Introduction to Finance

H O W T H I S C H A P T E R A P P L I E S TO M E . . .
High levels of consumer debt are used as a harbinger of tough economic times ahead. 
Similar to a fi rm, individuals have a capital structure, too. Add up your assets, subtract any 
debts, and the balance is your net worth, or “equity.” Your own personal capital structure 
is your mixture of debt and equity that is used to fi nance what you own and your lifestyle. 
Like a fi rm, use of debt without the ability to make interest payments and to reduce the 
principal can lead to fi nancial distress. The best use of debt for individuals is similar to that 
of fi rms: use in moderation and only to help purchase assets with the potential to grow in 
value, such as a house. At the current time, you may be using student loans to fi nance an 
investment in yourself, namely your education. Because of your education, your future 
earnings potential is expected to be greater than it otherwise would be and gives you the 
ability to repay the loan.
In Shakespeare’s play 
Hamlet, 
the elder Polonius counsels his son Laertes,
Neither a borrower nor a lender be.
We can tell that Polonius did not study modern-day fi nance! Lending money, in the form of
 
buying bonds or putting money in a bank account, can be an attractive investment strategy for 
some, and businesses often fi nd
 
themselves needing to borrow or raise funds for short periods 
(which was the topic of
 
Chapter 16) or longer periods. This chapter looks at the analysis a fi rm 
should do when
 
funds are needed for longer periods. 
The previous chapters described the capital budgeting process. We learned how to estimate 
a project’s cash fl ows and how to use techniques, such as net present value (NPV) and internal 
rate of return (IRR), for evaluating projects. In Chapter 17 we assumed that the project’s dis-
count rate, or its cost of capital, was given. In this chapter, we will explain how managers can 
estimate their fi rm’s cost of capital for “average risk” projects. This discount rate is adjusted 
up or down, as we learned in Chapter 17, depending on the project’s risk.
Before managers can estimate the cost of capital, two inputs are needed. First, the cost of 
each fi nancing source needs to be determined. Second, managers must determine the appro-
priate fi nancing mix to use to fund the fi rm. Once these are known, managers can estimate the 
fi rm’s weighted average cost of capital (WACC).