Corporate Finance - Stocks and Bonds - Coursework Example

COPORATE FINANCE Stocks and Bonds In order to be able to operate, a firm needs capital to purchase inventory and equipment, pay its personnel, utilities, and other necessities, and in general acquire what is needed to produce the good or service that make up its sales. Long-term funds must therefore be raised, which is usually a combination of debt (borrowings) and equity (ownership). Long-term debt may be raised through several ways, but the most common is through the sale or flotation of bonds. Equity capital, on the other hand, is in the form of stocks, of which there are at least two types – preferred and common stock. Bonds and stocks are types of securities, and they are each related to a different set of circumstances that govern the relationship between investor and investee. Financing through stocks and bonds is a delicate matter for a company because it impacts on the firm’s rate of return as well as financial risk. Financing through equity usually has a higher cost of capital, because equity holders are entitled to a pro-rata share of the profits. Theoretically, therefore, stockholders’ expected returns have no limit. However, since the stockholders are not entitled to any returns if the company incurs losses, then there is no default risk associated with equity. On the other hand, debt capital entails a cost of interest to the borrower-firm. Interest rates associated with long-term debt are lower than the cost of equity to the firm, because debt is contracted at a fixed rate and is therefore limited to that rate, even though the firm earns much higher rates of income. There is a risk, however, associated with the possibility of default. Even if the firm incurs losses, its obligation to pay interest on its debt is fixed, therefore its inability to meet with interest payments may incur for it costly penalties. The nature of the firm’s business affects the firm’s ideal capital structure – that is, the proportion of the needed capital it may finance through debt and through equity. The following are examples of industries and their average debt and equity ratios. It may be noted that companies in the same business do not necessarily have the same capital structures. For instance, in the consumer non-cyclical industry, Starbucks is financed entirely by equity, while Kellog relies slightly more on debt financing rather than equity. Sector and Company LT Debt Ratio Equity Ratio Technology 19% 81% Microsoft 0 100 IKON Office Solutions 32 68 Energy 26 74 Exxon Mobil 6 94 Chesapeake Energy 43 57 Transportation 38 62 United Parcel Service (UPS) 17 83 Continental Airlines 89 11 Basic Materials 42 58 Anglo American PLC 15 85 Century Aluminum 72 28 Capital Goods 43 57 Winnebago Industries 0 100 Caterpillar Inc. 69 31 Consumer/Noncyclical 45 55 Starbucks 0 100 Kellog Company 57 43 Services 45 55 Administaff, Inc. 0 100 Allied Waste 64 46 Utilities 63 37 Reliant Energy, Inc. 43 57 CMS Energy 72 28 Adapted from: Ehrhardt & Brigham, 2009, p. 474 Raising money from the bonds market. Large corporations could raise money through the bonds market. The process involves the underwriting of the bonds float by either one or several financial intermediaries, usually investment bankers. The underwriting institutions form a syndicate, and are headed by the lead underwriter. Together with the company, they determine the characteristics of the issue, such as the size of the float, the coupon or interest rate, the face value, the maturity, and whether they will be callable, convertible, and so forth. Recently the advantages of financing through hybrid bonds, which has a combination of features of debt and equity. Traditionally the province of financial institutions, hybrids are now being explored by non-financial companies such as Porsche, Otto and General Electric in the European bonds markets (Wood, 2007, p. 15). Raising money from the equities market. Raising capital through sale of shares is undertaken through a private placement among a few investors, or among the public thorugh an initial public offering (IPO). When financing through equity, the existing shareholders should consider that those who will fund the additional financing will be granted the powers and privileges attendant to ownership. Not only will they be entitled to their share of the profits, pro-rated according to their shareholdings, but they will also be entitled to vote on important matters concerning the policies and directions the company will be undertaking. One of the most important of these is the right to elect the board of directors, its chairman, and the executive officers of the corporation. More often than not, investors interested in obtaining a majority stake of the corporation do so not for financial investment, but for purposes of gaining control of the corporation. Thus, a corporation whose current ownership is interested in keeping control of the firm may opt to make a private placement, that is, to sell selectively to one or a few chosen potential investors. In this manner, they could keep the corporation private. On the other hand, the company may choose to access a wider source of financing, and thus opt to go public. This could be done by making an initial public offering or IPO, upon compliance with the requirements of the Securities and Exchange Commission. The IPO is the sale of new shares of stock to investors in the primary market. The proceeds of such sale goes to the coffers of the corporation as additional capitalization, after defraying the transaction costs of the float. The IPO process involves a series of steps including valuation, bookbuilding, price stabilization, and the payment of transaction costs. A corporation that is open to public ownership after an IPO is thereafter listed in the stock exchange, and their shares that comprise the float could then be bought sold in the secondary market between existing shareholders. One of the disadvantages of financing through a public offering is that stock values are subject to the fluctuation in the stock market. Over time, the prices of shares of stock fluctuate widely and at time sharply, depending on investor perceptions of the economic, political, and business environments. An IPO being held during a bear market may suffer from undervaluation by the general investing public, and thus raise only a fraction of the funds it could have garnered in a bull market. Since the purpose of the IPO is to raise capital for the company, undervaluation of the offered shares could disproportionately dilute the shareholdings while raising less than the targeted additional financing. Deciding between Debt and Equity Financing. As earlier mentioned, financing throught bonds and stocks involve capital costs of different natures. Typically, bonds involve the periodic payment of a fixed interest to the bondholder, until the maturity of the bond during which time the principal shall be returned in full. Immediately a constraint is imposed upon the borrower-firm, in the obligation to make the periodic payments and the guaranteed return of principal. Interest expense is a real cost carried by the income statement. As such, the corporation is constrained to operate its business such that it realizes sales sufficient to cover this cost over and above its other operating costs, before a profit could be realized. This form of financing has the advantage, however, of generating costs that are tax deductible, thus reducing the taxes (and lowering the tax brackets, if any exist) payable on the firm’s earnings before tax. Stocks, on the other hand, do not entail fixed periodic cash flows to the investor. There is, however, a general expectation of regular dividend payments either in the form of stocks or cash. Absent this, investors at least look forward to strong earnings growth, particularly if the firm is young and still in the process of expanding its business, because growth of earnings per share has the strong possibility of capital appreciation over the longer term. The stock investor could thus look forward to either dividends, or capital growth, as a source of return for his investment. Capital Asset Pricing Model The capital asset pricing model, or CAPM, is credited to William F. Sharpe. The development of this theory earned for Sharpe the Nobel Prize for economics. The CAPM relates expected return of an asset such as a stock, with both the rate of return on a risk free instrument (usually the rate of return on a benchmark government security), and the expected return on the market (represented by the index). Mathematically, it is summed up in the equation: kj = kRF + βj (km – kRF) where: kj = the expected rate of return of an investment kRF = risk-free rate of return βj = the beta of the investment km = the expected rate of return of the market According to Gitman (1995, p. 346) the beta coefficient is “an index of the degree of movement of an asset’s return in response to a change in the market return,” and the market return is “the return on the market portfolio of all traded securities”. One thing must be kept in mind, however, by “return” is meant the return or yield to the investor or source of the savings. From the point of view of the corporation or investee (the user of the fund), the “rate of return” is a “cost of capital” which it must meet if the investor’s expectation is to be satisfied, over and above the cost of operating the business and the transaction costs association with the float. The behaviour of the different rates of return are seldom as straightforward as the model suggests. The CAPM, being a theoretical model, makes eight Basic Assumptions for it to hold true. These are: 1. All investors think in terms of a single period, and they choose among alternative portfolios on the basis of each portfolio’s expected return and standard deviation over the period. 2. All investors can borrow or lend an unlimited amount of money risk-free rate of interest, kRF, and there are no restrictions on short sales of any asset2 3. All investors have identical estimates of the expected values, standard deviations, and correlations of returns among all assets, that is, investors have “homogeneous expectations.” 4. All assets are perfectly divisible and are perfectly marketable at the going price. 5. There are no transactions costs. 6. There are no taxes. 7. All investors are price takers (that is, all investors assume that their own buying and selling activity will not affect stock prices (Brigham and Gapenski 1996, p. 68)). 8. The quantities of all assets are given and fixed. (Jensen M. 1972, 357-398.) The concept of a beta coefficient is a theoretical one; its existence is in the realm of academic study, and as many researches have disproven as much as proven the practical validity of the beta. The reason for this is that CAPM specifies the beta to be quantitatively verifiable if the foregoing eight assumptions were true. A cursory look at the assumptions shows that this is impossible: all investors do not think and act alike, transaction costs are ever present, and of course, there will always be taxes. However, such assumptions are not unusual for theoretical models or theories. Their purpose is to minimize the “random noise” and distortions that occur spontaneously in actual markets, in order to describe the relationships among variables that are the subject of study. The usefulness of the theory is, however, not lost as far as the practical aspect is concerned. The behaviour of the significant variables – the expected rate of return of the asset, the expected return of the market, and the risk-free rate – relative to each other still provides a helpful guideline in making decisions concerning portfolio investments. In the case of the firm raising the funds, the CAPM is also a valuable tool in Relevance of CAPM in evaluating a firm’s cost of capital In the CAPM, a firm’s extraordinary returns are assumed to bear a fixed relation to the extraordinary returns of the market. The theory has proven of value to the firm in the process of evaluating its cost of capital. In investment theory, the variable kj represents the rate of return the investor expects to obtain from his stock placement. However, from the point of view of the firm, the same variable represents the cost the firm incurs by availing of this method of financing. The variable kj is thus equivalent to the cost of capital (of equity financing, in this case, although the same method could be employed for bonds – Ritter, 1998). For instance, assume that the firm’s stock known to vary twice as much as the general market with respect to the risk-free rate; thus, the stock is said to have a beta coefficient equal to 2. Supposing that analysts forecast the interest rate on benchmark government securities to amount to 10 percent (i.e., the risk-free rate) and the return on the general market to approximate 15 percent, through CAPM the cost of capital of the stock is expected to be: kj = kRF + βj (km – kRF) kj = 10% + 2 (15% – 10%) kj = 20% Therefore, the firm’s financial planners would compute their cost of equity capital at 20%. Assuming, further, that the firm’s capital structure involved 40% debt and 60% equity, and the interest paid by the firm on its long-term debt equals 12%, then the weighted average cost of capital of the firm, or WACC, would amount to: WACC = wd x kd + wj x kj WACC = 0.40 x 12% + 0.60 x 20% WACC = 16.8% The weighted average cost of capital is a necessary criteria for firms to evaluate the viability of proposed projects. If a firm were considering a project proposal with a rate of return of 15%, then given a weighted cost of capital of 16.8%, the firm should reject the proposal. Only projects or portfolios which promise a return of higher than 16.8% should be considered among the alternative projects the firms would possible undertake. REFERENCES Brigham E., Gapenski L. (1996) Intermediate Financial Management, Harcourt Brace College Publishers, Orlando, FL Ehrhardt, M C & Brigham, E F 2009 Corporate Finance: A Focused Approach, Third Edition. South-Western Cengage Learning Gitman, L. (1995), Basic Managerial Finance, Harper and Row, New York. Jensen M. (1972), “Capital Markets: Theory and Evidence,” Bell Journal of Economics and Management Science. Maxim, M 2008 T-Bonds start trading. International Financial Law Review, Oct, Vol. 27 Issue 10, p33-33 Ritter, J R 1998 Initial Public Offerings, Contemporary Finance Digest, vol. 2 no. 1, pp. 5-30 Wood, D 2007 Revving Up the Bond. 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