Table of Contents:

Capital Formation

Capital formation refers to activities undertaken by a company to raise capital for shortterm and long-term investment purposes (Piketty 2014; Sherman 2012).

In general, the net income earned by most companies, plus their internal resources of retained earnings, are not sufficient to finance all investments needed to achieve both their short-term and long-term corporate objectives. Even if these internal resources are sufficient, some companies still engage in external financing due to valid reasons related to tax and strategic management flexibility. Many companies routinely pursue some external financing resources, such as equity or debt financing, or both.

Equity Financing

Equity financing is the raising of capital by issuing company stocks. Stocks are certificates of company ownership, which typically carry a par value of $1. The price of the same stock in the market (e.g., the New York Stock Exchange) may fluctuate in time as a consequence of national economic conditions, industrial trends, political stability, and other factors unrelated to company performance. Shareholders are those who own stocks. They have the residual claims to what is left of the firm's assets after the firm has satisfied other high-priority claimants (e.g., bondholders, bankruptcy lawyers, and unpaid employees). Basically, there are two kinds of stocks: common stocks and preferred stocks (whose dividends have a priority over those of common stocks).

Companies may issue new stocks to raise capital. The process requires the approval of the company's board of directors (which mirrors the interests of all shareholders), because such a move may result in the dilution of company ownership. In addition, a public stock offering needs to be registered with the federal government (e.g., the U.S. Securities and Exchange Commission) and organized by an underwriting firm. The underwriting firm helps set the offering price, prepares the proper advertisements, and assists in placing all unsold issues to ensure a successful completion of the equity financing process. Companies issuing new stocks will incur an issuing expense.

FIGURE 7.1

Market risk premium.

The capital received by issuing stocks has a cost made up of the following components: the cost of equity capital, which includes the stock issuing fees; the dividends to be paid in future years; and the capital gains through stock price appreciation expected by investors in the future. Typically, this cost of equity is set to equal the return of an equity calculated by using the well-known capital asset pricing model (CAPM) (Hart 2014).

The CAPM defines the return of an equity as (see Figure 7.1)

where:

Rf = risk-free rate (e.g., 6.0% of 10-year U.S. Treasury bills)

Rm = expected return of a market portfolio, a group of stocks representing the

behavior of the entire market (e.g., S&P 500 Index). Rm depends on conditions not related to the individual stocks. The typical value for Rm is in the range of 15%, based on long-term U.S. market statistics

P (Beta) = relative volatility of a stock in comparison to that of a market portfolio, which by definition has a Beta of 1.0. The Standard & Poor's 500 stocks serve as a proxy for the overall market. If the Beta of a stock is 1.5, then its price will change by 1.5% for every 1.0% price change of the market portfolio in the same direction. An issue with a Beta of 0.5 tends to move 50% less. A stock with a negative Beta value tends to move in a direction opposite to that of the overall market. Stocks with large Beta values are more volatile and hence more risky. Beta values are published in the financial literature for most stocks that are publicly held.

Rm - Rf = market risk premium.

Since the value of Beta is based on historical data, numerous financial analysts view it as a major deficiency of the CAPM model. Another deficiency is its lack of timing constraints.

The same cost is assumed to be valid for capital projects of a 2- or 10-year duration. In practice, when evaluating a specific capital investment project, some companies adjust the value of Beta manually in order to arrive at a pertinent cost of equity capital.

 
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