The constant growth valuation and capm techniques for

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Unformatted text preview: ted risk–return preference of investors in the marketplace. The constant-growth valuation and CAPM techniques for finding ks are theoretically equivalent. But it is difficult to demonstrate that equivalency because of measurement problems associated with growth, beta, the risk-free rate (what maturity of government security to use), and the market return. The use of the constant-growth valuation model is often preferred because the data required are more readily available. Another difference is that when the constant-growth valuation model is used to find the cost of common stock equity, it can easily be adjusted for flotation costs to find the cost of new common stock; the CAPM does not provide a simple adjustment mechanism. The difficulty in adjusting the cost of common stock equity calculated by using CAPM occurs because in its common form the model does not include the market price, P0, a variable needed to make such an adjustment. Although CAPM has a stronger theoretical foundation, the computational appeal of the traditional constant-growth valuation model justifies its use throughout this text to measure common stock costs. 480 PART 4 Long-Term Financial Decisions The Cost of Retained Earnings cost of retained earnings, kr The same as the cost of an equivalent fully subscribed issue of additional common stock, which is equal to the cost of common stock equity, ks. Hint Using retained earnings as a major source of financing for capital expenditures does not give away control of the firm and does not dilute present earnings per share, as would occur if new common stock were issued. However, the firm must effectively manage retained earnings, in order to produce profits that increase future retained earnings. EXAMPLE As you know, dividends are paid out of a firm’s earnings. Their payment, made in cash to common stockholders, reduces the firm’s retained earnings. Let’s say a firm needs common stock equity financing of a certain amount; it has two choices relative to retained earnings: It can issue additional common stock in that amount and still pay dividends to stockholders out of retained earnings. Or it can increase common stock equity by retaining the earnings (not paying the cash dividends) in the needed amount. In a strict accounting sense, the retention of earnings increases common stock equity in the same way that the sale of additional shares of common stock does. Thus the cost of retained earnings, kr , to the firm is the same as the cost of an equivalent fully subscribed issue of additional common stock. Stockholders find the firm’s retention of earnings acceptable only if they expect that it will earn at least their required return on the reinvested funds. Viewing retained earnings as a fully subscribed issue of additional common stock, we can set the firm’s cost of retained earnings, kr , equal to the cost of common stock equity as given by Equations 11.5 and 11.6.6 kr ks (11.7) It is not necessary to adjust the cost of retained earnings for flotation costs, because by retaining earnings, the firm “raises” equity capital without incurring these costs. The cost of retained earnings for Duchess Corporation was actually calculated in the preceding examples: It is equal to the cost of common stock equity. Thus kr equals 13.0%. As we will show in the next section, the cost of retained earnings is always lower than the cost of a new issue of common stock, because it entails no flotation costs. The Cost of New Issues of Common Stock cost of a new issue of common stock, kn The cost of common stock, net of underpricing and associated flotation costs. underpriced Stock sold at a price below its current market price, P0. Our purpose in finding the firm’s overall cost of capital is to determine the aftertax cost of new funds required for financing projects. The cost of a new issue of common stock, kn, is determined by calculating the cost of common stock, net of underpricing and associated flotation costs. Normally, for a new issue to sell, it has to be underpriced—sold at a price below its current market price, P0. Firms underprice new issues for a variety of reasons. First, when the market is in equilibrium (that is, the demand for shares equals the supply of shares), additional demand for shares can be achieved only at a lower price. Second, when additional shares are issued, each share’s percent of ownership in the firm is diluted, thereby justifying a lower share value. Finally, many investors view the issuance of additional shares as a signal that management is using common stock equity financing because it believes that the shares are currently overpriced. Recognizing this information, they will buy shares only at a price below the current market price. Clearly, these and other factors necessitate underpricing of new 6. Technically, if a stockholder received dividends and wished to invest them in additional shares of the firm’s stock, he or she would first have to pay personal taxes...
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This document was uploaded on 01/19/2014.

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