Notes: FIN 303, Spring 09, Part 9 – Basics of Corporate Finance Professor James P. Dow, Jr. 91Part 9. The Basics of Corporate Finance The essence of business is to raise money from investors to fund projects that will return more money to the investors. To do this, there are three financial questions the company must answer: how much money should they raise, how best to raise the money and then how to return the profits to the investors. We already know the rule for determining how much money to raise. The company should try to raise enough money to fund every project with positive NPV. This section covers the other two questions. The financing options available to a company can differ depending on the size of the company. A small business is going to have fewer choices about how to raise funds than General Motors. Although General Motors has its own problems, it can’t raise $100 million from family and friends. In this section we will look at options for large corporations, who are assumed to have good access to financial markets. The next section will look at some of the special problems that face small businesses and start-up companies. Large corporations: What are their financing options and what do they cost? There are two basic ways for a company to raise capital: equity and debt. Equity investors get ownership in the company but do not have a guaranteed return. Issuing stock is the most obvious way to raise funds using equity. Retained earnings (when the company uses its own earning to finance projects) are also an equity investment. With retained earnings, the company takes money that could have been returned to shareholders and uses it to fund capital projects. Effectively, it is using the shareholders money to fund these projects, increasing the value of their equity holdings. Because of this, we should think of both retained earnings and newly-issued shares as examples of equity financing. Debt financing is borrowing; investors get a promise of fixed future payments, but do not have any ownership. Borrowing can be done through a financial intermediary, such as a bank, or directly by issuing bonds. There is a third category of assets, sometimes called hybrid securities, that is between equity and debt. Examples include warrants, convertible bonds and preferred stock. They all have some features that seem like equity and other features that seem like debt. Firms are finding it increasingly attractive to use these hybrid instruments; however, they are an advanced topic and we will not discuss them here. What are the costs of the options? The mix of debt and equity that a company uses is called its capital structure. For example, if a corporation has assets of $100,000 that were financed as follows, Debt 80,000 Equity 20,000 Total Capital 100,000 we would say that its capital structure consists of 80% debt and 20% equity.Notes: FIN 303, Spring 09, Part 9 – Basics of Corporate Finance Professor James P. Dow, Jr. 92 Later on, we will look at how managers decide on the capital structure that is best for their company; for the moment, we will take it as given. The capital structure that a firm wants to have is called their target structure. Ideally, firms would like to keep their capital structure close to their target structure when they raise funds. One way to do this would be to raise funds from each source according to their target weight, so if our hypothetical company needed to raise $10 million it could raise $8 million from debt and $2 million from equity. However, there can be fixed costs associated with each type of capital used and so, in practice, companies will often raise funds from only one source at a time, but will tend to mix types of funding over time to keep close to the desired capital structure on average. Each source of capital has its own cost. The cost of debt is basically the interest rate that the company has to pay on that debt. In order to issue equity, investors must expect to get a sufficient return on their investment, given the risk of the company. The required return on the investment is the cost of equity. The cost of capital for a company that uses several different sources of capital is the average of the individual costs. Since there may be different amounts of each type of capital, we calculate it as a weighted average, with the weights being the share of that type of capital in the targeted capital structure. The Weighted Average Cost of Capital Formula To determine the weighted average cost of capital you follow 4 steps: 1. Determine the target amount of each type of capital 2. Determine the weights 3. Determine the cost of each type of capital 4. Calculate the weighted average For the moment, we do not know how to do steps 1 and 3; however, given that information, we can do steps 2 and 4. The table below gives the amount of each type of capital for the company (Step 1). We can then determine the shares or weights of each type of capital (Step 2). The third column gives us the information about costs (Step 3). We then calculate the weighted average cost by multiplying the cost of each kind of capital by its weight and then adding the costs together. Value (given) Weight Cost (given) Weight×Cost Debt 80,000 0.8 8% 6.4% Equity 20,000 0.2 12% 2.4% Total Capital 100,000 1 8.8% The weighted average cost of capital for this company is 8.8%. So far, we have assumed that the cost of capital isn’t affected by the amount of capital the firm is trying to raise. Sometimes this may not be true. If a firm was issuing a lot of debt, it might increase the probability that the firm could not repay all the debt. This would increase the risk of the firm’s debt, and so increase the cost. In these situations, we would want to look at theNotes: FIN 303, Spring 09, Part 9 – Basics of Corporate Finance Professor James P. Dow, Jr. 93marginal cost of capital, that is, the cost actually faced by the firm given the amount of additional capital that it wants to raise. How to determine the target value and costs In a later section we will look at how companies decide on the best mix of debt and equity. However, if we assume that the company is currently around its target capital structure, we can simply look at how much capital it has of each type. Book vs. Market Values Book values of debt and equity are usually based on