The current capital structure of most respondents is

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Unformatted text preview: istent with their target capital structure. The average capital structure at the time of the survey was 34 percent debt, 5 percent preferred stock, and 61 percent common stock. • Most firms use one cost of capital regardless of the total amount of financing they require. Nearly all use the cost of capital for all new-project decisions; over three-quarters use it to estimate the firm’s value. • Firms use more than one method to calculate cost of equity; most employ the investors’ required return, calculated using CAPM. Source: Lawrence J. Gitman and Pieter A. Vandenberg, “Cost of Capital Techniques Used by Major U.S. Firms: 1997 vs. 1980,” Financial Practice and Education (Fall/ Winter 2000), pp. 53–68. Using the WMCC and IOS to Make Financing/Investment Decisions As long as a project’s internal rate of return is greater than the weighted marginal cost of new financing, the firm should accept the project.9 The return will decrease with the acceptance of more projects, and the weighted marginal cost of capital will increase because greater amounts of financing will be required. The decision rule therefore would be: Accept projects up to the point at which the marginal return on an investment equals its weighted marginal cost of capital. Beyond that point, its investment return will be less than its capital cost.10 This approach is consistent with the maximization of net present value (NPV) for conventional projects for two reasons: (1) The NPV is positive as long as the IRR exceeds the weighted average cost of capital, ka. (2) The larger the difference between the IRR and ka, the larger the resulting NPV. Therefore, the acceptance of projects beginning with those that have the greatest positive difference between 9. Although net present value could be used to make these decisions, the internal rate of return is used here because of the ease of comparison it offers. 10. So as not to confuse the discussion presented here, the fact that using the IRR for selecting projects may not yield optimal decisions is ignored. The problems associated with the use of IRR in capital rationing were discussed in greater detail in Chapter 10. 490 PART 4 Long-Term Financial Decisions IRR and ka, down to the point at which IRR just equals ka, should result in the maximum total NPV for all independent projects accepted. Such an outcome is completely consistent with the firm’s goal of maximizing owner wealth. EXAMPLE Figure 11.2 shows Duchess Corporation’s WMCC schedule and IOS on the same set of axes. By raising $1,100,000 of new financing and investing these funds in projects A, B, C, D, and E, the firm should maximize the wealth of its owners, because these projects result in the maximum total net present value. Note that the 12.0% return on the last dollar invested (in project E) exceeds its 11.5% weighted average cost. Investment in project F is not feasible, because its 11.0% return is less than the 11.5% cost of funds available for investment. The firm’s optimal capital budget of $1,100,000 is marked with an X in Figure 11.2. At that point, the IRR equals the weighted average cost of capital, and the firm’s size as well as its shareholder value will be optimized. In a sense, the size of the firm is determined by the market—the availability of and returns on investment opportunities, and the availability and cost of financing. In practice, most firms operate under capital rationing. That is, management imposes constraints that keep the capital expenditure budget below optimal (where IRR ka). Because of this, a gap frequently exists between the theoretically optimal capital budget and the firm’s actual level of financing/investment. Review Questions 11–13 What is the weighted marginal cost of capital (WMCC)? What does the WMCC schedule represent? Why does this schedule increase? 11–14 What is the investment opportunities schedule (IOS)? Is it typically depicted as an increasing or a decreasing function? Why? 11–15 How can the WMCC schedule and the IOS be used to find the level of financing/investment that maximizes owner wealth? Why do many firms finance/invest at a level below this optimum? S U M M A RY FOCUS ON VALUE The cost of capital is an extremely important rate of return used by the firm in the longterm decision process, particularly in capital budgeting decisions. It is the expected average future cost to the firm of funds over the long run. Because the cost of capital is the pivotal rate of return used in the investment decision process, its accuracy can significantly affect the quality of these decisions. Even with good estimates of project cash flows, the application of NPV and IRR decision techniques, and adequate consideration of project risk, a poorly estimated cost of capital can result in the destruction of shareholder value. Underestimation of the cost of capital CHAPTER 11 The Cost of Capital 491 can result in the mistaken acceptance of poor projects, whereas overestimation can cause good projects to be rejected. In either situation, the...
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