Introduction to Finance

FIGURE 18.3
 Corporate Bond 
Yields, 1919–2016
TA B L E 1 8 . 2
Statistical Data on Aaa and Baa Corporate Bond Yields, 1919–2016
Aaa Bond
Baa Bond
Minimum
2.46
2.94
Maximum
15.49
17.18
Average
5.81
7.00
Median
5.09
6.43
Standard Deviation
2.69
2.84
9
Randy Myers, “A Losing Formula,” 
CFO
, (May 2009), pp. 17–18.

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578
C H A PT E R 1 8 Capital Structure and The Cost of Capital
historic information on the diff erence, or spread, between its costs of debt and equity. Perhaps 
that spread is 4 percent. One way to check the reasonableness of a recent cost of capital cal-
culation is to compare the costs of debt and equity; does the new spread diff er markedly from 
4 percent? Financial managers can adjust the cost of capital used to evaluate projects based 
on current fi nancing costs and known, reasonable, historical relationships between fi nancial 
sources in light of current fi nancial market concerns, or “jitters.” 
CRISIS
Without such adjustments, the cost of capital may appear large during market panics 
when interest rates spike and/or stock prices fall, such as during the 2007–2009 Great Reces-
sion. Financial market history has shown that during a recession is the best time to invest in 
fi nancial assets if you are an individual, or in your business and product if you are a manager. 
When others are pessimistic and slashing capital budgets, this is a great time to prepare for 
the coming business cycle upturn. Cost of capital calculations using current data may appear 
to rule out any such investing, as the cost of capital will skyrocket as stock prices plunge. But 
keeping a longer-term value and using current and historical stock/bond premium relationships 
may lead to fi nancial and strategic decisions to invest in capital budgeting projects.
Diff iculty of Making Capital Structure Decisions 
Examining the various infl uences that aff ect a fi rm’s capital structure is diffi
cult. Unlike NPV 
or operating cash fl ow, we have no formula to determine the proportions of debt and equity a 
fi rm should use to fi nance its assets.
But we are not totally lost. Financial theory and research on fi rm behavior have given us a 
set of guidelines or principles by which to evaluate a fi rm’s proper mix of debt and equity. We 
can simplify the discussion by referring only to debt and equity, with little distinction between 
the various types of debt and equity. We discuss some of the variations in debt and equity later 
in the chapter.
In the following sections, we’ll examine a number of interrelationships aff ecting a fi rm’s 
capital structure decisions. First is the fi rm’s growth rate. All else equal, a fi rm with higher growth 
levels will need to tap the capital markets more frequently than a slow-growth or no-growth fi rm. 
Second, given a fi rm’s growth rate, the need for outside capital depends upon its return on assets 
(ROA) and dividend policy. Again, all else equal, a fi rm with a larger ROA can rely more on 
retained earnings as a source of fi nancing and will favor equity over debt fi nancing. A fi rm with 
a large dividend payout will need more outside capital to fi nance growth. Next, we will examine 
some analytical tools and theories advanced and tested to explain fi rms’ capital structures.