Introduction to Finance

fl otation costs 
costs of issuing 
stock; includes accounting, legal, 
and printing costs of off ering 
shares to the public, as well as the 
commission or fees earned by the 
investment bankers who market 
the new securities to investors

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C H A PT E R 1 8 Capital Structure and The Cost of Capital
We learned about the concept of effi
cient markets in Chapter 12; namely, that current 
market prices and interest rates refl ect all known information and the market’s expectations 
about the future. Financial managers can do little to “fi ght the market.” If managers feel their 
fi nancing costs are too high, then the market usually perceives risk the managers are ignoring. 
The effi
cient market ensures fi nancing costs are in line with the market’s perception of fi rms’ 
risks and expected returns.
DISCUSSION QUESTION 1
With interest rates at or near historic lows since the end of the Great Recession, why 
didn’t business fi rms borrow as much as possible? Why didn’t individuals borrow as 
much as they could to buy a house or newer cars?
18.4
Weighted Average Cost of Capital
We have seen how to compute the costs of the fi rm’s basic capital structure components. 
Now we will combine the components to fi nd the weighted average of the fi rm’s fi nancing 
costs.
The fi rm’s 
weighted average cost of capital (WACC)
represents the minimum required 
rate of return on its capital budgeting projects.
WACC is found by multiplying the marginal cost of each capital structure component by 
its appropriate weight and summing the terms:
WACC 
= 
w
d
k
d
+ 
w
p
k
p
+ 
w
e
k
e
(18-7)
The weights of debt, preferred equity, and common equity in the fi rm’s capital structure are 
given by 
w
d
, 
w
p
, and 
w
e
, respectively. As the WACC covers all of the fi rm’s capital fi nancing 
sources, the weights must sum to 1.0. 
The fi rm’s cost of common equity, 
k
e
, can refl ect the cost of retained earnings, 
k
re
, or the 
cost of new common stock, 
k
n
, whichever is appropriate. Most fi rms rely on retained earnings 
to raise the common equity portion of their fi nancial needs. If retained earnings are insuffi
-
cient, they can issue common stock to meet the shortfall. In this case, 
k
n
is substituted for the 
cost of common equity.
Capital Structure Weights 
The weights in equation 18-7 represent a specifi c intended fi nancing mix. These target weights 
represent a mix of debt and equity the fi rm will want to achieve or maintain over the planning 
horizon. As much as possible, the target weights should refl ect the combination of debt and 
equity that management believes will minimize the fi rm’s weighted average cost of capital. 
The fi rm should make an eff ort, over time, to move toward and maintain its target capital 
structure mix of debt and equity.
Measuring The Target Weights
As the fi rm moves toward a target capital structure, how will it know when it arrives? There 
are two ways to measure the debt and equity mix in the fi rm’s capital structure.
One method uses target weights based on the fi rm’s book values, or balance sheet amounts, 
of debt and equity. The weight of debt in the fi rm’s capital structure equals the book value of 
its debt divided by the book value of its assets. Similarly, the equity weight is the book value 
of its stockholders’ equity divided by total assets. Once the target weights are determined, the 
fi rm can issue or repurchase appropriate quantities of debt and equity over time to move the 
balance sheet numbers toward the target weights.
A second method uses the market values of the fi rm’s debt and equity to compare target 
and actual weights. The actual weight of debt in the fi rm’s capital structure equals the market 
value of its debt divided by the market value of its assets. Similarly, the equity weight is the