Introduction to Finance

($ Millions)
Market 
Weight
AA bonds 
$10.50
0.138
A bonds 
20.50
0.270
Preferred stock 
10.00 
0.132
Common stock 
35.00 
0.460
Total $76.00
1.000
Presently, Eastnorth Manufacturing’s capital structure is made up of 41 percent debt, about 
46 percent common equity, and about 13 percent preferred equity. To move toward its target 
capital structure, Eastnorth Manufacturing may want to issue common stock and use the pro-
ceeds to purchase outstanding preferred stock and bonds. Eastnorth Manufacturing does not 
need to restructure its fi nances immediately. The fl otation costs and administrative fees of such 
a program would be prohibitive. Some movement toward the target capital structure would 
occur if Eastnorth Manufacturing could identify several positive-NPV projects. Barring a 
market downtrend, these projects would increase its market value of equity. Also, it could use 
future additions to retained earnings to repurchase some outstanding debt or preferred equity.
What Do Businesses Use as Their Cost of Capital?
Surveys of U.S. fi rms fi nd that most fi rms use after-tax WACC as their required rate of return 
for projects. Other methods include management-determined target returns or the cost of some 
specifi c source of funds. A survey of U.S.-based multinationals found, surprisingly, that one-
half of them use a single fi rm-wide discount rate to evaluate projects regardless of risk dif-
ferences. The most popular method for estimating the cost of equity is the SML approach; 
surveys have shown that up to 85 percent of fi rms use this method. Because of its assumption 
regarding growth, few fi rms use the constant dividend growth model; about 4 percent of fi rms 
in a 2013 survey used this method, compared to 15 percent of fi rms in a 1999 survey and 
about 30 percent in a 1982 survey. It may take a while, but business managers do learn about 
fi nancial theory and concepts.
8
The student who has been watching the fi nancial markets throughout the course, or possibly 
the past several years, may notice a potential problem with the formulas in this section. The 
cost of debt relies on current interest rates for a fi rm’s debt. Similarly, the cost of equity relies 
on current estimates of beta (SML approach) or stock price. These values are always changing.