RM 1 – RISK MANAGEMENT WEEK 2 --- Unsystematic Risks is also known as Specific Risks, are risks that are unique

RISK AND RETURN to single company or industry. This type of risk can be mitigated through
diversification of investment
▪ Risk Management – In financial management, it is the process of identification, Example: Management risk, litigation or legal risk, regulatory risk
analyzation/evaluation/measure, acceptance (it is either you accept or you
decline) /mitigation of risk in an investment. RETURN OR REWARD
▪ Financial Risk Management – is the process of identifying risk, analyzing them - measure of an investments total interest, dividends, and capital gains expressed
and making investment decision based on either accepting or mitigating them. as financial gain or loss over a specific timeframe
▪ Risk - A measure of the uncertainty surrounding the return that an investment
will earn or, more formally, the variability of returns associated with a given asset. ▫ Total rate of return – total gain or loss experienced on an investment over a given
It is also the degree of uncertainty and/or potential financial loss period of time (previous to current)

TYPES OF RISK
▪ Credit/ Default Risk – potential loss arising from a bank, corporation, or
government borrower or counterparty failing to meet its obligations in accordance ▪ rt - total rate of return;
with the agreed terms ▪ ct – cashflow (dividends, interest payment, coupon payment)
--- Credit Risk – possibility of a loss resulting from a borrower’s failure to repay ▪ pt – present value
a loan or meet contractual obligations ▪ pt-1 – previous values

▪ Foreign Exchange Risk – losses that an international financial transaction may Apple Walmart
incur due to currency fluctuation. It is also known as currency risk, foreign Beginning $90.75 Beginning $55.33
exchange risk, and exchange rate risks. Affected: financial performance, financial Dividends 0 Dividends $ 1.09
position Ending $210.73 Ending $52.84

rt = 0+210.73 – 90.75 x100 rt = 1.09+52.84 – 55.33 x100

▪ Interest Rate Risk – can be triggered by a move upward in the prevailing rates for 90.75 55.33
rt= 132.21% rt= 2.53%
new debt instruments
▪ Liquidity Risk – is associated with an investor’s ability to transact their investment
▪ Risk and Return Trade Off – Rule of Theory, states that with
for cash. Typically, investors will require some premium for illiquid assets which
▫ high risk = high return
compensate them for holding securities over time that cannot be easily liquidated
▫ low risk = low return
--- Liquid premium is an incremental return that compensates an investor for
▪ Risk Preference – attitude of investors toward risk
owning an asset that is not highly liquid
there are three categories:
▫ Risk Averse - The attitude toward risk in which investors require an increased
▪ Political Risk – risk in an investment return that suffer as a result of political
return as compensation for an increase in risk. An investor who is risk averse
changes (such as fiscal policy, monetary policy) or instability in a country.
prefers less risky over more risky investments, holding the rate of return fixed. A
risk-averse investor who believes that two different investments have the same
▪ Litigation of Legal Risk – possibility that legal action will be taken because of an
expected return will choose the investment whose returns are more certain. Stated
individuals or corporations, inaction, products, services
another way, when choosing between two investments, a risk-averse investor will
--- Legal Risks – arise from non-compliance or breach of contract
not make the riskier investment unless it offers a higher expected return to
--- Litigation Risks - ex: Starbucks paid damages due to non-compliance in law,
compensate the investor for bearing the additional risk.
this could affect financial performance and stock market
----- Harry Markowit – assumed that most people are risk averse investor
▫ Risk Neutral - An investor who is risk neutral chooses investments based solely
▪ Disaster & Hazard Risk
on their expected returns, disregarding the risks. When choosing between two
--- Disaster Risks is a financial loss caused by natural disasters & hazards
investments, a risk-neutral investor will always choose the investment with the
developing
higher expected return regardless of its risk.
▫ Risk Seeker/Lover - prefers investments with higher risk and may even sacrifice
▪ Business Risk – risk that threatens the ability of company to stay in business,
some expected return when choosing a riskier investment. By design, the average
could originate from both external and internal factors
person who buys a lottery ticket or gambles in a casino prefers investments with
Example: Regulatory risk, inflation, workplace culture, ineffective management
higher risk and may even sacrifice some expected return when choosing a riskier
strategy and etc.
investment. By design, the average person who buys a lottery ticket or gambles in
a casino
▪ Market Risk & Systematic Risk
--- Market Risks is the risk of inherent to the entire market segment. It is the
WEEK 3
risk of losses on financial investments caused by adverse price & interest rate
RISK OF A SINGLE ASSET AND A RISK OF A PORTFOLIO
movements. It is also the adverse commodities and stock price, interest rate, and
currency exchange price movement.
▪ Risk Assessment Tool:
Example: Increase in prices of commodities, volatility of interest rate and changes
▫ Scenario Analysis
in currency prices.
▫ Probability Distribution
DIVERSIFICATION OF INVESTMENT
--- Scenario Analysis an approach for assessing risk that uses several possible
To reduce overall risk, it is best to diversify by combining, or adding to the portfolio,
alternative outcomes (scenarios) to obtain a sense of the variability among
assets that have the lowest possible correlation.
returns.
--- Diversification is a process of combining multiple investments or assets to
▪ Variability – the lack of consistency or pattern, the act of varying or changing
reduce or diversify risk. It is a good investment technique to mitigate risk.
(volatility)

Scenarios:
▫ Optimistic – positive, best possible result
▪ Unsystematic Risk or Systematic Risk
 ▫ Pessimistic – negative or worst possible result where;
▫ Most likely – most probable result ▫ n – number of data, number of observations, or number of years

▪ Range - A measure of an asset’s risk, which is found by

subtracting the return associated with the pessimistic (worst)
outcome from the return associated with the optimistic (best) The expression for the standard deviation of returns, is
outcome. The greater the range, the more variability, or risk, the
asset is said to have.
▫ high range – if short gap, not risky/less risky
▫ low range – if greater gap, risky

--- Probability Distribution provide more quantitative insight into an asset’s risk.
The probability of a given outcome is its chance of occurring or chance of an
outcome to happen. a. Based on Probability b. Based on Historical Data
--- Continuous Probability Distribution is a probability distribution showing all
the possible outcomes and associated probabilities for a given event. This type of
distribution can be thought of as a bar chart for a very large number of outcomes.
Figure 8.2 presents continuous probability distributions for assets C and D. Note
that although the two assets have the same average return (15 percent), the
distribution of returns for asset D has much greater dispersion than the
distribution for asset C. Apparently, asset D is more risky than asset C.
BASED ON HISTORICAL DATA

RISK OF A SINGLE ASSET

▪ Coefficient Variation – is a measure of relative dispersion that is useful in
comparing the risks of assets with differing expected returns.

▪ Standard Deviation (σr)- The most common statistical indicator of an asset’s risk;
it measures the dispersion around the expected value. It measures the dispersion
of an investment’s return around the expected return.
- high %, risky
- low %, less risky

where;
▫ r̄-
mean
▫ rj- return, total rate or percentage of return
▫ prj- probability
▪ Expected Value of Return (r̄)- The average return that an investment is
expected to produce over time.

Stock Price
 Year Beginning Ending Dividend CORRELATION
2010 35.00 36.50 3.50
2011 36.50 34.50 3.50
2012 34.50 35.00 4.00

Compute for rj:

2010: 3.5 + (36.5 - 35)

35 = 14.29%
2011: 3.5 + (34.5 – 36.5)
36.5 = 4.11% Correlation is a statistical measure of the relationship between any two series of
2012: 4.00 + (35 – 34.5) numbers. The numbers may represent data of any kind, from returns to test
34.5 = 13.04% scores. A relationship between two series of numbers must have an inverse
Compute for r̄: Compute for variance: relationship to mitigate the risk of the assets in a portfolio.
14.29 + 4.11 + 13.04 = 31.44 14.52 + 40.58 + 6.55 = 61.466 ▪ positively correlated - Describes two series that move in the same direction.
31.44 ÷ 3 = 10.48% 61.466 ÷ (3-1) = 30.8233% ▪ negatively correlated - Describes two series that move in opposite directions
▪ correlation coefficient- A measure of the degree of correlation between two
Compute for σr: Compute for CV: series
√30. 8233 = 5.55178% 5.55178% ▪ perfectly positively correlated- Describes two positively correlated series that
10.48 = 0.5297 have a correlation coefficient of +1
▪ perfectly negatively correlated - Describes two negatively correlated series that
have a correlation coefficient of +1
Year rj r̄ rj - r̄ (rj - r̄)2 ▪ uncorrelated - Describes two series that lack any interaction and therefore have
2010 14.29% 10.48% 3.81% 14.52% a correlation coefficient close to zero.
2011 4.11% 10.48% 6.37% 40.58%
2012 13.04% 10.48% 2.56% 6.55%

var. σr CV
30.8233% 5.55178% 0.53
30.8233% 5.55178% 0.53
30.8233% 5.55178% 0.53

RISK OF A PORTFOLIO
New investments must be considered in light of their impact on the risk and return
of an investor’s portfolio of assets. The financial manager’s goal is to create an
efficient portfolio, one that provides the maximum return for a given level of risk.
We therefore need a way to measure the return and the standard deviation of a
portfolio of assets. As part of that analysis, we will look at the statistical concept
of correlation, which underlies the process of diversification that is used to
develop an efficient portfolio.

--- How to measure a portfolio? COVARIANCE

Each portfolio has different combination of investment partition, some is 50/50, ▪ positively covariance - two series that move in the same direction.
25/75, and such. The return on a portfolio is a weighted average of the returns on ▪ negatively covariance- two series that move in the opposite direction.
the individual assets from which it is formed. We can use Equation 8.5 to find the
portfolio return, rp: ∑(𝑟𝑎 − 𝑟̄ 𝑎) × (𝑟𝑏 − 𝑟̄ 𝑏 )
𝑛−1

Year rx r̄x rx - r̄x ry r̄y ry - r̄y

2013 8 12 -4 16 12 4
2014 10 12 -2 14 12 2
where 2015 12 12 0 12 12 0
wj – weight of an asset 2016 14 12 2 10 12 -2
rj – total rate return of an asset 2017 16 12 4 8 12 -4

(rx - r̄x) × (ry - r̄y) COV

-16 -10
-4 -10
0 -10
-4 -10
-16 -10
RISK AND RETURN: The Capital Asset Pricing Model (CAPM)
▫ a model used in FM to explain the relationship between return and non- (2) risk premium – additional compensation additional risk. (Kapag mas
diversifiable risk. risky ang asset, dapat may risk premium and therefore tumataas yung
▫ From the book: Thus far, we have observed a tendency for riskier investments to market returns)
earn higher returns, and we have learned that investors can reduce risk through
diversification. Now we want to quantify the relationship between risk and return. The very essence of CAPM: To compute the assets actual return (yung dapat na
maging return ng isang asset or investment)
In other words, we want to measure how much additional return an investor
should expect from taking a little extra risk. The classic theory that links risk and
Beta Coefficient (β) - A relative measure of non-diversifiable risk. An index of the
return for all assets is the capital asset pricing model (CAPM). We will use the degree of movement of an asset’s return in response to a change in the market
CAPM to understand the basic risk–return trade-offs involved in all types of return. A relative measure of non-diversifiable risk. An index of the degree of
financial decisions. movement of an asset’s return in response to a change in the market return.
- Measurement of volatility of investment and measures risk of an investment as
Changes from return is based from: well
1. Level of Risk * When Beta is higher, risk is higher, and volatility is higher as well.
2. Inflationary Expectation
3. Risk Aversion Formula:

▫ Total Risk is risk associate in an investment. Thus, he total risk of a security can
be viewed as consisting of two parts:

Portfolio Betas. The beta of a portfolio can be easily estimated by using the betas
of the individual assets it includes. Letting wj represent the proportion of the
▪ Diversifiable risk (sometimes called unsystematic risk) represents the portion of
portfolio’s total dollar value represented by asset j and letting βj equal the beta of
an asset’s risk that is associated with random causes that can be eliminated
asset j, we can use Equation 8.7 to find the portfolio beta, βp
through diversification. It is attributable to firm-specific events, such as strikes,
lawsuits, regulatory actions, or the loss of key accounts.
▪ Non-diversifiable risk (also called systematic risk) is attributable to market factors
that affect all firms; it cannot be eliminated through diversification. Factors such
as war, inflation, the overall state of the economy, international incidents, and
where:
political events account for non-diversifiable risk.
wj – weight of an asset
βj – beta of an asset

Of course, which means that 100 percent of the portfolio’s

assets must be included in this computation. Portfolio betas are interpreted in the
same way as the betas of individual assets. They indicate the degree of
responsiveness of the portfolio’s return to changes in the market return. For
example, when the market return increases by 10 percent, a portfolio with a beta
of 0.75 will experience a 7.5 percent increase in its return (0.75 * 10,); a portfolio
with a beta of 1.25 will experience a 12.5 percent increase in its return (1.25 *
10,). Clearly, a portfolio containing mostly low-beta assets will have a low beta, and
one containing mostly high-beta assets will have a high beta.
Figure 8.7 shows that diversifiable risk gradually disappears as the number of
Asset Portfolio V Portfolio W
stocks in the portfolio increases. Non-diversifiable risk is represented by the
Proportion Beta Proportion Beta
horizontal black line below which the blue curve can never go, no matter how
diversified the portfolio becomes. 1 0.10 1.65 0.10 0.80
Because any investor can easily create a portfolio of assets that will eliminate 2 0.30 1.00 0.10 1.00
virtually all diversifiable risk, the only relevant risk is non-diversifiable risk. Any 3 0.20 1.30 0.20 0.65
investor or firm therefore must be concerned solely with non-diversifiable risk. The 4 0.20 1.10 0.10 0.75
measurement of non-diversifiable risk is thus of primary importance in selecting 5 0.20 1.25 0.50 1.05
assets with the most desired risk–return characteristics. Bp = 1.20 Bp = 0.91

CAPM states that, for additional risk that investor stake, there should be additional The Equation
return. Using the beta coefficient to measure non-diversifiable risk, the capital asset
pricing model (CAPM) is given by
CAPM graph:

where:
rj = required return on asset j
RF = risk-free rate of return, commonly measured by the return
on a U.S. Treasury bill
βj = beta coefficient or index of non-diversifiable risk for asset j
rm = market return; return on the market portfolio of assets
(rm - RF) = risk premium, additional risk or return
The CAPM can be divided into two parts:
(1) risk-free rate of return (RF) - which is the required return on a risk-free * RF should always be greater than rj
asset, typically a 3-month U.S. Treasury bill (T-bill), a short-term IOU Other things being equal, the higher the beta, the higher the required return, and
issued by the U.S. Treasury the lower the beta, the lower the required return.
* T-bill and bonds are risk free investment
--- market return - the return on the market portfolio of all traded securities.
-- security market line (SML). The depiction of the capital asset pricing model
(CAPM) as a graph that reflects the required return in the marketplace for each
level of non-diversifiable risk (beta). The SML will, in fact, be a straight line. It
reflects the required return in the marketplace for each level of non-diversifiable CHANGES IN RISK AVERSION
risk (beta). The slope of the security market line reflects the general risk preferences of
investors in the marketplace. As discussed earlier, most investors are risk averse;
CHANGES IN INFLATIONARY EXPECTATIONS that is, they require increased returns for increased risk. This positive relationship
Changes in inflationary expectations affect the risk-free rate of return, RF. The between risk and return is graphically represented by the SML, which depicts the
equation for the risk-free rate of return is; relationship between non-diversifiable risk as measured by beta (x axis) and the
required return (y axis). The slope of the SML reflects the degree of risk aversion:
the steeper its slope, the greater the degree of risk aversion because a higher level
of return will be required for each level of risk as measured by beta. In other
where: words, risk premiums increase with increasing risk avoidance. Changes in risk
r* or I = constant interest rate aversion, and therefore shifts in the SML, result from changing preferences of
IP = inflation premium or inflationary expectation investors.
In short, it measures the pagkatakot ng investor sa risk.
This equation shows that, assuming a constant real rate of interest, r*, changes in -- greater risk aversion results in higher required returns for each level of risk.
inflationary expectations, reflected in an inflation premium, IP, will result in Similarly, a reduction in risk aversion causes the required return for each level of
corresponding changes in the risk-free rate. Therefore, a change in inflationary risk to decline.
expectations that results from events such as international trade embargoes or
major changes in Federal Reserve policy will result in a shift in the SML. Because ▫ higher degree – risk averse (takot sa risk)
the risk-free rate is a basic component of all rates of return, any change in RF will - rj is affected and rm increases
be reflected in all required rates of return. ▫ lower degree – less likely to be risk averse (less takot sa risk)
Changes in inflationary expectations result in parallel shifts in the SML in direct
response to the magnitude and direction of the change. This effect can best be In changes in Risk Aversion, risk-free rate of return is not affected because it is free
illustrated by an example. from risk.
THE COST OF CAPITAL Net Proceeds - from the sale of a bond, or any security, are the funds that the firm
receives from the sale. The total proceeds are reduced by the flotation cost. Ito
▪ Cost of Capital lang yung ma r-receive ni company kapag bumili si investor ng share of stock.
- expense of making capital
- represents the firm’s cost of financing and is the minimum rate of return that a
project must earn to increase firm value. In particular, the cost of capital refers to Floatation Costs - total costs of issuing and selling securities. These costs apply to
the cost of the next dollar of financing necessary to finance a new investment all public offerings of securities: debt, preferred stock, and common stock. They
opportunity include two components:
- Investments with a rate of return above the cost of capital will increase the value (1) underwriting costs, or compensation earned by investment bankers for selling
of the firm, because these investments are worth more than they cost the security; and
- the higher the cost of capital, the better! (2) administrative costs, or issuer expenses such as legal and accounting costs.
Example:
Investment A * If FC is not given, use the par value. It is either in percentage form or peso form.
Cost = $100,000
Life = 20 years
Expected Return = 7 Net Proceeds = Price – Floatation Costs
The analyst studying this investment recalls that the company recently issued
bonds paying a 6% rate of return. He reasons that because the investment project Example
earns 7% while the firm can issue debt at 6%, the project must be worth doing, so A corporation is planning to sell P20,000,000.00 worth of 20-year maturity bonds,
he recommends that the company undertake this investment. each bond has a coupon rate of 9% and with a par value of P1,000.00. Since there
In short, mas kikita. are other bonds in the market with similar risk can earn a return greater than 9%,
the corporation need to sell the bonds at a discounted price of P980.00
Investment B The Floatation cost is estimated to be at 2%.
Cost = $100,000
Life = 20 years ▫ Needed capital: Php 20M
Expected Return = 12 ▫ Maturity: 20 yrs
Least costly financing source available Equity = 14
▫ Coupon rate: 0.09
The analyst assigned to this project knows that the firm has common stock
▫ Par Value: Php 1k
outstanding and that investors who hold the company’s stock expect a 14% ▫ Selling price: Php 980
return on their investment. The analyst decides that the firm should not
undertake this investment because it only produces a 12% return while the ▫ Floatation costs: 0.02 or Php 20 (1k × 2% = Php 20 FC)
company’s shareholders expect a 14% return. ▫ Net Proceeds: Php 960 (980 – 20)

COST OF LONG-TERM DEBT

SOURCES OF LONG TERM CAPITAL ▪ Before Tax Cost of Long-term Debt
In this chapter, our concern is only with the long-term sources of capital available ▪ After Tax Cost of Long-term Debt
to a firm because they are the sources that supply the financing necessary to * debts are tax deductibles
support the firm’s capital budgeting activities.
There are four basic sources of long-term capital for firms: Before Tax Cost of LT Debt
There are three ways to be calculated:
▪ Long-term debt - the financing cost associated with new funds raised 1. Use of financial calculator
through long-term borrowing. Typically, the funds are raised through the sale of 2. Use of excel (spread sheet)
corporate bonds. Nangungutang si company sa taong bayan. 3. Approximating (manual calculation) – not accurate
▫ Debt Financing
▫ Equity Financing – sells ownership Approximating the Cost
▪ Preferred stock - shares of a company's stock with dividends that are paid out to Although not as precise as using a calculator, there is a method for quickly
shareholders before common stock dividends are issued. No voting rights.
approximating the before-tax cost of debt. The before-tax cost of debt, rd, for a
▪ Common stock - represents a residual ownership stake in a company, has voting bond with a $1,000 par value can be approximated by
rights.
▪ Retained earnings - firm's cumulative net earnings or profit after accounting for
dividends. Ito yung earnings na nag r-replenish every period, earnings after
mabayaran lahat ng shareholder.

COST OF LONG-TERM DEBT

The cost of long-term debt is the financing cost associated with new funds raised where
through long-term borrowing. Typically, the funds are raised through the sale of I = annual interest in dollars
corporate bonds. Nd = net proceeds from the sale of debt (bond)
n = number of years to the bond’s maturity
* 1 000 is not constant, replace it Par Value
After Tax Cost of Debt g or constant rate of growth in dividends is not given sometimes. To get g:
Unlike dividend payment from stocks, a bond’s coupon payment is tax deductible.
With that, we also have to consider tax when computing for cost of debt. g = present – prev ×100
prev
The after-tax cost of debt, ri, can be found by multiplying the before-tax cost, rd,
by 1 minus the tax rate, T Example:
Duchess Corporation wishes to determine its cost of common stock equity. rs. The
market price, Po. of its common stock is $50 per share. The firm expects to pay a
dividend, D₁, of $4 at the end of the coming year, 2013. The dividends paid on the
Example: outstanding stock over the past 6 years (2007 through 2012) were as follows:
Tax rate of corporation in this example is 40%
ri = 9.39% × (1 – 40%)
ri = 5.63%

COST OF PREFERRED STOCKS

The cost of preferred stock, rp, is the ratio of the preferred stock dividend to the
firm’s net proceeds from the sale of the preferred stock.
Preferred stockholders have a higher claim to dividends or asset distributing than
common stockholders. Preferred stockholders have the combination of debt
(Fixed Dividend Payments) and Equity Ownership Securities but do not have voting
rights.
It turns out to be approximately 5% (more precisely, it is 5.05%). Substituting
The following equation gives the cost of preferred stock, r p, in terms of the annual
D1 = $4, P0 = $50, and g = 5, into Equation 9.5 yields the cost of common stock
dollar dividend, Dp , and the net proceeds from the sale of the stock, N p:
equity:

The 13.0% cost of common stock equity represents the return required by existing
or:
shareholders on their investment. If the actual return is less than that,
shareholders are likely to begin selling their stock.
Example:
Using the Capital Asset Pricing Model (CAPM)
The same corporation is contemplating issuance of 10% dividend paying preferred
Describes the relationship between the required return, rs, and the non-
stock which they expect to sell at P87.00 per share. The cost of Selling the stock is
diversifiable risk of the firm as measured by the beta coefficient, b.
P5.00 per share.
Dp = 87 × 0.10
Dp = Php 8.7

8.7
8.7−5

rp = 10.61%

COST OF COMMON STOCK

The cost of common stock is the return required on the stock by investors in the Example:
marketplace. There are two forms of common stock financing: (1) retained Duchess Corporation now wishes to calculate its cost of common stock equity, rs ,
earnings and (2) new issues of common stock. by using the CAPM. The firm’s investment advisors and its own analysts indicate
The cost of common stock equity, rs, is the rate at which investors discount the that the risk-free rate, RF , equals 7%; the firm’s beta, b, equals 1.5; and the market
expected common stock dividends of the firm to determine its share value. Two return, rm, equals 11%. Substituting these values into Equation 9.6, the company
techniques are used to measure the cost of common stock equity. One relies on estimates the cost of common stock equity, rs , to be
the constant-growth valuation model, the other on the capital asset pricing model
(CAPM)

▪ Constant-growth valuation (Gordon growth) model Assumes that the value of a

share of stock equals the present value of all future dividends (assumed to grow Gordon Growth vs CAPM
at a constant rate) that it is expected to provide over an infinite time horizon. The Using Gordon Growth is recommended as it has an easy adjustment mechanism
key expression derived for this model, first presented as Equation 7.4, is: and easy adjustment for floatation cost.
CAPM cannot be adjusted for adjustment mechanism.
If silent, use Gordon Growth

COST OF RETAINED EARNINGS

Solving Equation 9.4 for rs results in the following expression for the cost of The cost of retained earnings, rr , to the firm is the same as the cost of an
common stock equity: 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.

where
P0 = value of common stock
D1 = per-share dividend expected at the end of year 1 Thus, it is not necessary to adjust the cost of retained earnings for flotation costs
rs = required return on common stock because by retaining earnings the firm “raises” equity capital without incurring
g = constant rate of growth in dividends these costs.
COST OF NEW ISSUES OF COMMON STOCK In earlier examples, we found the costs of the various types of capital for Duchess
Corporation to be as follows:

Cost of debt, ri = 5.6,

Cost of preferred stock, rp = 10.6,
Cost of retained earnings, rr = 13.0,
The net proceeds from sale of new common stock, Nn, will be less than the current Cost of new common stock, rn = 14.0,
market price, P0. Therefore, the cost of new issues, r, will always be greater than
the cost of existing issues, rs, which is equal to the cost of retained earnings, rr. The The company uses the following weights in calculating its weighted average cost
cost of new common stock is normally greater than any other long-term financing of capital:
cost.

2. Expanded form of formula used when floatation cost is in percentage. An

alternative, but computationally less straightforward, form of this equation is:

where f represents the percentage reduction in current market price expected as

a result of underpricing and flotation costs. Simply stated, Nn in Equation 9.8 is
zequivalent to P0 × (1 - f) in Equation 9.8a. For convenience, Equation 9.8 is used to
define the cost of a new issue of common stock, r n .

New issues of Common Stock is issues underpriced, meaning it is sold at a discount

relative to its current market price.

3. If floatation cost is in peso form:

𝐷1
rn = 𝑃𝑜−𝐹𝐶
+𝑔

Example:
To determine its cost of new common stock, r n, Duchess Corporation has
estimated that on average, new shares can be sold for $47. The $3-per-share If expected return is 10%, 9.84% is not acceptable
underpricing is due to the competitive nature of the market. A second cost If expected return is 8%, 9.84 % is acceptable
associated with a new issue is flotation costs of $2.50 per share that would be paid Assuming an unchanged risk level, the firm should accept all projects that will earn
to issue and sell the new shares. The total underpricing and flotation costs per a return greater than 9.8%.
share are therefore $5.50.
Subtracting the $5.50-per-share underpricing and flotation cost from the current WEIGHTING SCHEMES
$50 share price results in expected net proceeds of $44.50 per share ($50.00 Firms can calculate weights on the basis of either book value or market value using
minus $5.50). Substituting D1 = $4, Nn = $44.50, and g = 5, into Equation 9.8 results either historical or target proportions.
in a cost of new common stock, rn:
Book Value versus Market Value
▪ Book Value Weights Weights that use accounting values to measure the
proportion of each type of capital in the firm’s financial structure
▪ Market Value Weights Weights that use market values to measure the proportion
Duchess Corporation’s cost of new common stock is therefore 14.0%. That is the of each type of capital in the firm’s financial structure.
value to be used in subsequent calculations of the firm’s overall cost of capital. Market value weights are clearly preferred over book value weights.

WEIGHTED AVERAGE COST OF CAPITAL Historical versus Target Weights

Reflects the expected average future cost of capital over the long run; found by ▪ Historical Weights can be either book or market value weights based on actual
weighting the cost of each specific type of capital by its proportion in the firm’s capital structure proportions.
capital structure. ▪ Target Weights, which can also be based on either book or market values, reflect
As an equation, the weighted average cost of capital, ra, can be specified as: the firm’s desired capital structure proportions.

When one considers the somewhat approximate nature of the calculation of

weighted average cost of capital, the choice of weights may not be critical.
However, from a strictly theoretical point of view, the preferred weighting scheme
is target market value proportions, and we assume this scheme throughout this
where chapter

wi = proportion of long-term debt in capital structure

wp = proportion of preferred stock in capital structure
ws = proportion of common stock equity in capital structure
wi + wp + s = 1.0