592
C H A PT E R 1 8 Capital Structure and The Cost of Capital
As
noted earlier in this chapter, fi rms can time interest rates by increasing their relative
use of debt when interest rates are perceived to be low, as was the case in 2012–2016.
An apparent implication of the pecking order and market timing hypotheses is that the fi rm
has no optimal capital structure. What implication does this have for computing a cost of cap-
ital and using it to evaluate capital budgeting projects? The answer: hardly any. Recall that the
WACC represents the minimum required return on a fi rm’s average risk capital budgeting pro-
jects. The target capital structure weights refl ect
management’s
impression of a capital structure
that is
sustainable
in
the long run, and that allows fi nancing fl exibility over time. Using the tar-
get structure and current fi nancing costs, management can compute the weighted average cost
of capital. The cost of capital calculation is paramount; should a fi rm fail to earn an appropriate
return on its capital budgeting projects, shareholder wealth and fi rm value will decline.
Part of the uncertainty over which theoretical perspective may be correct arises from
capital structure choices that depart from “plain vanilla” debt and equity.
Firms have devised
a myriad of fi nancing fl avors, as we discuss next.
Beyond Debt and Equity
Bright Wall Street investment bankers have introduced many variations on these two themes in
attempts to market new and diff erent instruments to meet the needs of many kinds of issuers and
investors.
23
Today, fi rms can choose among various security issues, as we saw in Chapter 10.
Consequently, many fi rms have several debt and equity layers on their balance sheets.
Debt can be made convertible to equity. Its maturity can be extended or shortened at the
fi rm’s option. Debt issues can be made senior or subordinate to other debt issues. Coupon
interest rates can be fi xed, fl oat up or down along
with other interest rates, or be indexed to a
commodity price.
24
Some bond issues do not pay interest. Corporations can issue bonds in the
United States or overseas. Bonds can be sold alone or with warrants attached that allow the
bond investor to purchase shares of common stock at predetermined prices over time.
Likewise, equity variations exist. Preferred stock has a claim on the fi rm that is junior to
the bondholder claim but senior to the common shareholder claim. Preferred stock can pay
dividends at a fi xed or a variable rate.
Even types of common stock can diff er. Firms can have diff erent classes of common
equity. Some classes can provide holders with higher levels of dividend income.
Some classes
may have superior voting rights. Examples of such fi rms include Google, Facebook, Ford
Motor Company, and Visa. Firms have issued separate classes of equity to fi nance acquisi-
tions, distributing part of the acquired fi rm’s earnings as dividends to holders of that particular
class of stock. Such was the case with General Motors. It issued its Class E stock to fi nance
its acquisition of EDS in the 1980s; dividends on the Class E shares were determined by the
earnings of the EDS subsidiary.
All these variations of debt and equity give the fi rm valuable fl exibility. Corporate fi n-
ancial managers’ decisions about the structure of a security issue may be more diffi
cult now,
but these choices also can allow them to lower the cost of capital and increase fi rm value.
25
Guidelines for Financing Strategy
We have covered a lot of ground and a lot of controversy. Let’s summarize the practical implic-
ations of these discussions and list the infl uences of theory and real-world evidence on a fi rm’s
capital structure decisions.
23
Finance is not just fi nance; it sometimes involves marketing research and analysis. Wall Street fi rms
serve two
customers: issuers and investors. By designing innovative securities to better meet their customers’ needs, investment
bankers can exploit market niches by being the fi rst mover into a new product area. Such innovation will attract busi-
ness, enhance income, and increase the fi rm’s reputation among market players.
24
For example, a silver mining fi rm whose profi ts and cash fl ow are sensitive to silver’s market price can reduce its
fi nancial leverage by issuing bonds that pay interest at a rate related to silver price fl uctuations.
25
An accessible review of issues related to capital structure and cost of capital is available in Zander’s 8-part series
“WACC: Practical Guide for Strategic Decision-Making” found on http://zanders.eu/en/latest-insights/wacc-practical-
guide-for-strategic-decision-making-part-1 with subsequent parts ending in 2, 3, and so on. Zanders, Treasury and
Finance
Solutions, is a European-based consulting fi rm. Their series on WACC was featured on the gtnews website,
March 2006–March 2007.
