Relative Costs of Capital - Financial Management

we illustrates the general risk –return trade -off between investors’ required rates of return and various sources of funds.As was noted, the risk-free rate, rf , is usually measured as the rate of return on short-term U.S. Treasury securities. Longer-term U.S. government bonds normally command a higher rate than shorter-term debt because bond prices vary more than prices of shorter-term debt securities over time for equal changes in interest rates. Thus, if interest rates rise, the price of long-term bonds falls, resulting in losses for any investor who must sell the security prior to maturity. Investors normally require a premium to compensate for this interest rate risk.

General Risk–Required Return Trade-Off

General Risk–Required Return Trade-Off

Long -term debt securities of the U.S. government are always less risky than corporate long -term debt securities of the same maturity. The reason, of course, is the finite probability, however small, that the company will default on its obligation to pay interest and principal. Because the government controls the money supply, it can always meet its nominal financial obligations by printing more money. The actual difference in returns, or yields, between government debt and high-quality corporate debt (Aaa rated) is often less than 1 percent and sometimes less than 0.5 percent. In mid-2004, the average yield on long-term Aaa corporate bonds was 5.87 percent, and the average yield on long -term U.S.Treasury bonds was 5.31 percent. Companies with higher default risk must offer high coupon interest rates to investors in order to sell their debt issues because the market recognizes that these higher-default-risk companies are more likely to have difficulty meeting their obligations than lower-default-risk companies. For example, the yield in mid-2004 on Baa-rated bonds was about 6.58 percent.

Preferred stock is normally riskier than debt. The claims of preferred stockholders on the firm’s assets and earnings are junior to those of debt holders. Also, dividends on preferred stock are more likely to be cut or omitted than interest on debt. Consequently, investors usually demand a higher return on a company’s preferred stock than on its debt.

Common stock is the riskiest type of security considered here, because dividends paid to common stockholders are made from cash remaining after interest and preferred dividends have been paid. Thus, the common stock dividends are the first to be cut when the firm encounters difficulties. Because there is a greater degree of uncertainty associated with common stock dividends than with the interest on debt or preferred stock dividends, common stock dividends are judged riskier. In addition, the market price fluctuations of common stocks tend to be wider than those of preferred stocks or long-term debt. As a result of this higher risk, investors’ required returns on common stock are higher relative to preferred stock and debt. Over the years, the differences between returns realized from long-term corporate debt and common stock of large companies have averaged approximately 6.0 percent.

So far, this section has shown that a particular security’s risk affects the return required by investors. The analysis must be taken one important step further, however. If capital markets are to clear (that is, supply equals demand), the firm must offer returns consistent with investor requirements. Suppose, for example, that a firm offers a security for sale in the capital markets at a return that is less than investors generally require. Obviously, not enough buyers will come forth.Unless the firm increases the return (by dropping the price, raising the interest or dividend rate, and so on), the securities will remain unsold, and the firm will not be able to raise its capital. Therefore, the cost of capital to the firm is equal to the equilibrium rate of return demanded by investors in the capital markets for securities with that degree of risk.

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Financial Management Topics