Question

1. Explain the concept of cost of capital and differentiate between it and weighted-average cost of capital.
2. What are the advantages and disadvantages of common versus preferred stock?
3. Describe the potential conflict of interest that exists between credit rating agencies (Moody’s, Standard and Poor, and Fitch) and companies to which they are giving bond ratings

Answer 1

Cost of capital is minimum return required for the company to generate value for the project & the investors. Capital can take in any form, like Common equity, Preferred equity, debt etc. It is extensively used in capital budgeting to decide whether the project is worth generating the value using the resources and finances. In the narrower sense, it refers to one capital source, can be either equity cost or before tax cost of debt.

WACC (weighted average cost of capital): It is the average interest that the company pays to its capital providers from different sources like common equity, debt, preferred equity and any other long-term debt. It is calculated by taking the market value weights and the cost of each capital. It is more a broad measure than just one source of cost of capital.

Common Equity

Advantages:

• Provides highest rate of return in the long run
• Has ownership control
• Share company's profits in the form of dividends
• Have voting rights, generally, proportional to the % of shares held

Disadvantages:

• Very volatile and is very risky investment as, at the time of selling shares, price of the stock can be less than that of the price bought originally.
• Possibility of dilution of control

Preferred equity

Advantages:

• Less volatile than that of common equity and hence is less risky.
• Given preference over common equity both in profit sharing and in the event of liquidation. That is, preferred equity shareholders receive dividends before the common equity shareholders
• No potential dilution of the control

Disadvantages:

• Preferred stock is sometimes called by the issuer
• Lower returns than that of the common equity

Potential conflict between rating agencies and the companies to which they issue ratings:

• issuer-pays model: Rating agencies are often compensated by the companies who pay them to rate their debt. Problem with this model is that there is an incentive conflict. To get more business, credit rating agencies may give higher ratings than deserved.