Cost of Capital Analysis PDF

Beta is used in the CAPM formula to estimate risk, and the formula would require a public company's own stock beta. For private companies, a beta is estimated based on the average beta among a group of similar public companies. Analysts may reﬁne this beta by calculating it on an after-tax basis. The assumption is that a private ﬁrm's beta will become the same as the industry average beta. Cost of Debt + Cost of Equity = Overall Cost of Capital The ﬁrm’s overall cost of capital is based on the weighted average of these costs. For example, consider an enterprise with a capital structure consisting of 70% equity and 30% debt; its cost of equity is 10% and the after-tax cost of debt is 7%. Therefore, its WACC would be: (0.7×10%)+(0.3×7%)=9.1%(0.7×10%)+(0.3×7%)=9.1% This is the cost of capital that would be used to discount future cash ﬂows from potential projects and other opportunities to estimate their net present value (NPV) and ability to generate value. Companies strive to attain the optimal ﬁnancing mix based on the cost of capital for various funding sources. Debt ﬁnancing is more tax-e_icient than equity ﬁnancing since interest expenses are tax-deductible and dividends on common shares are paid with after-tax dollars. However, too much debt can result in dangerously high leverage levels, forcing the company to pay higher interest rates to o_set the higher default risk. Cost of Capital vs Discount Rate The cost of capital and discount rate are somewhat similar and the terms are often used interchangeably. The cost of capital is often calculated by a company's ﬁnance department and used by management to set a discount rate (or hurdle rate) that must be beaten to justify an investment. That said, a company's management should challenge its internally generated cost of capital numbers, as they may be so conservative as to deter investment. The cost of capital may also di_er based on the type of project or initiative; a highly innovative but risky initiative should carry a higher cost of capital than a project to update essential equipment or software with proven performance. Importance of Cost of Capital Businesses and ﬁnancial analysts use the cost of capital to determine if funds are being invested e_ectively. If the return on an investment is greater than the cost of capital, that investment will end up being a net beneﬁt to the company's balance sheets. Conversely, an investment whose returns are equal to or lower than the cost of capital indicates that the money is not being spent wisely. The cost of capital can determine a company's valuation. Since a company with a high cost of capital can expect lower proceeds in the long run, investors are likely to see less value in owning a share of that company's equity. Cost of Capital by Industry Every industry has its own prevailing average cost of capital. The numbers vary widely. For example, according to a compilation from New York University's Stern School of Business, homebuilding has a relatively high cost of capital of 9.28%, while the retail grocery business is much lower, at 5.31%.2 According to the Stern School of Business, the cost of capital is highest among software Internet companies, paper/forest companies, building supply retailers, and semiconductor companies. Those industries tend to require signiﬁcant capital investment.2 Industries with lower capital costs include rubber and tire companies, power companies, real estate developers, and ﬁnancial services companies (non-bank and insurance). Such companies may require less equipment or may beneﬁt from very steady cash ﬂows.2 Why Is Cost of Capital Important? Most businesses strive to grow and expand. There may be many options: expand a factory, buy out a rival, or build a new, bigger factory. Before the company decides on any of these options, it determines the cost of capital for each proposed project. This indicates how long it will take for the project to repay what it costs, and how much it will return in the future. Such projections are always estimates, of course. However, the company must follow a reasonable methodology to choose between its options. What Is the Di_erence Between the Cost of Capital and the Discount Rate? The two terms are often used interchangeably, but there is a di_erence. In business, the cost of capital is generally determined by the accounting department. It is a relatively straightforward calculation of the breakeven point for the project. The management team uses that calculation to determine the discount rate, or hurdle rate, of the project. That is, they decide whether the project can deliver enough of a return to not only repay its costs but reward the company's shareholders. How Do You Calculate the Weighted Average Cost of Capital? The weighted average cost of capital represents the average cost of the company's capital, weighted according to the type of capital and its share on the company balance sheet. This is determined by multiplying the cost of each type of capital by the percentage of that type of capital on the company's balance sheet and adding the products together. The Bottom Line The cost of capital measures the cost that a business incurs to ﬁnance its operations. It measures the cost of borrowing money from creditors, or raising it from investors through equity ﬁnancing, compared to the expected returns on an investment. This metric is important in determining if capital is being deployed e_ectively. Key Takeaways: o The cost of capital represents the return a company needs to achieve in order to justify the cost a capital project, such as purchasing new equipment or constructing a new building. o The cost of capital encompasses the cost of both equity and debt, weighted according to the company’s preferred or existing capital structure. This is known as the weighted average cost of capital (WACC) o A company’s investment decisions for new projects should always generate a return that exceeds the ﬁrm’s cost of the capital used to ﬁnance the project. Otherwise, the project will not generate a return for investors. C. Capital Structure What is Capital Structure? Capital structure is the particular combination of debt and equity used by a company to ﬁnance its overall operations and growth. Equity capital arises from ownership shares in a company and claims to its future cash ﬂows and proﬁts. Debt comes in the form of bond issues or loans, while equity may come in the form of common stock, preferred stock, or retained earnings. Short- term debt is also considered to be part of the capital structure. Dynamics of Debt and Equity Both debt and equity can be found on the balance sheet. Company assets, also listed on the balance sheet, are purchased with debt or equity. Capital structure can be a mixture of a company's long-term debt, short-term debt, common stock, and preferred stock. A company's proportion of short-term debt versus long-term debt is considered when analyzing its capital structure. When analysts refer to capital structure, they are most likely referring to a ﬁrm's debt- to-equity (D/E) ratio, which provides insight into how risky a company's borrowing practices are. Usually, a company that is heavily ﬁnanced by debt has a more aggressive capital structure and, therefore, poses a greater risk to investors. This risk, however, may be the primary source of the ﬁrm's growth. Debt is one of the two main ways a company can raise money in the capital markets. Companies beneﬁt from debt because of its tax advantages; interest payments made as a result of borrowing funds may be tax-deductible. Debt also allows a company or business to retain ownership, unlike equity. Additionally, in times of low interest rates, debt is abundant and easy to access. Equity allows outside investors to take partial ownership of the company. Equity is more expensive than debt, especially when interest rates are low. However, unlike debt, equity does not need to be paid back. This is a beneﬁt to the company in the case of declining earnings. On the other hand, equity represents a claim by the owner on the future earnings of the company. Optimal Capital Structure Companies that use more debt than equity to ﬁnance their assets and fund operating activities have a high leverage ratio and an aggressive capital structure. A company that pays for assets with more equity than debt has a low leverage ratio and a conservative capital structure. That said, a high leverage ratio and an aggressive capital structure can also lead to higher growth rates, whereas a conservative capital structure can lead to lower growth rates. Analysts use the D/E ratio to compare capital structure. It is calculated by dividing total liabilities by total equity. Savvy companies have learned to incorporate both debt and equity into their corporate strategies. At times, however, companies may rely too heavily on external funding and debt in particular. Investors can monitor a ﬁrm's capital structure by tracking the D/E ratio and comparing it against the company's industry peers. Why Do Di_erent Companies Have Di_erent Capital Structure? Firms in di_erent industries will use capital structures better suited to their type of business. Capital-intensive industries like auto manufacturing may utilize more debt, while labor-intensive or service-oriented ﬁrms like software companies may prioritize equity. How Do Managers Decide on Capital Structure? Assuming that a company has access to capital (e.g. investors and lenders), they will want to minimize their cost of capital. This can be done using a weighted average cost of capital (WACC) calculation. To calculate WACC the manager or analyst will multiply the cost of each capital component by its proportional weight. How Do Analysts and Investors Use Capital Structure? A company with too much debt can be seen as a credit risk. Too much equity, however, could mean the company is underutilizing its growth opportunities or paying too much for its cost of capital (as equity tends to be more costly than debt). Unfortunately, there is no magic ratio of debt to equity to use as guidance to achieve real-world optimal capital structure. What deﬁnes a healthy blend of debt and equity varies depending on the industry the company operates in, its stage of development, and can vary over time due to external changes in interest rates and regulatory environment. What Measures Do Analysts and Investors Use to Evaluate Capital Structure? In addition to the weighted average cost of capital (WACC), several metrics can be used to estimate the suitability of a company's capital structure. Leverage ratios are one group of metrics that are used, such as the debt-to-equity (D/E) ratio or debt ratio. The Bottom Line Capital structure is the speciﬁc mix of debt and equity that a company uses to ﬁnance its operations and growth. Debt consists of borrowed money that must be repaid, often with interest, while equity represents ownership stakes in the company. The debt-to-equity (D/E) ratio is a commonly used measure of a company's capital structure and can provide insight into its level of risk. A company with a high proportion of debt in its capital structure may be considered riskier for investors, but may also have greater potential for growth. KEY TAKEAWAYS: Capital structure is how a company funds its overall operations and growth. Debt consists of borrowed money that is due back to the lender, commonly with interest expense. Equity consists of ownership rights in the company, without the need to pay back any investment. The debt-to-equity (D/E) ratio is useful in determining the riskiness of a company’s borrowing practices. D. Dividend Policy A dividend policy outlines how a company will distribute its dividends to its shareholders. This policy details speciﬁcs about payouts including how often, when, and how much is distributed. There are many types of dividend police including stable, constant, and residual policies. Understanding Dividends Before we jump into looking at divided policies, let’s talk about dividends. Dividends are a distribution of a portion of a company's earnings to its shareholders. A company can choose to reinvest those earnings into itself to drive future growth, or it can distribute those earnings to whoever owns equity in the company. Dividends are usually declared by a company's board of directors and are paid out on a per-share basis to all shareholders who own the stock. The decision to pay dividends is inﬂuenced by the company's proﬁtability, cash ﬂow, ﬁnancial health, and growth prospects. All else being equity, it’s usually best or at least most attractive to investors if companies pay a consistent, steady amount of dividends on a periodic basis. For example, investors generally prefer knowing they’ll get $1 per share each quarter as opposed to getting a varying amount awarded each quarter. However, some investors may also prefer the potential of getting higher dividends at the risk of maybe getting lower dividends as well. Dividends usually vary based on the industry, size, and maturity of companies. Mature companies in stable industries may not need as much cash, so they may be more likely to issue dividends. Growth-oriented companies in capital-intensive sectors like technology or biotechnology may prefer to hold onto their cash and not issue dividends. In either case, the company needs to have a policy that outlines what it plans to do - we’ll talk about that policy next. How a Dividend Policy Works Some companies choose to reward their common stock shareholders by paying them a dividend. A dividend is paid on a regular basis and usually represents a portion of the proﬁts that these companies earn. This gives shareholders a regular stream of income, which is why dividend-paying stocks are a favorite for some investors. Having a dividend policy in place is important for dividend-paying companies. This is a structure that highlights several key points, including: How often dividends are paid out (monthly, quarterly, or annually) When they are paid How much to pay shareholders These decisions are made by a company's management team. It must also decide what, if any, other factors may have to be put in place that would inﬂuence dividend payments. An additional factor to consider includes providing shareholders with the option to take their dividends in cash or allowing them to reinvest them by purchasing additional shares through a dividend reinvestment program (DRIP). Types of Dividend Policies: o Stable Dividend Policy - A stable dividend policy is the easiest and most commonly used. The goal of this policy is to provide shareholders with a steady and predictable dividend payout each year, which is what most investors seek. Investors receive a dividend regardless of whether earnings are up or down. The goal is to align the dividend policy with the long-term growth of the company rather than with quarterly earnings volatility. This approach gives the shareholder more certainty concerning the amount and timing of the dividend. o Constant Dividend Policy – The primary drawback of the stable dividend policy is that investors may not see a dividend increase in boom years. Under the constant dividend policy, a company pays a percentage of its earnings as dividends every year. In this way, investors experience the full volatility of company earnings. If earnings are up, investors get a larger dividend and if earnings are down, investors may not receive a dividend. The primary drawback to the method is the volatility of earnings and dividends. It is di_icult to plan ﬁnancially when dividend income is highly volatile. o Residual Dividend Policy – The residual dividend policy is also highly volatile, but some investors see it as the only acceptable dividend policy. With a residual dividend policy, the company pays out what dividends remain after the company has paid for capital expenditures (CAPEX) and working capital. This approach is volatile, but it makes the most sense in terms of business operations. Investors do not want to invest in a company that justiﬁes its increased debt with the need to pay dividends. o No Dividend Policy – Some companies decide not to pay dividends at all, particularly those in high-growth industries or early-stage startups reinvesting proﬁts to fuel expansion. These companies prioritize reinvestment of earnings into research, development, acquisitions, or debt reduction rather than distributing dividends. By forgoing dividends, the company aims to accelerate growth and enhance shareholder value through a higher future stock price rather than income generation. Note that this type of policy may actually still be documented. o Hybrid Dividend Policy – A hybrid dividend policy combines elements of the di_erent policies above. For example, a manufacturing company might adopt a hybrid policy by o_ering a stable base dividend supplemented by additional payouts based on residual earnings from exceptional periods or one-time gains. This approach allows ﬂexibility so that investors can expect a baseline amount of dividends but also realize they may be awarded higher dividends if operations go well. Importance of Dividend Policies A dividend policy is a ﬁnancial guide that helps management issue dividends. This clarity is essential because it sets expectations among investors about what potential income they might get from their investments. For income-oriented investors like retirees or those who are risk-averse, a predictable dividend stream provides assurance and helps them plan their ﬁnances like they might want or need. It also attracts a certain segment of investors who prefer stable income over capital appreciation. Second, a well-deﬁned dividend policy enhances transparency and credibility in the eyes of investors. A company is not required to issue dividends, and it may choose to stop paying a dividend at any time. By committing to a speciﬁc dividend policy, companies demonstrate their ﬁnancial discipline and intention to not only generate consistent cash ﬂows for the company but to distribute this cash. Next, a dividend policy can inﬂuence the company’s cost of capital and shareholder value. Consistently paying dividends or increasing dividends over time can enhance the company's attractiveness to investors. In the long run, this can lower its cost of equity and increase the net proceeds of what it’s able to raise for future share issuances. This is because dividends provide tangible returns to shareholders, making the stock more appealing meaning the company can sell new shares in the future at higher o_erings. Last, a dividend policy helps set a company's overall corporate strategy. For mature companies in stable industries, a dividend policy could reﬂect the fact that the company isn’t looking to scale and is probably going to maintain its operations. On the other hand, growth-oriented companies may choose not to pay dividends and reinvest earnings into expanding operations or acquiring new technologies. In both cases, the dividend policy communicates this strategic plan and can be somewhat of a roadmap for management when thinking about future plans regarding cash. The Bottom Line Dividend-paying stocks can give you a steady stream of income while adding value to your portfolio. But before you jump in, make sure you review the dividend policies of certain companies. These policies are set by corporate management and highlight how much to pay, when, and how often. KEY TAKEAWAYS: A dividend policy dictates the structure of a company's dividend payout. Dividends are often part of a company's strategy. Stable, constant, and residual are the main types of dividend policies, though there are alternatives. Even though investors know companies are not required to pay dividends, many consider it a bellwether of that speciﬁc company's ﬁnancial health. E. Mergers and Acquisitions Mergers and acquisitions (M&A) are the di_erent ways companies are combined. Entire companies or their major business assets are consolidated through ﬁnancial transactions between two or more companies. A company may: Purchase and absorb another company outright Merge with it to create a new company Acquire some or all of its major assets Make a tender o_er for its stock Stage a hostile takeover All of these ways of combining or consolidating assets are M&A activities. The term M&A also is used to describe the divisions of ﬁnancial institutions that facilitate or manage such activities. Understanding Mergers vs. Acquisitions The terms mergers and acquisitions are often used interchangeably, however, they have slightly di_erent meaning. When one company takes over another and establishes itself as the new owner, the purchase is called an acquisition. Unfriendly or hostile takeover deals, in which target companies do not wish to be purchased, are always regarded as acquisitions. However, an acquisition can also be done with the willing participation of both companies. On the other hand, a merger describes two ﬁrms that join forces to move forward as a single new entity, rather than remain separately owned and operated. In general, the two ﬁrms are of approximately the same size, and this action is known as a merger of equals. A deal can be classiﬁed as a merger or an acquisition based on whether the acquisition is friendly or hostile and how it is announced. In other words, the di_erence lies in how the deal is communicated to the target company's board of directors, employees, and shareholders. Types of Mergers and Acquisitions Mergers In a merger, the boards of directors for two companies approve the combination and seek shareholders' approval. This type of M&A activity is designed to boost both brands, allowing each to bring their existing strengths to a new company and create a bigger piece of the industry pie for the new company that is formed. For example, in 2024, HBC announced that it was acquiring the Neiman Marcus Group and merging it with another brand that it owned, Saks Fifth Avenue. Both NMG (which owns Neiman Marcus and Bergdorf Goodman) and Saks are luxury retailers, but their share of retail sales has declined with the rise of online shopping and the reduction of brick-and-mortar retail. The merger will consolidate the three existing brands (Saks, Neiman Marcus, and Bergdorf Goodman) into a single luxury retail brand known as Saks Global. This consolidation is intended to make it easier to compete with online retail giants. Acquisitions In a simple acquisition, the acquiring company obtains the majority stake in the acquired ﬁrm, which does not change its name or alter its organizational structure. In some cases, the target company may require the buyers to promise that the target business remains solvent for a period after acquisition through the use of a whitewash resolution. An acquisition often allows the acquiring company to move into a new or related industry, expanding its o_erings by tapping into the acquired company's existing customer base and services. An example of this type of transaction was Amazon's acquisition of Whole Foods in 2017. The acquisition allowed Amazon to expand into grocery delivery services (groceries make up a large portion of many people's budgets) as well as tap into the market for health-conscious customers. Whole Foods, which had been losing market share to customers who could ﬁnd similar products at lower prices in other grocery chains, beneﬁtted from Amazon's broad customer base and ease of connecting with consumers. Consolidations Corporate consolidation happens when two or more companies combine to increase their market share and eliminate competition. For example, Facebook consolidated its dominance in the social media industry by acquiring other social media companies that had promising business models and could have become competitive with Facebook. An example of this is when it acquired Instagram in 2012 for $1 billion. Instagram continued to operate as a separate company under the parent Facebook company (now Meta Platforms). However, other instances of consolidation under Facebook resulted in acquired social media companies being integrated into the Facebook platform. For example, the messaging service Beluga was acquired by Facebook, then rebranded as Facebook Messenger. Tender O_ers In a tender o_er, one company o_ers to purchase the outstanding stock of the other ﬁrm at a speciﬁc price rather than the market price. The acquiring company communicates the o_er directly to the other company's shareholders, bypassing the management and board of directors. For example, in 2008, Johnson & Johnson made a tender o_er to acquire Omrix Biopharmaceuticals for $438 million. The company agreed to the tender o_er and the deal was settled by the end of December 2008. Acquisition of Assets In an acquisition of assets, one company directly acquires the assets of another company. The company whose assets are being acquired must obtain approval from its shareholders. The purchase of assets is typical during bankruptcy proceedings, wherein other companies bid for various assets of the bankrupt company, which is liquidated upon the ﬁnal transfer of assets to the acquiring ﬁrms. Management Acquisitions In a management acquisition, also known as a management-led buyout (MBO), a company's executives purchase a controlling stake in another company, taking it private. These former executives often partner with a ﬁnancier or former corporate o_icers in an e_ort to help fund a transaction. This type of M&A transaction is typically ﬁnanced disproportionately with debt, and the majority of shareholders must approve it. For example, in 2022, Tesla Motors CEO Elon Musk purchased Twitter, Inc. for $44 billion, taking the company private. The deal included $25.5 billion of margin loan and debt ﬁnancing. How Mergers are Structured Mergers can be structured in di_erent ways, based on the relationship between the two companies involved in the deal: Horizontal merger: Two companies that are in direct competition and share the same product lines and markets Vertical merger: A customer and company or a supplier and company, such as an ice cream maker merging with a cone supplier Congeneric mergers: Two businesses that serve the same consumer base in di_erent ways, such as a TV manufacturer and a cable company Market-extension merger: Two companies that sell the same products in di_erent markets Product-extension merger: Two companies selling di_erent but related products in the same market Conglomeration: Two companies that have no common business areas Mergers may also be distinguished by following two ﬁnancing methods, each with its own ramiﬁcations for investors. Purchase Mergers As the name suggests, this kind of merger occurs when one company purchases another company. The purchase is made with cash or through the issue of some kind of debt instrument. The sale is taxable, which attracts the acquiring companies, who enjoy the tax beneﬁts. Acquired assets can be written up to the actual purchase price, and the di_erence between the book value and the purchase price of the assets can depreciate annually, reducing taxes payable by the acquiring company. Consolidation Mergers With this merger, a brand new company is formed, and both companies are bought and combined under the new entity. The tax terms are the same as those of a purchase merger. Vertical vs. Horizontal Acquisitions Horizontal integration and vertical integration are competitive strategies that companies use to consolidate their position among competitors. Horizontal integration is the acquisition of a related business. A company that opts for horizontal integration will take over another company that operates at the same level of the value chain in an industry—for instance when Marriott International, Inc. acquired Starwood Hotels & Resorts Worldwide, Inc. Vertical integration refers to the process of acquiring business operations within the same production vertical. A company that opts for vertical integration takes complete control over one or more stages in the production or distribution of a product. Apple, for example, acquired AuthenTec, which makes the touch-ID ﬁngerprint sensor technology that goes into its iPhones.13 How Acquisitions Are Financed A company can buy another company with cash, stock, assumption of debt, or a combination of some or all of the three. At times, the investment bank involved in the sale of one company might o_er ﬁnancing to the buying company. This is known as staple ﬁnancing and is done to produce larger and timely bids. In smaller deals, it is also common for one company to acquire all of another company's assets. Company X buys all of Company Y's assets for cash, which means that Company Y will have only cash (and debt, if any). Of course, Company Y becomes merely a shell and will eventually liquidate or enter other areas of business. Another acquisition deal known as a reverse merger enables a private company to become publicly listed in a relatively short time period. Reverse mergers occur when a private company that has strong prospects and is eager to acquire ﬁnancing buys a publicly listed shell company with no legitimate business operations and limited assets. The private company reverses merges into the public company, and together they become an entirely new public corporation with tradable shares. How Mergers and Acquisitions Are Valued Both companies involved on either side of an M&A deal will value the target company di_erently. The seller will obviously value the company at the highest price possible, while the buyer will attempt to buy it for the lowest price possible. Fortunately, a company can be objectively valued by studying comparable companies in an industry, and by relying on the following metrics. Price-to-Earnings Ratio (P/E Ratio) With the use of a price-to-earnings ratio (P/E ratio), an acquiring company makes an o_er that is a multiple of the earnings of the target company. Examining the P/E for all the stocks within the same industry group will give the acquiring company good guidance for what the target's P/E multiple should be. Enterprise-Value-to-Sales Ratio (EV/Sales) With an enterprise-value-to-sales ratio (EV/sales), the acquiring company makes an o_er as a multiple of the revenues while being aware of the price-to-sales (P/S ratio) of other companies in the industry. Discounted Cash Flow (DCF) A key valuation tool in M&A, a discounted cash ﬂow (DFC) analysis determines a company's current value, according to its estimated future cash ﬂows. Forecasted free cash ﬂows (net income + depreciation/amortization (capital expenditures) change in working capital) are discounted to a present value using the company's weighted average cost of capital (WACC). Admittedly, DCF is tricky to get right, but few tools can rival this valuation method. Replacement Cost In a few cases, acquisitions are based on the cost of replacing the target company. For simplicity's sake, suppose the value of a company is simply the sum of all its equipment and sta_ing costs. The acquiring company can literally order the target to sell at that price, or it will create a competitor for the same cost. Naturally, it takes a long time to assemble good management, acquire property, and purchase the right equipment. This method of establishing a price certainly wouldn't make much sense in a service industry wherein the key assets (people and ideas) are hard to value and develop. Impact on Shareholders Generally speaking, in the days leading up to a merger or acquisition, shareholders of the acquiring ﬁrm will see a temporary drop in share value. At the same time, shares in the target ﬁrm typically experience a rise in value. This is often because the acquiring ﬁrm will need to spend capital to acquire the target ﬁrm at a premium to the pre-takeover share prices. After a merger or acquisition o_icially takes e_ect, the stock price usually exceeds the value of each underlying company during its pre-takeover stage. In the absence of unfavorable economic conditions, shareholders of the merged company usually experience favorable long-term performance and dividends. The shareholders of both companies may experience a dilution of voting power due to the increased number of shares released during the merger process. This phenomenon is prominent in stock-for-stock mergers, when the new company o_ers its shares in exchange for shares in the target company, at an agreed- upon conversion rate. Shareholders of the acquiring company experience a marginal loss of voting power, while shareholders of a smaller target company may see a signiﬁcant erosion of their voting powers in the relatively larger pool of stakeholders. How Do Mergers Di_er From Acquisitions? In general, "acquisition" describes a transaction, wherein one ﬁrm absorbs another ﬁrm via a takeover. The term "merger" is used when the purchasing and target companies mutually combine to form a completely new entity. Because each combination is a unique case with its own peculiarities and reasons for undertaking the transaction, the use of these terms tends to overlap. Why Do Companies Acquire Other Companies? Two of the key drivers of capitalism are competition and growth. When a company faces competition, it must both cut costs and innovate at the same time. One solution is to acquire competitors so that they are no longer a threat. Companies also grow by acquiring new product lines, intellectual property, human capital, and customer bases. By combining business activities, overall performance e_iciency tends to increase, and across-the-board costs tend to drop as each company leverages the other company's strengths. What Is a Hostile Takeover? Friendly acquisitions are most common and occur when the target ﬁrm agrees to be acquired; its board of directors and shareholders approve of the acquisition, and these combinations often work for the mutual beneﬁt of the acquiring and target companies. Unfriendly acquisitions, commonly known as hostile takeovers, occur when the target company does not consent to the acquisition. Hostile acquisitions don't have the same agreement from the target ﬁrm, and so the acquiring ﬁrm must actively purchase large stakes of the target company to gain a controlling interest, which forces the acquisition. The Bottom Line Mergers and acquisitions, or M&A, are the di_erent ways that businesses and their assets can be bought, consolidated, or combined with another business. An acquisition is usually the outright purchase of one company by another; in a merger, the two businesses generally combine to form a new company. Both mergers and acquisitions can be ﬁnanced through a combination of stock, debt, or cash. They may be friendly or unfriendly; an unfriendly acquisition is often known as a hostile takeover and is not desired by the acquired company. KEY TAKEAWAYS: Mergers and acquisitions (M&A) refers to the ways businesses, or their assets, are consolidated or combined. In an acquisition, one company purchases another outright. A merger is the combination of two ﬁrms, which subsequently form a new legal entity under the banner of one corporate name. Mergers and acquisitions require the valuation of a company or its assets to decide how much to pay for those assets. M&A can be ﬁnanced through a combination of debt, cash, and stock. F. Corporate Governance What Is Corporate Governance? Corporate governance is the system of rules, practices, and processes by which a company is directed and controlled. Corporate governance essentially involves balancing the interests of a company's many stakeholders, which can include shareholders, senior management, customers, suppliers, lenders, the government, and the community. As such, corporate governance encompasses practically every sphere of management, from action plans and internal controls to performance measurement and corporate disclosure. Understanding Corporate Governance Governance refers to the set of rules, controls, policies, and resolutions put in place to direct corporate behavior. A board of directors is pivotal in governance, while proxy advisors and shareholders are important stakeholders who can a_ect governance. Communicating a company's corporate governance is a key component of community and investor relations. For instance, Apple Inc.'s investor relations site proﬁles its corporate leadership (the executive team and board of directors) and provides information on its committee charters and governance documents, such as bylaws, stock ownership guidelines, and articles of incorporation. Most successful companies strive to have exemplary corporate governance. For many shareholders, it is not enough for a company to be proﬁtable; it also must demonstrate good corporate citizenship through environmental awareness, ethical behavior, and other sound corporate governance practices. Beneﬁts of Corporate Governance Good corporate governance creates transparent rules and controls, guides leadership, and aligns the interests of shareholders, directors, management, and employees. It helps build trust with investors, the community, and public o_icials. Corporate governance can give investors and stakeholders a clear idea of a company's direction and business integrity. It promotes long-term ﬁnancial viability, opportunity, and returns. It can facilitate the raising of capital. Good corporate governance can translate to rising share prices. It can reduce the potential for ﬁnancial loss, waste, risks, and corruption. It is a game plan for resilience and long-term success. Corporate Governance and the Board of Directors The board of directors is the primary direct stakeholder inﬂuencing corporate governance. Directors are elected by shareholders or appointed by other board members and charged with representing the interests of the company's shareholders. The board is tasked with making important decisions, such as corporate o_icer appointments, executive compensation, and dividend policy. In some instances, board obligations stretch beyond ﬁnancial optimization, as when shareholder resolutions call for certain social or environmental concerns to be prioritized. Boards are often made up of a mix of insiders and independent members. Insiders are generally major shareholders, founders, and executives. Independent directors do not share the ties that insiders have. They are typically chosen for their experience managing or directing other large companies. Independents are considered helpful for governance because they dilute the concentration of power and help align shareholder interests with those of the insiders. The board of directors must ensure that the company's corporate governance policies incorporate corporate strategy, risk management, accountability, transparency, and ethical business practices. The Principles of Corporate Governance While there can be as many principles as a company believes make sense, some of the most common ones are: Fairness: The board of directors must treat shareholders, employees, vendors, and communities fairly and with equal consideration. Transparency: The board should provide timely, accurate, and clear information about such things as ﬁnancial performance, conﬂicts of interest, and risks to shareholders and other stakeholders. Risk Management: The board and management must determine risks of all kinds and how best to control them. They must act on those recommendations to manage risks and inform all relevant parties about the existence and status of risks. Responsibility: The board is responsible for the oversight of corporate matters and management activities. It must be aware of and support the successful, ongoing performance of the company. Part of its responsibility is to recruit and hire a chief executive o_icer (CEO). It must act in the best interests of a company and its investors. Accountability: The board must explain the purpose of a company's activities and the results of its conduct. It and company leadership are accountable for the assessment of a company's capacity, potential, and performance. It must communicate issues of importance to shareholders. Corporate Governance Models

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