internal equity

Examples of internal equity in the following topics:

• Pay

  • By considering internal and external equity, a company can work toward a fair base pay system, attracting and retaining the best employees.
  • The manager looks at the internal and external equity to determine that $8.00 an hour is a fair base pay for workers.
  • An important question in external equity is how you define your market.
  • How do companies combine internal and external equity to decide the pay associated with each job?
  • Combine internal equity and external equity analysis to determine fair pay

• Pecking Order

  • Financing comes from internal funds, debt, and new equity.
  • When it comes to methods of raising capital, companies will prefer internal financing, debt, and then issuing new equity, respectively.
  • Raising equity, in this sense, can be viewed as a last resort.
  • As a result, investors will place a lower value to the new equity issuance.
  • This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required.

• Trade-Off Consideration

  • Trade-off considerations are important because they take into account the cost and benefits of raising capital through debt or equity.
  • An important purpose of the theory is to explain the fact that corporations are usually financed partly with debt and partly with equity.
  • Therefore, a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing.
  • As more capital is raised and marginal costs increase, the firm must find a fine balance in whether it uses debt or equity after internal financing when raising new capital.
  • Describe the balancing act between debt and equity for a company as described by the "trade-off" theory

• Capital Structure Overview and Theory

  • For example, a firm that sells 20 billion dollars in equity and 80 billion dollars in debt is said to be 20% equity-financed and 80% debt-financed.
  • The cost of equity for a leveraged firm is equal to the cost of equity for an unleveraged firm, plus an added premium for financial risk
  • The optimal structure, then would be to have virtually no equity at all.
  • It states that companies prioritize their sources of financing (from internal financing to issuing shares of equity) according to least resistance, preferring to raise equity for financing as a last resort.
  • This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, while debt is preferred over equity if external financing is required.

• The "Bond Yield Plus Risk Premium" Approach

  • The risk premium on its equity is 4%.
  • Thus, the required return on the company's equity is 10%.
  • This is also referred to as the internal rate of return (IRR).
  • The normal historical equity risk premium for all equities has been just over 6%.
  • A hypothetical graph showing yield to maturities (or internal rates of return) for corresponding present values.

• Relationships between ROA, ROE, and Growth

  • What is the company's ROA and internal growth rate?
  • In review, return on equity measures the rate of return on the ownership interest (shareholders' equity) of common stockholders.
  • This is in contrast to return on equity, which measures a firm's efficiency at generating profits from every unit of shareholders' equity.
  • In terms of growth rates, we use the value known as return on assets to determine a company's internal growth rate.
  • We use the value for return on equity, however, in determining a company's sustainable growth rate, which is the maximum growth rate a firm can achieve without issuing new equity or changing its debt-to-equity ratio.

• The Cost of New Common Stock

  • The cost of new equity is 15.3%.
  • When evaluating a new project, a company is presented with the decision of financing the project using internal or external sources.
  • If a mixture of these sources is used, the company must then decide the proportion of internal versus external sources that will be utilized, and subsequently the marginal cost of capital.
  • If a company plans to issue new common equity, or external equity, in order to finance a new project, the cost of that equity must be calculated and factored into the weighted average cost of capital to be used during the evaluation process.
  • The cost of external equity is higher than the cost of existing equity, or retained earnings.

• Other Comprehensive Income

  • Accumulated Other Comprehensive Income (AOCI) is all the changes in equity other than transactions from owners and distributions to owners.
  • Other comprehensive income, disclosed in the stockholder's equity section, is the total non-owner change in equity for a reporting period or all the changes in equity other than transactions from owners and distributions to owners.
  • Most changes to equity, such as revenues and expenses, appear in the income statement.
  • Unrealized gains and losses on available for sale securities (debt and equity)
  • Some IFRSs (international financial reporting standards) require or permit that some components be excluded from the income statement and instead be included in other comprehensive income.

• Introduction to the Balance Sheet

  • The stockholder's equity or just equity refers to the ownership interest in a company.
  • The difference between assets and liabilities is referred to as equity.
  • Equity is either calculated as proprietary or residual.
  • For residual equity dividends to preferred shareholders are deducted from net income before calculating residual equity holders' dividend per share.
  • Both internal and external users use the balance sheet.

• Defining the Cost of Capital

  • The cost of capital is the cost of obtaining funds, through debt or equity, in order to finance an investment.
  • A company's securities typically include both debt and equity; therefore, one must calculate both the cost of debt and the cost of equity to determine a company's cost of capital.
  • Thus, the costs of debt and equity are weighted to reflect the extent of their use.
  • The cost of capital can be compared to the internal rate of return (IRR) of a project or investment.
  • Equation used to determine net present value, and therefore internal rate of return.