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Unformatted text preview: in effect the “magic number” that is used to decide whether a proposed corporate investment will increase or decrease the firm’s stock price. Clearly, only those investments that are expected to increase stock price (NPV $0, or IRR cost of capital) would be recommended. Because of its key role in financial decision making, the importance of the cost of capital cannot be overemphasized. Some Key Assumptions The cost of capital is a dynamic concept affected by a variety of economic and firm-specific factors. To isolate the basic structure of the cost of capital, we make some key assumptions relative to risk and taxes: business risk The risk to the firm of being unable to cover operating costs. financial risk The risk to the firm of being unable to cover required financial obligations (interest, lease payments, preferred stock dividends). Hint Because of the positive relationship between risk and return, a firm’s financing cost (cost of capital) will change if the acceptance of a project changes the firm’s business or financial risk. The cost of capital can therefore be more easily measured by assuming that new projects do not change these risks. target capital structure The desired optimal mix of debt and equity financing that most firms attempt to maintain. 1. Business risk—the risk to the firm of being unable to cover operating costs— is assumed to be unchanged. This assumption means that the firm’s acceptance of a given project does not affect its ability to meet operating costs. 2. Financial risk—the risk to the firm of being unable to cover required financial obligations (interest, lease payments, preferred stock dividends)—is assumed to be unchanged. This assumption means that projects are financed in such a way that the firm’s ability to meet required financing costs is unchanged. 3. After-tax costs are considered relevant. In other words, the cost of capital is measured on an after-tax basis. This assumption is consistent with the framework used to make capital budgeting decisions. The Basic Concept The cost of capital is estimated at a given point in time. It reflects the expected average future cost of funds over the long run. Although firms typically raise money in lumps, the cost of capital should reflect the interrelatedness of financing activities. For example, if a firm raises funds with debt (borrowing) today, it is likely that some form of equity, such as common stock, will have to be used the next time it needs funds. Most firms attempt to maintain a desired optimal mix of debt and equity financing. This mix is commonly called a target capital structure—a topic that will be addressed in Chapter 12. Here, it is sufficient to CHAPTER 11 The Cost of Capital 471 say that although firms raise money in lumps, they tend toward some desired mix of financing. To capture the interrelatedness of financing assuming the presence of a target capital structure, we need to look at the overall cost of capital rather than the cost of the specific source of funds used to finance a given expenditure. EXAMPLE A firm is currently faced with an investment opportunity. Assume the following: Best project available today Cost Life IRR $100,000 20 years 7% Cost of least-cost financing source available Debt 6% Because it can earn 7% on the investment of funds costing only 6%, the firm undertakes the opportunity. Imagine that 1 week later a new investment opportunity is available: Best project available 1 week later Cost Life IRR $100,000 20 years 12% Cost of least-cost financing source available Equity 14% In this instance, the firm rejects the opportunity, because the 14% financing cost is greater than the 12% expected return. Were the firm’s actions in the best interests of its owners? No; it accepted a project yielding a 7% return and rejected one with a 12% return. Clearly, there should be a better way, and there is: The firm can use a combined cost, which over the long run will yield better decisions. By weighting the cost of each source of financing by its target proportion in the firm’s capital structure, the firm can obtain a weighted average cost that reflects the interrelationship of financing decisions. Assuming that a 50–50 mix of debt and equity is targeted, the weighted average cost here would be 10% [(0.50 6% debt) (0.50 14% equity)]. With this cost, the first opportunity would have been rejected (7% IRR 10% weighted average cost), and the second would have been accepted (12% IRR 10% weighted average cost). Such an outcome would clearly be more desirable. The Cost of Specific Sources of Capital This chapter focuses on finding the costs of specific sources of capital and combining them to determine the weighted average cost of capital. Our concern is only with the long-term sources of funds available to a business firm, because these sources supply the permanent financing. Long-term financing supports the 472 PART 4 Long-Term Financial Decisions firm’s fixed-asset investments.1 We assume throughout the chapter that such investments are selected by using appropriate capital bu...
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