2.
Direct
intervention by shareholders. As large institutions increasingly own shares, these
institutions have the power and sophistication to persuasively intervene on corporate
issues.
3.
The threat of firing. Shareholders can nominate and elect their own board of
directors or persuade the board to ¡°encourage¡± the current management to quit or
be fired.
4.
The threat of takeovers. If management’s poor performance is reflected in a low
stock price, a competitor may buy enough shares to have a controlling interest. At
that point, the acquirer can replace management with their own management team.
1.B: The Cost of Capital
a: Explain why the cost of capital used in capital budgeting should be a
weighted average of the costs of various types of capital the company uses.
How a company raises capital and how they budget or invest it are considered independently.
Most companies have separate departments for the two tasks. The financing department is
responsible for keeping costs low and using a balance of funding sources: common equity,
preferred stock, and debt. Generally, it is necessary to raise each type of capital in large
sums. The large sums may temporarily overemphasize the most recently issued capital, but in
the long run, the firm will ascribe to target weights for each capital type. Because of these and
other financing considerations, the investment decision must be made assuming a weighted
average cost of capital including each of the different sources of capital and using the long-
run target weights.
b: Define and calculate the component cost of: 1) debt 2) preferred stock 3)
retained earnings (3 different methods) and 4) newly issued stock or external
equity.
The after-tax cost of debt [k
d
(1- t)] is used to compute the weighted average cost of capital.
It is the interest rate on new debt (k
d
) less the tax savings due to the deductibility of interest
(k
d
t).
After-tax cost of debt = interest rate- tax savings = k
d
- k
d
(t)
After tax cost of debt = k
d
(1- t)
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