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Chapter 7 TYPES AND COSTS OF FINANCIAL CAPITAL FOCUS In this chapter, we characterize financial markets and focus on developing an understanding of the how one obtains and pays for financial capital. Without adequate capital, even the best ideas and ventures cannot succeed. The cost of debt is relatively easy to understand and apply because it is primarily captured in the stated interest rate for a loan or bond. In contrast, the cost of equity is more difficult to grasp. One typically pays only a small part, if any, of the cost of equity through cash payments (dividends). More often, the majority, if not all, of the cost of equity is “paid” to the providers of equity capital by increases in the value of equity (capital gains). LEARNING OBJECTIVES 1. Understand some of the basic characteristics of the financial markets 2. Understand how risk-free securities prices reflect risk-free borrowing rates 3. Explain how corporate debt prices reflect higher interest rates when a borrower may default 4. Explain investment risk 5. Estimate the cost of public equity capital (e.g., exchange-listed common stock) 6. Estimate the cost of private equity capital 7. Explain how capital costs combine into a weighted average cost of capital (WACC) 8. Understand venture investors’ target returns and their relation to capital costs CHAPTER OUTLINE 7.1 IMPLICIT AND EXPLICIT FINANCIAL CAPITAL COSTS 7.2 FINANCIAL MARKETS 7.3 DETERMINING THE COST OF DEBT CAPITAL A. Determinants of Market Interest Rates B. Risk-Free Interest Rate C. Default Risk Premium D. Liquidity and Maturity Risk Premiums E. A Word on Venture Debt Capital 7.4 WHAT IS INVESTMENT RISK? A. Measuring Risk as Dispersion around an Average B. Historical Return Versus Risk Relationships 7.5 ESTIMATING THE COST OF EQUITY CAPITAL A. Cost of Equity Capital for Public Corporations B. Cost of Equity Capital for Private Ventures C. Sources and Costs of Venture Equity Capital 7.6 WEIGHTED AVERAGE COST OF CAPITAL A. A Life Cycle-Based WACC Example A. Using WACC to Complete the Calibration of EVA SUMMARY 119
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Chapter 7: Types and Costs of Financial Capital DISCUSSION QUESTIONS AND ANSWERS 1. Describe how the costs of debt and equity differ from the perspective of accounting measures. While accountants recognize that financial capital has a cost and recommend its complete inclusion in performance appraisal and decision making, historical accounting for this cost is incomplete, at least in formal financial statements. Unlike debt, much of equity’s cost is not an expense in a traditional accounting sense (with documentation); only a part of this cost (e.g., dividends) is reflected in historical financial statements. There is virtually no historical accounting for the nondividend component of equity cost, even though it is clear that the nondividend cost component increases with cuts in dividends.
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