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Potential Agency Problems An agency relationship occurs when a principal hires an agent to perform some duty.

A conflict, known as an "agency problem", arises when there is a conflict of interest between the needs of the principal and the needs of the agent.

In finance, the two primary agency relationships that exist are between: Managers and stockholders Managers and creditors

1. Stockholders versus Managers

If the manager owns less than 100% of the firm's common stock, a potential agency problem between mangers and stockholders exists. Managers, at times, may make decisions that have the potential to be in conflict with the best interests of the shareholders. For example, managers may grow their firm to escape a takeover attempt to increase their own job security. However, a takeover may be in the shareholders' best interest.

2. Stockholders versus Creditors

Creditors decide to loan money to a corporation based on the riskiness of the company, its capital structure and its potential capital structure. All of these factors will affect the company's potential cash flow, which is the main concern of creditors. Stockholders, however, have control of such decisions through the managers. Since stockholders will make decisions based on their best interest, a potential agen cy problem exists between the stockholders and creditors. For example, managers could

borrow money to repurchase shares to lower the corporation's share base and increase shareholder return. Stockholders will benefit; however, creditors will be concerned given the increase in debt that would affect future cash flows.

Motivating Managers to Act in Shareholder's Best Interest Four primary mechanisms are used to motivate managers to act in stockholders' best interests:

Managerial compensation Direct intervention by stockholders Threat of firing Threat of takeovers

1.Managerial Compensation Managerial compensation should be constructed not only to retain competent managers, but to align managers' interests with those of stockholders as much as possible.

This is typically done with an annual salary plus performance bonuses and company shares. Company shares are typically distributed to managers either as: Performance shares, where managers will receive a certain number shares based on the company's performance. Executive stock options, which allow the manager to purchase shares at a future date and price. With the use of stock options, managers are aligned closer to the interest of the stockholders as they themselves will be stockholders.

2.Direct Intervention by Stockholders

Today, the majority of a company's stock is owned by large institutional investors, such as mutual funds and pensions. As such, these large institutional stockholders have the ability to exert influence on mangers and, as a result, the firm's operations.

3.Threat of Firing If stockholders are unhappy with current management, they can encourage the existing board of directors to change the existing management, or stockholders may even reelect a new board of directors that will accomplish the task.

4.Threat of Takeovers If a stock price deteriorates because of management's inability to run the company effectively, competitors or stockholders may take a controlling interest in the company and bring in their own managers.

To learn more about governance, please see the article, Governance Pays

What is Capital Budgeting? Capital budgeting is defined as the process of planning for projects on assets with cash flows of a period greater than one year.

These projects can be classified as:

Replacement decisions to maintain the business Existing product or market expansion New products and services Regulatory, safety and environmental Other, including pet projects or difficult to evaluate projects

Additionally, projects can also be classified as mutually exclusive or independent: - Mutually exclusive projects are potential projects that are unrelated, and any combination of those projects can be accepted. - Independent projects indicate there is only one project among all possible projects that can be accepted.

The Importance of Capital Budgeting Capital budgeting is important for many reasons: - Since projects approved via capital budgeting are long term, the firm becomes tied to the project and loses some of its flexibility during that period. - When making the decision to purchase an asset, managers need to forecast the revenue over the life of that asset. - Lastly, given the length of the projects, capital-budgeting decisions ultimately define the strategic plan of the company.

The Cost of Capital The following sections discuss the cost of capital in terms of its components, calculations, and company internal targets. Readers should know the costs that make up the weighted cost of capital (WACC).

Interpreting the Cost of Capital Given the importance of capital budgeting, a company should use the weighted average of the costs of the various types of capital it may use in financing its operations.

A company uses debt, common equity and preferred equity to fund new projects, typically in large sums. In the long run, companies typically adhere to target weights for each of the sources of funding. When a capital budgeting decision is being made, it is important to keep in mind how the capital structure may be affected.

Cost Components A company's weighted average cost of capital (WACC) is comprised of the following costs: 1.Cost of debt 2.Cost of preferred stock 3.Cost of retained earnings 4.Cost of external equity

1. Cost of Debt In the WACC calculation, the after-tax cost of debt is used. Using the after-tax cost takes into account the tax savings from the tax-deductibility of interest.

The after-tax cost of debt can be calculated as follows:

Formula 11.1

After-tax cost of debt = kd (1-t)

Look Out! It is important to note that kd represents thecost to issue new debt, not the firm's existing debt.

Example: Cost of Debt

Newco plans to issue debt at a 7% interest rate. Newco's total (both federal and state) tax rate is 40%. What is Newco's cost of debt?

Answer:

kd (1-t) = 7% (1-0.40) = 4.2%

2.Cost of Preferred Stock Cost of preferred stock (kps) can be calculated as follows:

Formula 11.2 kps = Dps/Pnet where:

Dps = preferred dividends Pnet = net issuing price Example: Cost of preferred stock Assume Newco's preferred stock pays a dividend of $2 per share and it sells for $100 per share. If the cost to Newco to issue new shares is 4%, what is Newco's cost of preferred stock?

Answer: kps = Dps/Pnet = $2/$100(1-0.04) = 2.1%

Cost of Retained Earnings Cost of retained earnings (ks) is the return stockholders require on the company's common stock.

There are three methods one can use to derive the cost of retained earnings: a)Capital-asset-pricing-model (CAPM) approach b)Bond-yield-plus-premium approach c)Discounted cash flow approach a)CAPM Approach To calculate the cost of capital using the CAPM approach, you must first estimate the risk-free rate (rf), which is typically the U.S. Treasury bond rate or the 30-day Treasurybill rate as well as the expected rate of return on the market (rm).

The next step is to estimate the company's beta (bi), which is an estimate of the stock's risk. Inputting these assumptions into the CAPM equation, you can then calculate the cost of retained earnings.

Formula 11.3

Example: CAPM approach For Newco, assume rf = 4%, rm = 15% and bi = 1.1. What is the cost of retained earnings for Newco using the CAPM approach?

Answer: ks = rf + bi (rm - rf) = 4% + 1.1(15%-4%) = 16.1%

b)Bond-Yield-Plus-Premium Approach This is a simple, ad hoc approach to estimating the cost of retained earnings. Simply take the interest rate of the firm's long-term debt and add a risk premium (typically three to five percentage points):

Formula 11.4

ks = long-term bond yield + risk premium

Example: bond-yield-plus-premium approach The interest rate on Newco's long-term debt is 7% and our risk premium is 4%. What is the cost of retained earnings for Newco using the bond-yield-plus-premium approach?

Answer: ks = 7% + 4% = 11%

c)Discounted Cash Flow ApproachAlso known as the "dividend yield plus growth approach". Using the dividend-growth model, you can rearrange the terms as follows to determine ks.

Formula 11.5 ks = D1 + g; P0

where: D1 = next year's dividend g = firm's constant growth rate P0 = price Typically, you must also estimate g, which can be calculated as follows:

Formula 11.6 g = (retention rate)(ROE) = (1-payout rate)(ROE)

Example: discounted cash flow approach Assume Newco's stock is selling for $40; its expected return on equity (ROE) is 10%, next year's dividend is $2 and the company expects to pay out 30% of its earnings. What is the cost of retained earnings for Newco using the discounted cash flow approach?

Answer:

g must first be calculated: g = (1-0.3)(0.10) = 7.0%

ks = 2/40 + 0.07 = 0.12 or 12%

Exam Tips and Tricks

Of the three approaches to determine the cost of retained earnings, be most familiar with the CAPM approach and the dividend-yield-plus-growth approach

Cost of Newly Issued Stock Cost of newly issued stock (kc) is the cost of external equity, and it is based on the cost of retained earnings increased for flotation costs (cost of issuing common stock). For a constant-growth company, this can be calculated as follows:

Formula 11.7 kc = D1__ + g P0 (1-F) where: F = the percentage flotation cost, or (current stock price - funds going to company) / current stock price

Example: cost of newly issued stock As in our previous example for Newco, assume the company's stock is selling for $40, its expected ROE is 10%, next year's dividend is $2 and the company expects to pay out 30% of its earnings. Additionally, assume the company has a flotation cost of 5%. What is Newco's cost of new equity?

Answer: kc = 2+ 0.07 = 0.123, or 12.3% 40(1-0.05)

It is important to note that the cost of newly issued stock is higher than the company's cost of retained earnings. This is due to the flotation costs.

Target Capital Structure The target (optimal) capital structure is simply defined as the mix of debt, preferred stock and common equity that will optimize the company's stock price. As a company raises new capital it will focus on maintaining this target (optimal) capital structure.

Look Out!

It is important to note is that while the target structure is the capital structure that will optimize the company's stock price, it is also the capital structure that minimizes the company's weighted-average cost of capital (WACC).

Calculating Weighted Average Cost of Capital A company's weighted average cost of capital (WACC) is calculated as follows:

Formula 11.8 WACC = (wd) [kd (1-t)] + (wps)(kps) + (wce)(kce)

Where: Wd = weight percentage of debt in company's capital structure

Wps = weight percentage of preferred stock in company's capital structure Wce = weight percentage of common stock in company's capital structure

As discussed previously, the weights of debt, preferred securities and common equity are based on the company's target (optimal) capital structure.

Look Out!

One thing to note is that the weights should be based on the market value of the firm's securities, unless the firm's book value shown on the balance sheet is similar to the market value.

Example: WACC For Newco, assume the following weights: wd = 40%, wps = 5% and wce = 55%. Compute Newco's weighted average cost of capital using the costs calculated in the examples above. For the purposes of this example, assume new equity comes from retained earnings and the discounted cash flow approach is used to derive kce.

Answer: WACC = (wd)(kd)(1-t) + (wps)(kps) + (wce)(kce) WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) + (0.55)(0.12) WACC = 0.084, or 8.4%

Taking the example further, suppose new equity needs to come from newly issued common stock; the WACC would then be calculated using a kc of 12.3%. Thus our WACC would be as follows:

WACC = (wd)(kd)(1-t) + (wps)(kps) + (wce)(kce) WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) + (0.55)(0.123) WACC = 0.086 or 8.6%

For more on the WACC, including its components and importance, check out the following article: Investors Need A Good WACC

Marginal Cost of Capital The marginal cost of capital (MCC) is the cost of the last dollar of capital raised, essentially the cost of another unit of capital raised. As more capital is raised, the marginal cost of capital rises. With the weights and costs given in our previous example, we computed Newco's weighted average cost of capital as follows:

WACC = (wd)(kd)(1-t) + (wps)(kps) + (wce)(kce) WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) + (0.55)(0.12) WACC = 0.084, or 8.4%

We originally determined the WACC for Newco to be 8.4%. Newco's cost of capital will remain unchanged as new debt, preferred stock and retained earnings are issued until the company's retained earnings are depleted.

Example: Marginal Cost of Capital Once retained earnings are depleted, Newco decides to access the capital markets to raise new equity. As in our previous example for Newco, assume the company's stock is selling for $40, its expected ROE is 10%, next year's dividend is $2.00 and the company expects to pay out 30% of its earnings. Additionally, assume the company has a flotation cost of 5%. Newco's cost of new equity (kc) is thus 12.3%, as calculated below:

kc = 2+ 0.07 = 0.123, or 12.3% 40(1-0.05)

Answer: Using this new cost of equity, we can determine the WACC as follows:

WACC = (wd)(kd)(1-t) + (wps)(kps) + (wce)(kce) WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) + (0.55)(0.123) WACC = 0.086, or 8.6% The WACC has been stepped up from 8.4% to 8.6% given Newco's need to raise new equity.

Figure 11.1

Look Out! At some point, as the company continues to raise capital, the MCC can be higher than the WACC.

MCC Vs. WACC The marginal cost of capital is simply the weighted average cost of the last dollar of capital raised. As mentioned previously, in making capital decisions, a company keeps with a target capital structure. There comes a point, however, when retained earnings have been depleted and new common stock has to be used. When this occurs, the company's cost of capital increases. This is known as the "breakpoint" and can be calculated as follows:

Formula 11.9 Breakpoint for retained earnings = retained earnings wce

Example:

For Newco, assume we expect it to earn $50 million next year. As mentioned in our previous examples, Newco's payout ratio is 30%. What is Newco's breakpoint on the marginal cost curve, if we assume wce = 55%?

Answer: Newco's breakpoint = $50 million (1-0.3) = $63.6 million 0.55

Thus, after Newco raises roughly $64 million of total capital, new common equity will need to be issued and Newco's WACC will increase to 8.6%.

Factors that affect the cost of capital can be categorized as those that are controlled by the company and those that are not.

Factors Affecting the Cost of Capital These are the factors affecting cost of capital that the company has control over:

1.Capital-structure policy

2.Dividend policy 3.Investment policy 1.Capital Structure Policy As we have been discussing above, a firm has control over its capital structure, targeting an optimal capital structure. As more debt is issued, the cost of debt increases, and as more equity is issued, the cost of equity increases. 2.Dividend Policy Given that the firm has control over its payout ratio, the breakpoint of the MCC schedule can be changed. For example, as the payout ratio of the company increases the breakpoint between lower-cost internally generated equity and newly issued equity is lowered. 3.Investment Policy It is assumed that, when making investment decisions, the company is making investments with similar degrees of risk. If a company changes its investment policy relative to its risk, both the cost of debt and cost of equity change.

Uncontrollable Factors Affecting the Cost of Capital These are the factors affecting cost of capital that the company has no control over:

1.Level of interest rates 2.Tax rates 1.Level of Interest Rates The level of interest rates will affect the cost of debt and, potentially, the cost of equity. For example, when interest rates increase the cost of debt increases, which increases the cost of capital. 2.Tax Rates Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt decreases, decreasing the cost of capital.