Foundations of Financial Management: An Analysis (part 42)

 “Money poisons you when you’ve got it, and starves you when you haven’t.”

 – D.H. Lawrence

Cost of Capital (Part D)

by

Charles Lamson

Optimal Capital Structure---Weighting Costs

Having established the techniques for computing the cost of the various elements in the capital structure in the last few posts, we must discuss methods of assigning weights to these costs. We will attempt to weight capital components in accordance with our desire to achieve a minimum overall cost of capital. This represents an optimum capital structure. For the purpose of this discussion, Table 1 (Cost of Capital for the Lamson Corporation) from part 39 of this analysis is reproduced.

How does the firm decide on the appropriate weights for debt, preferred stock, and common stock financing? Though debt is the cheapest form of financing, it should be used only within reasonable limits. In the Lamson Corporation example, that carried an after-tax cost of 7.05 percent, while other sources of financing cost at least 10.94%. Why not use more debt? The answer is that the use of debt beyond a reasonable point may greatly increase the firm's financial risk and thereby drive up the costs of all sources of financing.

Assume you are going to start your own company and are considering three different capital sources structures. For ease of presentation, only debt and equity (common stock) are being considered. The costs of the components in the capital structure change each time we vary the debt-assets mix (weights).

The firm is able to initially reduce the weighted average cost of capital with debt financing, but beyond Plan B the continued use of debt becomes unattractive and greatly increases the costs of the sources of financing. Traditional financial theory maintains that there is a U-shaped cost-of-capital curve relative to debt utilization by the firm, as Illustrated in Figure 1. In this example, the optimum capital structure occurs at a 40 percent debt-to-assets ratio.

Most firms are able to use 30 to 50 percent debt in their capital structure without exceeding norms acceptable to creditors and investors. Distinctions should be made, however, between firms that carry high or low business risks. A growth firm in a reasonably stable industry can afford to absorb more debt than its counterparts in cyclical industries.

In determining the appropriate capital mix, the firm generally begins with its present capital structure and ascertains whether its current position is optimal. If not, subsequent financing should carry the firm toward a mix that is deemed more desirable. Only the costs of new or incremental financing should be considered. 

Capital Acquisition and Investment Decision Making

So far the various costs of financial capital and the optimum capital structure have been discussed. Financial capital, as you may have figured out, consists of bonds, preferred stock, and common equity. These forms of financial capital appear on the corporate balance sheet under liabilities and equity. The money raised by selling the securities and remaining earnings is invested in the real capital of the firm, the long-term productive assets of plant and equipment.

Long-term funds are usually invested in long-term assets, with several asset financing mixes possible over the business cycle. Obviously a firm wants to provide all of the necessary financing at the lowest possible cost. This means selling common stock when prices are relatively high to minimize the cost of equity. The financial manager also wants to sell debt at low interest rates. Since there is short-term and long-term debt, the manager needs to know how interest rates move over the business cycle and when to use short-term versus long-term debt.

Corporations are allowed some leeway in the money and capital markets, and it is not uncommon for the debt-to-equity ratio to fluctuate between x and y over a business cycle. The firm that is at point y has lost the flexibility of increasing its debt-to-assets ratio without incurring the penalty of higher capital costs.

Cost of Capital in the Capital Budgeting Decision

The current cost of capital for each source of funds is important when making a capital budgeting decision. Historical costs for past fundings may have very little to do with current costs against which present returns must be measured. When raising new financial capital, a company will tap the various sources of financing over a reasonable time. Regardless of the particular source of funds the company is using for the purchase of an asset, the required rate of return, or discount rate, will be the weighted average cost of capital. As long as the company earns its cost of capital, the common stock value of the firm will be maintained or will increase, since stockholder expectations are being met. For example, assume the Lamson Corporation was considering making an investment in 8 projects with the returns and costs shown in Table 4.

Table 4 Investment projects available to the Lamson Corporation

These projects in Table 4 could be viewed graphically and merged with the weighted average cost of capital to make a capital budgeting decision as indicated in Figure 3.

Notice in Figure 3 that the Lamson Corporation is considering 95 million dollars in potential projects, but given the weighted average cost of capital of 10.41 percent, it will choose only projects A through E, or 50 million dollars in new investments. F, G, and H would probably reduce the value of the common stock because these projects do not provide a return equal to the overall cost of raising funds. The use of the weighted average cost of capital assumes the Lamson Corporation is in its optimum capital structure range. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 321-326*

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