Basic Concepts and Theories

Introduction

long-term investments we make today will determinevalue of our business tomorrow. In order to make long-term investments in new product lines, new equipment and other assets, managers must knowcost of obtaining funds to acquire these assets. cost associated with different sources of funds is calledcost of capital. Cost of Capital representsrate a business must pay for each source of funds - debt, preferred stock, common stock, and retained earnings.

Since we want to maintain existing market values, cost of capital isminimum acceptable rate of return for long-term investments. Ifbusiness earns more than its cost of capital, the market value ofbusiness will increase. Likewise, if returns on long-term investments are below the cost of capital, market values will decline. This leads us to a very fundamental objective within financial management - maximizing values forowners of the business. Therefore, how we manage capital is extremely important to fulfilling the basic objective of increased shareholder value.

The Economics of Capital

An understanding of economics and capital can also help us understand how we should manage capital within an organization. For example, total amount of capital available is determined by the total amount of investment. overall economy has a total capital equal to the sum of all capital goods (assets). Since these goods lose value over time, some level of reinvestment is needed to maintainasset base at its current size. Additional investments will cause the capital stock of an economy to grow, similar toassets of a business.

amount invested in the economy is determined byafter tax rate of return on capital. actual level of investment depends onwillingness of people to invest in assets. People invest based on the returns they expect to receive. returns to investors must be adjusted for inflation, taxes, depreciation, and risk related toinvestment. It is the after tax real rate of return that drives investment.

Overall, after tax rate will remain constant over time due to changes in investment spending. For example, ifrate of return on capital were to increase, there will be an increase in investment spending. As the capital stock expands from increased investing, the rate of return on capital will drop back down. Conversely, whenrate of return on capital is low, there will be a decrease in investment. As capital shrinks, the rate of return on capital rises. Consequently, investment spending will keep rates of return on capital at stable levels.

Taxation of capital will increasecost of capital. In order to supply capital, investors must receive a minimum after tax real rate of return. users of capital not only pay investors a nominal rate of return, but they also incurcost of economic depreciation (lost values of capital assets) and related taxes on capital. These total costs representcost of capital.

Basic Considerations in Managing Capital

Now that we understandimportance of capital, let's focus on how we manage capital within an organization. overall objective is to find an "optimal" capital structure - the right mix of capital sources (debt and equity) that minimizes overall cost of capital and maximizes values to the shareholders (owners of the business). When we raise capital, we have two choices - issue debt or issue stock. Debt is represented by bonds which are long-term instruments sold to investors. Stock isownership interest of the business and depending upon the rules of incorporation, stockholders will have certain rights. Therefore, we start our understanding of capital management by looking atadvantages and disadvantages of two sources of capital:

Some advantages to using stock are:

• No fixed payments are required to investors; dividends are paid only as earnings are available.
• No maturity date on the security, invested capital does not have to be repaid.
• Improves the credit worthiness of the company.

Some disadvantages to using stock are:

• Dilutesearnings per share to shareholders.
• Issuance costs are higher than debt.
• Issuing more stock can increase the overall cost of capital.
• Dividend payments to shareholders are not tax deductible.

Some advantages to using debt are:

• Interest payments are tax deductible.
• Does not dilute earnings per share or control withincompany.
• Cost is fixed; interest and principal do not change.
• Expected returns to investors are usually lower than stock.

Some disadvantages to using debt are:

• Fixed charges must be paid regardless of available earnings or cash flow.
• Adds more risk tobusiness.
• Has a maturity date and the capital invested must be repaid to investors.

In addition to understandingpros and cons of financial securities, we also need to recognize that several conditions will impact how we raise capital. These conditions include:

Economic Conditions: demand and supply of capital inmarketplace can impact how capital is raised. For example, expectations of inflation will influence the cost that is paid for capital. Higher rates of inflation erodevalues of investments and thus, investors will demand higher rates of return.

Market Conditions: demand for higher rates of return will increasecost of capital. For example, if we raise capital with a security that is not highly marketable, investors will require higher rates of return forincreased risk.

Operating Conditions: level of fixed costs used to operatebusiness needs to be considered. For example, higher fixed costs can result in wider variations to operating income from numerous factors - increased competition, slower economic growth, etc. This is referred to as business risk.

Financial Conditions: existing levels of outstanding debt will impact how capital will be raised. Higher levels of debt (including preferred stock) can result in wider variations to earnings due to higher fixed obligations that must be paid (interest to debt holders and fixed dividends to preferred stock holders). This is referred to as financial risk.

Not only do we need to look at various conditions, but we need to consider how financing will impact capital structure. Capital structure appears onright side of the Balance Sheet as liabilities and equity; i.e. the long-term sources of funds to finance assets. Assets appear on the left side of the Balance Sheet. Capital structure ispermanent financing of the business through the use debt and stock. total of all liabilities and equity is referred to as Financial Structure. Therefore, Capital Structure = Financial Structure - Current Liabilities.

Findingright capital structure encompasses numerous considerations - growth rates in sales, risk attitudes of management, liquidity of assets, control position ofcompany, etc. Finding the right capital structure also involves finding the right amount of financial leverage. Financial leverage isfinancing of assets with fixed obligations - debt and preferred stock. use of financial leverage increases return on equity up to a certain level of operating income. As you use more financial leverage (debt and preferred stock), higher levels of operating income are needed to coveradditional fixed obligations (interest on debt and fixed dividends on preferred stock).

Generally, the use of financial leverage will improve financial performance whenever returns are higher thancosts of obtaining funds. In a perfect world, management would favor more leverage whenever return on capital exceedsafter tax costs of debt. However, higher returns also result in higher risk tobusiness (risk return tradeoff). Therefore, the use of financial leverage is a balancing act between higher returns for shareholders vs. higher risk to shareholders.

Financial leverage can be measured with ratios such as debt to total assets. Financial leverage is also expressed asDegree of Financial Leverage or DFL. DFL is the percentage change in earnings given a change in operating income (Earnings Before Interest & Taxes or EBIT). higher the DFL, riskier the business. We can use the following formula to calculate DFL:

DFL = EBIT / EBIT - I - (P / (1-TR)) where I is Interest and P is Preferred Dividends and TR is tax rate.



In addition to financial leverage, there is operating leverage. Operating leverage isuse of fixed costs in production over variable costs. For example, replacing production workers (variable cost) with robots (fixed cost) would be an example of increased operating leverage. As operating leverage increases, more sales are needed to coverincreased fixed costs. Since variable costs have been reduced, profits will increase more given an increase in sales after the breakeven point has been reached. High levels of fixed costs increase business risk. Like financial leverage, we can measureDegree of Operating Leverage (DOL) as the percentage change in operating income given a change in sales. following formula can be used to calculate DOL:

DOL = CM / CM - FC where CM is Contribution Margin and FC is Fixed Cost.



Usually firms use one form of leverage overother to finance investments. For example, manufacturing companies tend to invest heavily in fixed assets and thus operating leverage is used much more than financial leverage. Service type companies have low levels of investment in fixed assets and therefore, financial leverage is widely used to finance the business. Leverage is relative totype of fixed cost approach that is appropriate for funding the business and leverage by its very definition creates risk. Therefore, the use of leverage will always include a tradeoff between risk and return.

Approaches to Managing Capital

One way to understand how to manage capital is to look atvarious approaches that can be used for finding the right capital structure. As we previously indicated, the right capital structure is that mix of debt and stock that maximizes the value offirm while at the same time maintains a relatively low overall cost of capital. Two very different approaches to capital management are the Net Operating Income Approach andNet Income Approach.

Net Operating Income Approach: This approach to capital management concludes that it does not matter how you mixcapital structure. value of the business is not determined by how you arrange the right side of Balance Sheet. Additionally, the overall cost of capital will not change as you changemix of capital. Therefore, values are determined by the capitalization of operating income or EBIT (Earnings Before Interest Taxes).

Example 3 - Calculate Market Value of Business under Net Operating Income Approach to Capital Management

Norton Company has $ 400,000 in outstanding debt at 7% interest. Norton's cost of capital is 12% and expected operating income or Earnings Before Interest & Taxes (EBIT) is $ 120,000.

Earnings to Shareholders = $ 120,000 - $ 28,000 (7% interest on debt) = $ 92,000.
Total Market Value = $ 120,000 / .12 = $ 1,000,000
Market Value of Stock = $ 1,000,000 - $ 400,000 = $ 600,000
Cost of Equity = $ 92,000 / $ 600,000 = 15.3%

Net Income Approach: In contrast toNet Operating Income Approach, the Net Income Approach concludes that the capital structure of an organization has a major influence on the value of the organization. Therefore, use of leverage will change both the cost of capital and the value of the firm. Net Income is capitalized in arriving atmarket value of the firm.

Example 4 - Calculate Market Value of Business under Net Income Approach to Capital Management Referring back to Example 3, we can calculatefollowing values:

Market Value of Stock = $ 92,000 / 15.3% = $ 601,307
Total Value = $ 601,307 + $ 400,000 = $ 1,001,307
Overall Cost of Capital = $ 120,000 / $ 1,001,307 = 12%

Franco Modigliani and Merton Miller have provided some guidance betweenNet Operating Income Approach and the Net Income Approach. Modigliani and Miller concluded that capital structure is not a major factor indetermination of values. Values are determined by the investment and operating decisions that generate cash flows. It is cash flows that give rise to values. This approach to valuation has become a mainstay within financial management. But what about capital structures? Mike Jenson, founder of the Journal of Financial Economics, may have resolvedanswer to this question. Jenson noted that whenever a company makes a change in its capital structure, it sends a signal to investors. This signaling effect does in fact result in changes to valuations. For example, when the Chairman of the Federal Reserve speaks about interest rates, a signal is sent to marketplace and valuations quickly change. Therefore, shifts in capital structure do impact the value of a business.

Jenson also noticed that managers have a tendency to guard capital and minimize distribution of dividends to shareholders. This follows with the so-called "pecking order" of financing whereby managers prefer internal sources of capital to external sources of capital. specific pecking order is as follows:

1. Internal sources of capital - retained earnings / cash

2. External sources of capital - debt

3. External sources of capital - convertible securities

4. External sources of capital - preferred stock

5. External sources of capital - common stock

Consequently, capital structures can impact valuations due toso-called signaling effect. Additionally, the real source of values will reside in cash flows (more specifically free cash flows). Free cash flows are excess cash that can be withdrawn from a business after paying everything off. And in order to generate free cash flows, management must generate returns in excess of cost of capital.

Calculating the Cost of Capital

In order to evaluate projects of average risk, we must knowoverall cost of capital. Cost of Capital is calculated asweighted average of each component of capital - debt, common stock, preferred stock, and retained earnings. Each component is calculated as follows:

Cost of Debt (Cd): Calculate the after tax cost of debt based oneffective interest rate. following formula is used to calculate the cost of debt:

Cd = I ( 1 - TR) where I is Interest Rate on Debt and TR isTax Rate.

Example 5 - Calculate the Cost of Debt

Cantor Corporation borrowed $ 100,000 at 8% interest. amount ofloan proceeds was $ 96,000 and the tax rate is 35%.

Cost of Debt = ($ 100,000 x .08) / $ 96,000 x ( 1 - .35) = 8.3% x .65 = 5.4%.

Cost of Common Stock (Ccs): Three different methods can be used to calculateCost of Common Stock. three methods are:

1. Dividend Growth - Dividends paid to common shareholders along withoverall expected growth rate is used to calculate a cost for the common stock. formula for calculating the cost of common stock is: (Dividends in Year 1 / Market Value of Stock) + Overall Growth Rate.

Example 6 - CalculateCost of Common Stock based on Dividend Growth

Cantor Corporation expects to pay a $ 6.00 dividend this year to common shareholders. Historically, dividends have grown by 2% each year. Cantor's common stock is currently selling for $ 45.00 per share.

Cost of Common Stock = ($ 6.00 / $ 45.00) + .02 = 15.3%.

2. Capital Asset Pricing Model (CAPM) - CAPM ismost widely used approach to calculating the cost of common stock. CAPM uses three components to calculate the cost of common stock - (1) rf isrisk free rate earned by investors (such as U.S. Treasury Bonds; (2) b is the beta coefficient which expresses the risk of the common stock in relation to the market; and (3) rm is the rate earned inmarket (such as the Standard & Poor’s 500 Composite Index). CAPM formula is Ccs = rf + b ( rm - rf ).

Example 7 - CalculateCost of Common Stock based on CAPM

Cantor Corporation has common stock with a listed beta of 1.35. estimated market return is 12% andrisk free rate based on Treasury Bonds is 6.5%.

Ccs = 6.5% + 1.35 ( 12% - 6.5% ) = 13.9%

3. Bond Plus - A simple approach to calculating the cost of common stock is to add a risk premium tocost of debt. formula is Ccs = Cd + risk premium. risk premium is the additional rate that must be paid to common shareholders above what is paid to bond holders.

Example 8 - CalculateCost of Common Stock based on Bond Plus

Referring back to Example 5, we calculated a cost of debt of 5.4%. We have estimated a market risk premium on common stock of 4%.

Ccs = 5.4% + 4.0% = 9.4%

Cost of Preferred Stock (Cps): If your capital structure includes preferred stock, the cost of preferred stock is calculated byamount of dividends in relation to the market price of the preferred stock. formula is Cps = Dividends / Market Price of Stock.

Example 9 - CalculateCost of Preferred Stock

Assume we have preferred stock selling for $ 80 per share and dividends per share are $ 10. cost of preferred stock is:

Cps = $ 10 / $ 80 = 12.5%

Cost of Retained Earnings: cost of retained earnings (internal funds) within a capital structure is similar tocost of common stock. We can think of the cost of retained earnings in relation to the opportunity cost of how we can use these funds. Generally, the cost of retained earnings is slightly less thancost of common stock since no issuance costs is incurred.

After we have calculated each component cost of capital, we will calculate a weighted average based onrelative market values of each component. following example will illustrate how weighted average cost of capital is calculated.



Our overall cost of capital is calculated as a weighted average based onrelative market values of each component of capital. If market values are not available, use %’s derived from targeted or forecasted capital structure. If worse comes to worse, you can fall back on book values. In any event, the weighted average cost of capital isoverall cost of capital that will be used to evaluate capital investments.

Cost of Equity and Risk

Cost of Equity israte of return required by those who invest in equity securities. expected return can be broken down into two components - Risk Free Rate and Risk Premium. A good benchmark for establishingRisk Free Rate is the rate paid on 30 year U.S. Treasury Bonds since the risk of default is virtually non-existent. Risk Premium can be established by understanding two forms of risk - Business Risk and Financial Risk. Inabsence of debt, shareholders are confronted with one form of risk, business risk. Business Risk isrisk of changes to operating income from numerous factors that influence business. When we introduce debt, we have to include financial risk. Financial Risk is the risk of changes to earnings fromuse of increased debt. More debt results in higher interest payments, which impacts earnings. Consequently, Risk Premium consists of Business Risk + Financial Risk. following graph summarizes these relationships:



In the above graph, we have a total risk free rate of 5%. addition of business risk increases required rate on stock to 10%. When we introduce debt, this adds financial risk and increases the required return on stock. final total rate of return on stock with all forms of risk climbs from 12% to 16% over a range of Debt to Equity Ratios. Sincecost of capital represents the rate that must be paid to investors for the use of long-term funds, higher risk to investors will increasecost of capital.

The Financing Decision

We have an understanding of what capital is (Chapter 1) and we understand how to calculatecost of capital (Chapter 2). remainder of this course will focus on how to arrange financing; i.e. how do we actually raise capital. financing decision must consider several factors. Some of these factors include:

• Flexibility - Today's financing decisions will influence tomorrow's financing decisions. Ifbusiness expects to raise capital in the future, it can not maximize its use of debt today. We need to provide a cushion so we can have flexibility with future financing decisions.
• Risk - Financing withuse of debt will increase risk. There is a limit to how much debt we can use to finance our business. Too much debt can ultimately lead to bankruptcy.
• Income - Financing can influence earnings and thus affect return on equity. If we are concerned about returns to equity shareholders, then our financing decision will need to be adjusted. Income is also influenced by our ability to take advantage of tax deductions for interest on debt.
• Control - If we have concerns about control overorganization, then we have to consider how financing will change control. Financing decisions are connected to either ownership (equity) or creditors (debt).
• Timing - Financing decisions need to be timed to take advantage ofmarketplace. What type of securities should be sold? When should they be sold? What length of maturity should be used for debt financing?

Refinancing Risk

One of the objectives withinfinancing decision is to match the maturity of liabilities with the life expectancy of assets. This allows liabilities to be self-liquidating. Ifmaturity of liabilities is less than the life expectancy of assets, then you face refinancing risk since you have to raise new capital to pay off liabilities. Ifmaturity of liabilities is longer than the life expectancy of assets, then there will be plenty of assets around to pay off debts. However, these surplus assets may not earn enough to increasemarket value of the firm.

mismatching of liabilities with assets can occur if financing is not available. For example, suppose long-term financing is not available. Short-term sources of financing may have to be used. Mismatching can also be intentional. For example, suppose you expect long-term interest rates to fall. You may want to finance assets with short-term maturities since you can refinance in a few years at much lower rates.

Inflation

Another factor to consider infinancing decision is inflation. By using debt financing during periods of high inflation, you will repay the debt with dollars that are worth less. As expectations of inflation increase, rate of borrowing will increase since creditors must be compensated for a loss in value. Since inflation is a major driving force behind interest rates, financing decision should be cognizant of inflationary trends.

Floatation Cost

Equity sources of capital will cost more than debt sources of capital. One reason is due to higher risk to investors. Whenever investors incur more risk, they demand higher rates of return; i.e. risk return tradeoff. Additionally, actual out-of-pocket cost associated with equity financing is higher than debt financing. These costs are referred to as floatation costs. Floatation costs include all costs of issuing securities, such as banker's fees, legal fees, filing costs, etc.

Marginal Cost of Capital

A basic consideration withinfinancing decision is how much money do we need to raise? If we assume that all projects have the same average level of risk, then we can establish an optimal capital budget by plottingMarginal Cost of Capital. relationship between cost of capital and required financing is referred to asMarginal Cost of Capital. Marginal Cost of Capital Rate isdiscount rate used for capital budgeting analysis. Marginal Cost of Capital is calculated as follows:

1. Determinecost and percentage of financing needed for each source of capital - debt, stock, retained earnings.

2. Calculate breaking points whereweighted average cost of capital begins to increase under different financing plans. break point can be calculated as: Maximum Amount of Lowest Source of Capital / Percent of Financing Provided by this Specific Source of Capital.

3. Calculate the weighted average cost of capital overrange of financing between the break points.

4. A graph can be used to showrange of cost of capital in relation to total financing. If a project's internal rate of return is greater than the marginal cost of capital, thenproject should be accepted.





At $ 2.8 million, cost of capital jumps from 9.8% to 12.3%. If we compare this graph to our proposed projects, we will select projects A and B since they have an internal rate of return greater thanmarginal cost of capital (9.8% up to $ 2.8 million and 12.3% above $ 2.8 million). total investment amount of projects A and B is $ 3.5 million ($ 1.8 for project A + $ 1.7 for project B). Therefore, optimal capital budget for Bishop Corporation is $ 3.5 million.

EBIT / EPS Comparison

Inprevious example, we selected a 50 / 50 mix for financing capital projects. One of the objectives of capital management is to findright mix of capital. A comparison of Earnings Before Interest Taxes (EBIT) with Earnings per Share (EPS) under different financing plans can help determine which type of financing is most advantageous - debt financing or equity financing. Since debt has little effect on EBIT, we start our analysis with EBIT. We simply want to calculate what EPS will be under each financing plan. Bothdebt and stock financing plans are plotted on a graph. Depending upon what we expect EBIT to be, the graph can tell us which financing plan will give ushighest EPS. following graph plots EBIT and EPS under debt and stock financing:



At a level of $ 2 million EBIT, EPS issame under either the stock or debt financing plan. If we expect EBIT to be below $ 2 million, then we would favorstock plan since it yields a higher EPS. If we expect EBIT to be above $ 2 million, then debt would be preferred over stock after consideringincreased risk.



In the above example, it is quite clear that Atco can benefit fromuse of more debt. However, suppose Atco expects EBIT to fall dramatically overnext few years. Atco should graphtwo financing plans under different levels of EBIT. In order to prepare a graph, we need to determine three points:

1. minimum level of EBIT needed to cover fixed financing charges (debt and preferred stock) under 100% Stock Plan.

2. minimum level of EBIT needed to cover fixed financing charges (debt and preferred stock) under 100% Bond Plan.

3. Indifference Point where EPS issame under the 100% Stock Plan and the 100% Bond Plan. following formula can be used to calculateIndifference Point:

EPS = ((EBIT - I) (1 - TR) - PD) / number of shares outstanding
EPS: Earnings per Share EBIT: Earnings Before Interest Taxes TR: Tax Rate
PD: Preferred Dividends



Now that we have calculated all three points per Example 13, we can summarize our analysis onfollowing graph:



At an EBIT of $ 760,000, we have an EPS of $ 1.10.

Assessing Risk

Once returns have been analyzed under different financing plans with EBIT / EPS comparisons, it is necessary to assess risk. Coverage ratios are commonly used to assess the risk associated with different financing plans. Coverage ratios showadditional risk associated with higher levels of debt financing. Examples of coverage ratios include:

• Debt to Total Assets Ratio = Total Long-term Liabilities / Total Assets
• Times Interest Earned Ratio = EBIT / Interest Expense
• Times Burden Earned Ratio = EBIT / Interest Expense + (Principal Repayment / (1 - TR))

Targeted Debt Levels

One approach to establishingright mix of capital is to follow a targeted debt level. Since some level of debt is desirable for maintaining higher returns, many managers will establish a target debt level for their capital structures (such as 40% of capital should be debt). Therefore, financing decisions should sometimes take into account a targeted set of coverage ratios. One of the principal concerns with using more debt isability to cover the additional fixed charges. As we just discussed inprevious segment, coverage ratios are used to monitor debt levels.

Another concern withuse of more debt is financial flexibility. As we increase debt, we risk the possibility of closing off this source of financing in the future. If we expect more and more financing infuture, then we need to make sure we have the flexibility to tap into debt financing overlong-term.

The Overall Process

basic process for making financing decisions often boils down to three steps:

1. Measuring returns under different financing plans. A comparison of EBIT / EPS under different financing plans can help. You also need to understand how much earnings will grow infuture. If you expect EBIT to decline in the future, then you will favor stock over debt. If you expect strong growth in earnings, then you haveability to service higher debt loads and thus you will lean towards debt over equity.

2. Assessingrisk of each plan. objective is to grow the business with some use of leverage and avoid excessive loads of equity. Coverage ratios (as previously discussed) are widely used to monitor risk. Under ideal circumstances, you want to growbusiness according to a desired growth rate (G). A desired growth rate can be calculated as follows: G = P x R x A x T where P is Profit Margin, R is Retention Ratio, A is Asset Turnover, and T is Financial Leverage.

If the actual growth rate exceedsdesired growth rate, then you need to make sure you don't borrow too heavily since you need to maintain borrowing capacity. Higher debt loads for fast growing companies can hold back values. If there is low growth, financing with debt may be preferred since steady cash flows are available to service debt financing. Slow growing companies need to aggressively pursue investment opportunities for increased growth.

3. Recognizingneed for financial flexibility. Selecting a financing plan that allows for future flexibility can be critical to future success. You must be able to make competitive investments infuture to maintain or improve market share.

The Financial Marketplace

Once a company has decided how much capital to raise and best mix of capital, it must go to the marketplace to raisecapital. Financial Marketplace is where investors and companies trying to raise capital come together. Capital markets trade long-term sources of funds, such as stocks and bonds. Capital markets can be broken down into primary markets and secondary markets. Primary markets are those markets where new issues of securities are sold. Secondary markets are where outstanding securities are traded (such asNew York Stock Exchange).

trading of stocks and bonds will usually involveuse of financial intermediaries, such as banks, pension funds, mutual funds, finance companies, etc. Therefore, the actual source of capital comes from financial intermediaries that purchasesecurities. One of the most important financial intermediaries isInvestment Banker.

Investment Bankers

Investment Bankers provide critical services for raising capital. They help sell new securities by establishingprice of the security. Investment Bankers determine how the securities will be sold and they distributesecurities to investors. Investment Bankers also investigate the company prior to issuance of securities and certifyissue. This function is necessary in the United States since the sale of securities must be registered withSecurities and Exchange Commission (SEC).

process for selling securities is called underwriting. Underwriting involves the purchase of securities byInvestment Banker and the resale of securities to investors. difference between the two prices (purchase vs. sale) is calledspread. spread represents compensation to the Investment Banker for services rendered.

Investment Banker wants to set a low price forsale of securities so that he can sell all of the securities. On the other hand, the company trying to raise capital wants a high price to raise as much capital as possible. Therefore, establishingright price for securities can be very difficult. For seasoned issues of securities, offering price can be linked to the price of existing securities. For example, price for a common stock issue can be set at a certain percentage below the closing market price onlast day of the SEC Registration Period.

Initial Public Offerings (IPO’s)

Private and closely held companies become publicly traded companies by "going public." process for going public is called an Initial Public Offering or IPO. An IPO is a major transformation for a company wherebycompany raises capital by issuing stock for the first time. Going public also establishes a market price forcompany. However, going public has several disadvantages:

1. IPO’s require registration withSEC.
2. Company is now subject to increased scrutiny and review by investors and other outside interest.
3. IPO process can be very difficult on those who are directly involved in making it happen.
4. New owners (shareholders) can be demanding, putting pressure on management for higher earnings and growth.
5. Stock prices may not accurately reflectvalue of the company.

In order to go public, a company must apply for membership with an exchange where its stock will be traded. There are requirements for stock exchange membership, such as complete disclosure of financial information. Additionally, company must register with the SEC since the sale of stock will take place in interstate commerce. purpose of a registration statement is to inform investors onmerits of the new stock offering. Registration statements includefollowing:

• Description of company assets
• Complete set of audited financial statements
• Statement concerning how capital will be used
• Description of any provisions contained insecurities

Registration Process has three distinct periods:

1. Pre-Filing Period: Preliminary negotiations and conferences between the issuer of securities andInvestment Banker will take place during the Pre-Filing Period. During this period, basic issues such as how much capital can be raised and what type of securities should be issued are addressed. DuringPre-Filing Period, offers to buy or sell securities are prohibited.

2. Waiting Period: This period starts whenRegistration Statement is filed with the SEC. 20-day waiting period gives the SEC a chance to review the Registration Statement. If the Registration Statement is incomplete,SEC will issue comments on how to correct the Registration Statement. Any amendments toRegistration Statement result in a new 20-day waiting period.

During the waiting period, Investment Banker will publish a tombstone ad that describes the pending issue of securities. tombstone ad must include:

• Name of Issuer
• Amount of securities being offered
• Approximate date of offering
• Price of securities if known

Additionally, investors can obtain a prospectus that contains information similar to what is contained inRegistration Statement. outside cover of the prospectus will be stamped in red ink - "Preliminary Prospectus." Investors sometimes call this prospectus a "red herring." Similar topre-filing period, offers to sell or buysecurities are prohibited. However, oral offers can be accepted during the 20-day waiting period.

3. Post Effective Period: Once approved by the SEC, Registration Statement becomes effective and the securities can be sold to investors. A final prospectus must be made available to investors. Prior to issuingsecurities, the Master Registration Statement is updated by filing a short form with SEC.

final price for the securities is set atclosing day when the SEC clears the issue. Investment Bankers pay the issuer of securities by the fourth day after securities have been issued and investors are required to payInvestment Banker by the tenth day. process of raising capital is now complete.

Private Placements

issuance of equity and debt securities will sometimes take place directly between the issuer and investor. This is type of direct issue is referred to as a private placement. Usually a select group of investors is involved and most private placements are for the issuance of debt instruments, not stock. Additionally, direct business loans with a term more than 15 years are classified as private placements.

Private placements are not subject to formal registration withSEC and thus, they are less expensive to issue. However, since securities are not sold in an established capital market, the placement of securities will often involve restrictive covenants imposed byinvestors. Since there is a lack of market forsecurities, investors will demand a higher rate of return.

Although private placements are exempt from SEC registration, certain rules (Regulation D) are imposed on private placements:

• No advertising ofsecurities is allowed
• issuing company must exercise care to ensure that investors are buying for their own accounts and not engaged in underwriting services.
• SEC must be notified within 15 days offirst offering.

Course Summary

cost associated with capital is rarely reflected on the Income Statement. Accordingly, many financial managers mistakenly think there is no cost of capital. Therefore, one of the first steps in managing capital is to calculatecost of capital. cost of capital is calculated asweighted average of each capital component - long-term debt, common stock, preferred stock, and retained earnings.

cost of capital serves asbenchmark for making investment decisions. If a project can earn a rate of return higher than the cost of capital, then the market value offirm will increase.

Not only do we need to understandcost of capital, but we need to find the right mix of capital components. To findright mix, we need to consider several factors. Three important factors to consider are:

1. What are the returns (EPS) under each offinancing plans? We can compare EPS at different levels of EBIT and select the best plan to maximize returns.

2. What is risk of each financing plan? We can use coverage ratios to assess risk.

3. Finally, we need to make sure that financing plan does not limit our financing options in the future. We need to have flexibility year after year when it comes to financing.

Once we have determined right mix of capital, we must raise the capital by having investors purchase the securities. capital markets bring investors and companies trying to raise capital together. Investment Bankers often serve as the middleman in underwriting issue of securities.