Some investor puts up this 5000 even though he knows that no dividend is

# Some investor puts up this 5000 even though he knows

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outside sources. Some investor puts up this \$5,000, even though he knows that no dividend is expected in the foreseeable future. You issue 1,000 shares, turning over 500 shares to the outside investor and keeping the other 500 shares for yourself. Given that dividends are not expected anytime soon, is the cost of capital 0 percent? Well, let’s see. Imagine that 10 years from now, the company is sold to a larger firm for \$10 million. Both your shares and the outside investor’s shares are worth \$5 million. The outside investor’s annual rate of return is 99.5 percent (= (5 million/5000) 1/10 – 1). We normally talk of the cost of capital in terms of the rate of return. The 99.5 percent return might be viewed as the cost of capital . Your firm has given the outside investor a great return on his money, and that return has come out of your pocket. If you could turn the clock back, you might choose to forego the furniture in order to own 100 percent of your firm. Then, you could have pocketed the entire \$10 million sales price. As it is, that furniture cost you \$5 million, so to speak, not just \$5,000. This situation occurs again and again with the founders of successful businesses. Take Microsoft, for example, which Bill Gates and Paul Allen started in 1975. Microsoft’s initial public offering (IPO) occurred in 1986, at which time the firm issued \$60 million of stock. Because of both stock splits and stock price appreciation, a \$1 investment in the IPO would have been worth almost \$375 by the end of 2007.
Including dividends, the annual rate of return on the stock, beginning at the IPO date, was about 35 percent. Since Microsoft’s stock had such a high rate of return, the founders have, in essence, given away many billions of dollars to other shareholders. Now, magazine estimated the net worth of Bill Gates and Paul Allen to have been \$58 billion and \$16 billion, respectively, in 2008. So, while we shouldn’t feel sorry for Messieurs Gates and Allen, they might very well be even richer had they been able to issue fewer shares. Perhaps the firm could have borrowed funds instead of issuing the stock. Alternatively, perhaps the founders could have either delayed Microsoft’s initial public offering or, at least, issued fewer shares at that time. Now, these alternatives may not have been feasible. For example, a smaller public offering would likely have provided fewer funds for new projects. Our point is simply that stock issuance is very costly after the fact for the old stockholders of a firm that later becomes quite successful. 13.7 Cost of Capital for Divisions and Projects Previous sections of this chapter all assumed that the risk of a potential project is equal to the risk of the existing firm. How should we estimate the discount rate for a project whose risk differs from that of the firm? The answer is that each project should be discounted at a rate commensurate with its own risk. For example, let’s assume that we use the CAPM to determine the discount rate.

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