment of their loans, and to interest at predetermined interest rates. Investors in a company's equity are the owners of the company. They hold rights to the residual after all contractual payments, including those to lenders, are made.

Investing in equity is more risky7 than investing in debt. Equity owners are paid only if the company first meets its contractual obligations to lenders. This higher risk means that equity owners require an expectation of a greater return on average than the interest rate paid to debt holders. Consider a simple case in which a company- has three possible performance levels—weak results, normal results, and strong results. Investors do not know which level will actually occur. Each level is equally probable. To keep the example simple, we assume that all after-tax income is paid to equity holders as dividends so that there is no growth. The data are shown in Table 4A.1.

We see that, no matter what happens, lenders will get a return of 10%:

Table 4A.1 Cost of Capital Example

Possible Performance

Levels

Weak

Normal

Strong

Results

Results

Results

Net operating income (S/vear)1

40 000

100 000

160 000

Interest payment (S/vear)

10 000

10 000

10 000

Net income before tax (S/vear)

30 000

90 000

150 000

Tax at 40% (S/year)

12 000

36 000

60 000

After-tax income = Dividends (S/year)

18 000

54 000

90 000

Debt (S)

100 000

100 000

100 000

Value of shares (S)

327 273

327 273

327 273

Xet operating income per year is revenue per year minus cost per vear.

Xet operating income per year is revenue per year minus cost per vear.

CHAPTER 4 Comparison Methods Part 1

Owners get one of three possible returns: - - nncc 18 000 \

90 000 327 273

These three possibilities average out to 16.5%. If things are good, owners do better than lenders. If things are bad, owners do worse. But their average return is greater than returns to lenders.

The lower rate of return to lenders means that companies would like to get their capital with debt. However, reliance on debt is limited for two reasons.

If a company increases the share of capital from debt, it increases the chance that it will not be able to meet the contractual obligations to lenders. This means the company will be bankrupt. Bankruptcy may lead to reorganizing the company or possibly closing the company. In either case, bankruptcy costs may be high.

Lenders are aware of the dangers of high reliance on debt and will, therefore, limit the amount they lend to the company.

4A.2 Company Size and Sources of Capital

Large, well-known companies can secure capital both by borrowing and by selling ownership shares with relative ease because there will be ready markets for their shares as well as any debt instruments, like bonds, they may issue. These companies will seek ratios of debt to equity that balance the marginal advantages and disadvantages of debt financing. Hence, the cost of capital for large, well-known companies is a weighted average of the costs of borrowing and of selling shares, which is referred to as the weighted average cost of capital. The weights are the fractions of total capital that come from the different sources. If market conditions do not change, a large company that seeks to raise a moderate amount of additional capital can do so at a stable cost of capital. This cost of capital is the company's MARR.

We can compute the after-tax cost of capital for the example shown in Table 4A. 1 as follows.

Weighted average cost of capital

This company has a cost of capital of about 15%.

For smaller, less well-known companies, raising capital may be more difficult. Most investors in large companies are not willing to invest in unknown small companies. At start-up, a small company may rely entirely on the capital of the owners and their friends and relatives. Here the cost of capital is the opportunity cost for the investors.

If a new company seeks to grow more rapidly than the owners' investment plus cash flow permits, the next source of capital with the lowest cost is usually a bank loan. Bank loans are limited because banks are usually not willing to lend more than some fraction of the amount an owner(s) puts into a business.

If bank loans do not add up to sufficient funds, then the company usually has two options. One option is the sale of financial securities such as stocks and bonds through stock exchanges that specialize in small, speculative companies. Another option is venture capitalists. Venture capitalists are investors who specialize in investing in new companies. The cost of evaluating new- companies is usually high and so is the risk of investing in them. Together, these factors usually lead venture capitalists to want to put enough money into a small company so that they will have enough control over the company.

In general, new equity investment is very expensive for small companies. Studies have shown that venture capitalists typically require the expectation of at least a 35% rate of return after tax. Raising funds on a stock exchange is usually even more expensive than getting funding from a venture capitalist.

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