By the end of this section, you will be able to:
- Calculate the required return to preferred shareholders.
- Calculate the WACC of a firm that issues preferred shares.
- Discuss how issuing new equity impacts the cost of equity capital.
- Explain the functionality of convertible debt.
A company can finance its assets in two ways: through debt financing and through equity financing. Thus far, we have treated these sources as two broad categories, each with a single cost of capital. In reality, a company may have different types of debt or equity, each with its own cost of capital. The same principle would apply: the WACC of the firm would be calculated using the weights of each of these types multiplied by the cost of that particular type of debt or equity capital.
Preferred Shares
Although our calculations of WACC thus far have assumed that companies finance their assets only through debt and common equity, we saw at the beginning of the chapter that the basic WACC formula is
In addition to common stock, a company can raise equity capital by issuing preferred stock. Owners of preferred stock are promised a fixed dividend, which must be paid before any dividends can be paid to common stockholders.
In the order of claimants, preferred shareholders stand in line between bondholders and common shareholders. Bondholders are paid interest before preferred shareholders are paid annual dividends. Preferred shareholders are paid annual dividends before common shareholders are paid dividends. Should the company face bankruptcy, the same priority of claimants is followed in settling claims—first bondholders, then preferred stockholders, with common stockholders standing at the end of the line.
Preferred stock shares some characteristics with debt financing. It has a promised cash flow to its holders. Unlike common equity, the dividend on preferred stock is fixed and known. Also, there are consequences if those preferred dividends are not paid. Common shareholders cannot receive any dividends until preferred dividends are paid, and in some cases, preferred shareholders receive voting rights until they are paid the dividends that are due. However, preferred shareholders cannot force the company into bankruptcy as debt holders can. For tax and legal purposes, preferred stock is treated as equity.
The cost of the preferred equity capital is calculated using the formula
Suppose that Greene Building Company has issued preferred stock that pays a dividend of $2.00 each year. If this preferred stock is selling for $21.80 per share, then the company’s cost of preferred stock is
Think It Through
Calculating Common Equity Financing
Greene Building Company uses 40% debt, 15% preferred stock, and 45% common stock in its capital structure. The yield to maturity on the company’s bonds is 7.2%. The cost of preferred equity is 9.17%. In the most recent year, Greene paid a dividend of $3.15 to its common shareholders. This dividend has been growing at a rate of 3.0% per year, which is expected to continue in the future. The company’s common stock is trading for $32.25 per share. Greene pays a corporate tax rate of 21%. Estimate the WACC for Greene.
Solution:
The cost of Greene’s common equity financing must be calculated. This can be done using the constant dividend growth model:
The weights and the costs for each component of capital are placed in the WACC formula:
The WACC for Greene Building Company is estimated to be 9.47%. Note that debt financing is the cheapest cost of capital for Greene. The reason for this is twofold. First, because debt holders face the least amount of risk because they are paid first in the order of claimants, they require a lower return. Second, because interest payments are tax-deductible, the interest tax shield lowers the effective cost of debt to the company. Preferred shareholders will require a higher rate of return than debt holders, 9.17%, because they are later in the order of claimants. Common shareholders are the residual claimants, standing at the end of the line to receive payment. After all other claimants are paid, any remaining money belongs to the shareholders. If this residual amount is small, the common shareholders receive a small payment. If there is nothing left after all other claimants have been paid, common shareholders receive nothing. Thus, common shareholders have the greatest amount of risk and require the highest rate of return.
Also, note that the weights for debt, preferred stock, and common stock in the capital structure sum to 100%. The company must finance 100% of its assets.
Issuing New Common Stock
An existing firm can acquire equity capital to expand its assets in two ways: the retention of earnings or the sale of new shares of stock. Thus far in the chapter, the cost of equity capital calculations have assumed that the earnings were being retained for equity capital financing.
The net income that is left after all expenses are paid is the residual income that belongs to the shareholders. Instead of receiving a fixed payment for letting the firm use their capital (like bondholders who receive fixed interest payments), the reward to shareholders for letting the company use their capital varies from year to year. In a good year, net income and the reward to shareholders is high. In a poor year, net income is low or perhaps even negative.
The net income can either be paid immediately and directly to shareholders in the form of dividends or be retained within the company to fund growth. Shareholders are willing to allow the company to retain these earnings because they expect that the money will be used to fund profitable projects, leading to an even larger reward for shareholders in future years.
Although managers do not need to actively solicit the funds that are retained to fund the business, managers cannot view these funds as costless. The shareholders will require a return on those funds to entice them to allow the company to delay paying the dollars to them immediately in terms of a dividend.
Suppose a company has $1 million in net income one year. If it pays $250,000 in dividends and retains $750,000, then it can finance $750,000 more in assets. If the company has a capital structure of 25% debt and 75% equity and wants to maintain that capital structure, it must increase its debt by $250,000 to balance the increase in equity. Thus, the company would be increasing its total financing by $1 million. Of that financing, 25% would be debt financing, and 75% would be equity financing.
To increase its assets by more than $1 million, the company would need to decide to either change its capital structure or issue new stock. Consider the firm represented by the market-value balance sheet in Figure 17.5. The firm has $900 million in assets. These assets are financed by $225 million in debt capital and $675 million in equity capital, resulting in a capital structure of 25% debt and 75% equity.
The retained earnings of $750,000 cause the equity on the balance sheet to increase to $675.75 million. The company could sell $250,000 in bonds, increasing its debt to $225.25 million. Figure 17.6 shows the impact on the balance sheet. The company has increased its financing by $1,000,000 and can expand assets by $1,000,000. The capital structure remains 25% debt and 75% equity.
What if the economy is in an expansionary period and this company thinks it has the opportunity to grow at a rate of 5%? The company knows that it will need more assets to be able to grow. If it needs 5% more assets, its assets will need to increase to $945 million. To increase the left-hand side of its balance sheet, the company will also need to increase the right-hand side of the balance sheet.
Where does the company get the $45 million in capital? With $750,000 in retained earnings, the company can increase its equity to $675.75 million, but if the remainder of $44.25 million was financed through debt, the company’s capital structure would change. Its weight of debt would increase to
If the company has determined that its optimal capital structure is 25% debt and 75% equity, financing the majority of the growth through debt would cause it to stray from these levels. Funding the growth while keeping the capital structure the same would require the firm to issue new shares. Figure 17.7 shows how the firm would need to finance $45 million in growth while maintaining its desirable capital structure. The firm would need to increase equity capital to $708.75 million; retained earnings could provide $750,000, but $33 million of new equity would need to be sold.
Investors who are providing common equity financing require a return to entice them to let the company use their money. If this company has paid $0.50 per share in dividends to shareholders and this dividend is expected to increase by 3% each year, we can use the constant dividend growth model to estimate how much common shareholders require. If the stock is trading for $8.00 per share, the cost of common equity financing is estimated as
If, however, the firm must issue more equity, its cost of equity for those additional shares will be higher than 9.44%. Even if shareholders are willing to pay $8.00 per share for the stock, the firm will incur flotation costs; this means the firm will not receive the entire $8.00 to use to finance new assets and generate a profit for shareholders. Flotation costs include the costs of filing with the Securities and Exchange Commission (SEC) as well as the fees paid to investment bankers to place the new shares.
When new equity must be issued to finance the company, the flotation costs must be subtracted from the price of the stock to determine the net proceeds the firm will receive. The cost of this new equity capital is calculated as
where F represents the flotation costs of the new stock issue. If, in this example, the flotation cost is $0.25 per share, then the cost of raising new equity capital is
Issuing new common equity is the most expensive form of raising capital. Equity capital is already expensive because the common shareholders are the residual claimants who will only be paid if all other claimants are paid. Because of this risk, they require a higher rate of return than providers of capital who have precedence in the order of claimants. Flotation costs must be added to this equity cost when new shares are issued to grow the company.
Think It Through
Cost of Issuing New Equity
You are a financial manager for American Motor Works (AMW). The target capital structure for the company is 30% debt and 70% equity. You know that your company’s after-tax cost of debt is 4.6%. Your company paid a dividend of $3 per share last year, and it has a policy of increasing its dividend at a rate of 1.5% each year. AMW stock is currently trading for $27.50 per share. You estimate that the company’s retained earnings will be $10 million this year. If the company needs to issue new shares of stock, flotation costs are expected to be $0.75 per share.
Given this information, you are tasked with calculating the company’s WACC. You need to provide an estimate of WACC if retained earnings are used and an estimate if new equity must be issued.
Solution:
First, calculate the cost of equity capital for AMW using the constant dividend growth model:
Using 12.57% as the equity cost of capital and 4.6% as the after-tax cost of debt, the WACC is calculated as
The WACC for AMW when it is using retained earnings for equity financing is 10.18%. If the company has $10 million in retained earnings this year, its equity will increase by $10 million. Given its target capital structure of 30% debt and 70% equity, AMW will be able to increase its overall financing by by using its retained earnings and issuing new debt of $4,285,714.
If AMW wants to expand its assets by more than $14,285,714 during the next year, it will need to issue new stock or increase the weight of debt in its capital structure. The company will incur flotation costs of $0.65 per share to issue new stock. The cost of new equity capital will be
With this more expensive newly issued equity capital, AMW’s WACC will become
If AMW wants to take on a large project that requires investment in more than $14,285,714 worth of assets, such as building a new production facility, the company will need to issue more equity and will face a higher WACC than when using retained earnings as its equity financing.
Convertible Debt
Some companies issue convertible bonds. These corporate bonds have a provision that gives the bondholder the option of converting each bond held into a fixed number of shares of common stock. The number of common shares the bondholder would receive for each bond is known as the conversion ratio.
Suppose that you own a convertible bond issued by Sheridan Sodas with a face value of $1,000 and a conversion ratio of 20 shares that matures today. If you convert the bond today, you will receive 20 shares of Sheridan common stock. If you do not convert, you will receive $1,000. If you convert, you are basically paying $1,000 for 20 shares of Sheridan stock. The conversion price is If Sheridan is trading for more than $50 per share, you would want to convert. If Sheridan is trading for less than $50 per share, you would not want to convert; you would prefer the $1,000. In other words, you will choose to convert whenever the stock price exceeds the conversion price at maturity.
A convertible bond gives the holder an option; the bondholder is able to choose between the face value cash or receiving shares of stock. Options always have a positive value to holders. It is always preferable to be able to choose $1,000 or shares of stock than to simply be given $1,000. There is a possibility that the shares of stock will be more valuable, and there is no way the choice can put you in a worse position.
Because holders of convertible bonds have the valuable option of conversion that holders of nonconvertible bonds do not have, convertible debt can be offered with a lower interest rate. It might seem as if the firm could lower its weighted average cost of capital by issuing convertible debt rather than nonconvertible debt. However, this is not the case. Remember that holders of convertible bonds choose whether they would prefer to convert the bond and become a stockholder or receive the face value of the bond at maturity.
If a bond has a face value of $1,000, the convertible bond holders will consider whether the stock they can convert to is worth more than $1,000. Only when the price of the stock has increased enough that the value of the stock received is more than $1,000 will the bondholders convert. However, this means that instead of paying $1,000, the firm is paying the bondholder in stock worth more than $1,000. In essence, the firm (and the current shareholders) would be selling an equity position in the company for less than the market price of that equity position. The lower interest rate compensates for the possibility that conversion will occur.