Introduction to Finance

565
CHAPTER 
18
Capital Structure and 
The Cost of Capital
L E A R N I N G O B J E C T I V E S
After studying this chapter, you should be able to do the following:
LO 18.1
Explain how capital structure aff ects a fi rm’s capital budgeting discount rate.
LO 18.2
Describe the relationship between required return and cost of capital.
LO 18.3
Calculate a fi rm’s cost of debt fi nancing and cost of equity fi nancing.
LO 18.4
Explain how a fi rm can estimate its cost of capital.
LO 18.5
Explain how a fi rm’s growth potential, dividend policy, and capital structure are 
related.
LO 18.6
Explain how EBIT/eps analysis can assist management in choosing a capital 
structure.
LO 18.7
Describe how a fi rm’s business risk and fi nancial risk together can aff ect the 
relationship between sales and earnings per share.
LO 18.8
Describe the factors that aff ect a fi rm’s capital structure.
W H E R E W E H A V E B E E N . . .
We have seen how a fi rm can choose a short-term or long-term fi nancing strategy (Chapter 16) 
and familiarize itself with the workings of the fi nancial markets, security pricing, and IPOs 
(Chapters 10 and 11). Part of the fi nancing decision depends on the fi rm’s asset needs. New 
asset purchases, restructurings, or corporate strategies may lead to the need for new fi nancing 
or a new fi nancing strategy for the fi rm. Likewise, changes in fi nancial market conditions 
(due to fl uctuations in interest rates, stock price, or exchange rates) may make new fi nancial 
strategies look appealing.
W H E R E W E A R E G O I N G . . .
We’ve gone full circle now. Part 1 of this text, “Institutions and Markets,” discussed the pur-
pose, evolution, and working of fi nancial institutions. Part 2, “Investments,” showed how 
these institutions and the fi nancial markets work to bring together suppliers and users of 
capital, how interest rates are determined on a variety of fi nancial instruments, how securities 

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C H A PT E R 1 8 Capital Structure and The Cost of Capital
markets work, how securities are priced, and how risk and return infl uence investor decisions 
and security prices. Part 3, “Financial Management,” has reviewed fi nancial statements and 
fi nancial decisions in the context of businesses. And what inputs do fi rms use to help guide 
their long-term fi nancing decisions and corporate strategies? As we will see in this chapter, 
the inputs are none other than information from the fi nancial system and fi nancial markets.