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What Are the Benefits of Issuing Common Stock

When a company issues common stock, it is called either an initial public offering or a secondary offering. The initial public stock offering, or IPO, gives existing shareholders liquidity by publicly trading the stock on a public stock exchange and gives the company an influx of cash. When a company issues stock after the initial public offerings, this is called a secondary offering. There are many reasons companies issue common stock.

Pay Down Debt


If the company is carrying a heavy debt load as a result of expanding the business, a responsible corporate decision would be to pay down the debt using corporate cash flow or the proceeds gained from issuing stock. With an enhanced balance sheet, the company can entertain into more ambitious expansion plans. Cash on Hand If a company believes that its current stock price is strong in the face of a possibly declining outlook for its products, it might seek to issue stock to have ample cash for the downturn, buy back stock at lower prices if there is a decline in stock prices or have funds available to take strategic advantage of competitor's weakness during a downturn. Issuing stock can be part of an opportunistic business strategy. Acquisitions Stock is often issued once a company has decided that a related business has better growth prospects than the business the company is currently engaged in or can be melded into the current product line. This is how Standard & Poor 500 companies often grow. Using current cash flow and a stock issuance, a company will buy a smaller company in a field it wishes to enter. This regularly happens to small-cap companies that have important products but need either capital or to be acquired by a larger company to grow sales. Credit Ratings

Stocks that are publicly traded have common stock and bond ratings. These ratings are enhanced if they are public companies that can come to the public markets and raise cash to pay down debt or raise capital. As a result, rating agencies treat public companies that have enhanced liquidity as better risks than companies that must rely on private placements or bank lines of credit, so the cost of loans go down for companies that issue stock.

Considerations
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If the company has outstanding prospects, it may stagger the sale of stock over time, issuing stock at a higher and higher price each time. However, the corporate treasurer must make certain that the stock issuance is absolutely necessary so that stock is not sold too cheaply and existing investors lose much of the benefit of a stock's subsequent rise.

How To Calculate Required Rate Of Return


1)The required rate of return takes risk into account, not just ROI. 2)It is used for discounting cash flows in many financial models. 3)Risk/return preferences, inflation expectations & the firm's capital are key. The required rate of return (RRR) is a component in many of the metrics and calculations used in corporate finance and equity valuation. It goes beyond just identifying the return of the investment, and factors in risk as one of the key considerations to determining potential return. The required rate of return also sets the minimum return an investor should accept, given all other options available and the capital structure of the

firm. To calculate the required rate, you must look at factors such as the return of the market as a whole, the rate you could get if you took on no risk (the risk-free rate of return), and the volatility of the stock or the overall cost of funding the project. Here we examine this metric in detail and show you how to use it to calculate the potential returns of your investments. (For background reading, check out FYI On ROI: A Guide To Return On Investment.)

TUTORIAL: Risk And Diversification Discounting Models One particularly important use of the required rate of return is in discounting most types of cash flow models and some relative value techniques. Discounting different types of cash flow will use slightly different rates with the same intention - finding the net present value. Common uses of the required rate of return include:

Calculating the present value of dividend income for the purpose of evaluating stock prices Calculating the present value of free cash flow to equity Calculating the present value of operating free cash flow

Equity, debt and corporate expansion decisions are made by placing a value on the periodic cash received and measuring it against the cash paid. The goal is to receive more than what you paid. In corporate finance, the focus is on the cost of funding projects compared to the return; in equities, the focus is on the return given compared to the risk taken on.

Equity and Debt In equities the required rate of return is used in various calculations. For example the dividend discount model uses the RRR to discount the periodic payments and calculate the value of the stock. Finding the required rate of return can be done by using the capital asset pricing model (CAPM). The CAPM will require that you find certain inputs:

the risk free rate (RFR) the stocks beta the expected market return.

Start with an estimate of the risk free rate. You could use the current yield to maturity of a 10 year T-bill lets say its 4%.

Then, take the expected market risk premium for this stock. This can have a wide range of estimates. For example, it could range between 3% to 9%, based on factors such as business risk, liquidity risk, financial risk. Or, you can simply derive it from historical yearly market returns. Lets use 6%, rather than any of the extreme values. Often, the market return will be estimated by a brokerage, and you can just subtract the riskfree rate. (Learn how to calculate the risk premium and why academic studies usually estimate a low. Check out The Equity-Risk Premium: More Risk For Higher Returns and Calculating The Equity Risk Premium.) Last of all, get the beta of the stock. The beta for a stock can be found on most investment websites. To calculate beta manually, use the following regression model:

Return of Stock = + stock Rmarket

Where:

stock is the beta coefficient for the stock, meaning it is the covariance between the stock and the market divided by the variance of the market. We will assume the beta is 1.25. Rmarket is the return expected from the market. For example, the return of the S&P 500 can be used for all stocks trading on it - and even some stocks not on the index, but related to businesses that are.

is a constant that measures excess return for given level of risk (For more on this, see Calculating Beta: Portfolio Math For The Average Investor.)

Now we put together these three numbers using the capital asset pricing model:

E(R) = RFR + stock (Rmarket RFR) E(R) = 0.04 + 1.25 (6) E(R) = 11.5%

Where:

E(R) = the required rate of return, or expected return RFR = the risk free rate stock = beta of the stock Rmarket = return of the market as a whole

(Rmarket RFR) = the market risk premium, or the return above the risk-free rate to accommodate additional unsystematic risk

Dividend Discount Approach An investor could also use the dividend discount model, also known as the Gordon growth model. By finding the current stock price, the dividend payment and an estimate of the growth rate for dividends, you can rearrange the formula into:

k=(D/S)+g

Where:

k = required rate of return D = dividend payment (expected to be paid next year) S = current stock value (if using the cost of newly issued common stock you will need to minus the flotation costs) g = growth rate of the dividend

Again, it is important to note that there needs to be some assumptions, particularly the continued growth of the dividend at a constant rate. Required Rate of Return in Corporate Finance Investment decisions are not limited to stocks; every time money is risked for something like expansion or a marketing campaign an analyst can look at the minimum return these expenditures demand. If the current project will give a lower return than other potential projects, then it will not be done. Other factors do go into these decisions, such as risk, time horizon and available resources, among others, but the required rate of return is the basis for deciding between multiple investments. When looking at an investment decision in corporate finance, the overall required rate of return will be the weighted average cost of capital (WACC). (Learn more about this metric in Investors Need A Good WACC.)

Capital Structure The WACC is the cost of financing new projects based on how a company is structured. If a company is 100% debt then it would be easy: just find the interest on the issued debt and adjust for taxes (because interest is tax deductible). In reality, a corporation is much more complex. Finding the true cost of capital requires a calculation based on a combination of sources. Some would even argue that, under certain assumptions, the capital structure is irrelevant, as outlined in the Modigliani-Miller theorem.

To calculate the WACC simply take the weight of the source of financing and multiply it by the corresponding cost. There is one exception: you should multiply the debt portion by one minus the tax rate. Then sum the totals. The equation looks something like this:

WACC = Wd [kd(1-t)] + Wps(kps) + Wce(kce)

Where:

WACC = weighted average cost of capital (firm wide required rate of return) Wd = weight of debt kd = cost of debt financing t = tax rate Wps = weight of preferred shares kps = cost of preferred shares Wce = weight of common equity kce = cost of common equity

When dealing with internal corporate decisions to expand or take on new projects, the required rate of return is used as a minimum acceptable return benchmark - given the cost and returns of other available investment opportunities. (For more check out Evaluating A Company's Capital Structure.) The Bottom Line The required rate of return is a difficult metric to pinpoint due to the various estimates and preferences from one decision maker to the next. The risk return preferences, inflation expectations and the firms capital structure all play a role in determining the required rate. Any one of the many factors can have major effects on an assets intrinsic value. As with many things, practice makes perfect. As you refine your preferences and dial in estimates, your investment decisions become dramatically more predictable.

How to Build a Stock Portfolio


A proven strategy for building a stock portfolio that gives decent returns while posing minimun risks. This is a long term strategy that has proven itself over 30 years of markets ups and downs. There is no single strategy for being successful in the stock market. If we look at the great investors, Warren Buffet, T. Rowe Price and Peter Lynch, they all had different investment strategies. However, few people have the natural investment talents and insights that these men held. Below than is a strategy than can be used by the rest of us to earn high returns while maintaining minimum risks. This stock portfolio strategy is based on 3 basic principles: 1. Diversify 2. Buy Quality Stock 3. Pay the Right Price Here are these principles laid out in nine detailed steps.

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Diversify Buying several stocks in different industries will prevent wiping out your investments if any one industry goes down. This should be a minimum of 10 stocks in 10 industries. The more stocks, the closer your portfolio will mirror the market, but more than 50 stocks is overkill, and becomes difficult to maintain. 10 stocks in 10 industries should mirror about 85% of the market, and if you buy 20 stocks in 20 industries, you will just about have the market mirrored. Restrict Total Investment Restrict your stock portfolio to a small portion of your asset base. Buy in Equal Dollar Amounts When building your stock portfolio, buy your stocks in equal dollar amounts instead of round lots. In other words, if you have $20,000 to invest in 10 stocks, buy $2000 worth of each stock. If you buy an even block, for example 100 shares of an $80/share stock, the value in that stock will total $8000 and will make up 40% of your stock holdings instead of 10%. This will go against our goal in item 1, which is to diversify. Buy Quality Stocks Quality of the stock is sometime difficult to determine, but here are some general steps you can take to pick a high quality stock. A. Large Company B. A Standard & Poor rating of B+ or higher C. A leader or one of the leaders in their industry D. Has been around for many years E. Has a history of paying dividends Get Good Dividends There are two reasons that you want to go with a company that pays dividends. A. Dividends increase the total return more than capital gains alone B. History shows that companies that pay dividend tend to fail less often Convertible Preferred Stock If the company you are interested in also has a Convertible Preferred Stock, you may want to buy this instead Do Not Trade Often High volatility will most often lead to a worse rate of return. As part of this, trading stocks often will create higher costs due to fees and higher taxes. Unless there is a compelling reason to change, you should hold onto stocks 3 to 5 years. Buy When Stock is Down Do not buy stock in a company when it is making the front cover of Business Week for it's success. By this time the stock has already gone up and you will be buying at a peak. Instead buy when the company is down, but from your other research you know it is a quality company and will recover. Have Patience As stated in item 7, you should plan on holding on to your stocks at least 3 to 5 years. You should sell the stock when the reason you bought the stock is no longer valid. Also consider selling a stock from a company that is going through a merger. Usually you will be offered a higher price at the time of the merger and most likely the company will change and not be the same company you selected.

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