Cost Implications of the Funding Methodology
Chapter 2 explained that by increasing the organization's profitability, activity, and leverage ratios, an increase in return on equity would occur and that ratio analysis would be supplemented with EVA (economic value added) and MVA (market value added) analysis. Here is the tie-in, which contains the foundation for creating value. When sane investors buy stock, they do so with the expectation of making money. Each share of stock represents a right to a percentage of the company's assets and net income.
Theoretically, investors pay a price for a share of stock with an expectation of the percentage increase in the respective asset value (increase in stock price) and a respective share of income stream (dividend payout). In other words, investors are anticipating some combination of stock price appreciation or dividend payout. A company that sells a percentage of its company has to forgo a percentage of its asset appreciation and its income streams. That percentage is referred to as a company's cost of capital.
A company's assets are financed with either debt or equity. In today's world of finance, almost all companies have debt. That debt component has a cost associated with it as well, called interest expense. If a company's assets are financed with debt and equity, it is important to know the percentage of each relative to total assets.
The sum of the percentage of equity and debt multiplied by their respective costs is called the ...