Introduction to Finance

LO 18.1 
The capital structure decision is a diffi
cult but important one 
for managers to make. An inappropriate mix of debt and equity can 
lead to higher fi nancing costs, which will hurt shareholders’ wealth. 
It can aff ect capital budgeting actions, too; as we learned in this 
chapter, the after-tax cost of capital is the required return on average 
risk capital budgeting projects. The cost of capital will be higher than 
it should be if management selects a target capital structure that has 
too little debt compared to equity—or too much.
LO 18.2 
The required return on a capital budget project is the return 
needed to pay for its appropriate fi nancing sources. A fi rm’s target 
capital structure and fi nancing costs determine the overall cost of cap-
ital (also called the weighted average cost of capital). This weighted 
average cost of capital is the required return for an average risk pro-
ject. In line with the expected return/risk trade-off , safer projects 
should have lower costs of capital (required returns) and higher risk 
projects should have higher costs of capital (required returns). In fi n-
ance, we have three diff erent terms for the same concept: cost of cap-
ital, required return, and discount rate all refer to the same concept. 
From the fi nancing side, it is the cost of capital; from the capital 
budgeting perspective it is the required return and required return is 
used as the discount rate to fi nd a project’s NPV.
LO 18.3. 
We reviewed how to estimate the cost of debt, which must 
be the fi rm’s after-tax cost of debt, as interest is tax-deductible. The 
after-tax cost of debt is used for consistency, as all other costs (pre-
ferred stock, common stock, retained earnings) are already after-tax. 
The costs of preferred and common equity are “after tax” as dividends 
are paid out from net income. In addition, as we learned in Chapter 17, 
capital budget cash fl ows are after-tax cash fl ows. We want to discount 
after-tax cash fl ows with after-tax cost of capital.
LO 18.4 
Once a target capital structure is selected, the cost of each 
fi nancing source is weighted by its target weight to fi nd the weighted 
average cost of capital (WACC). The WACC will be the required return 
when doing capital budgeting analysis of an average risk project. 
LO 18.5 
A fi rm with higher sales and asset growth, all else the same, 
will need more outside fi nancing. If the fi rm has adequate profi ts, 
annual additions to retained earnings can internally fi nance much of 
the growth; if the fi rm does not have adequate profi ts, the fi rm will 
need to access the capital markets to either raise debt or equity fi nan-
cing—or both. And if a profi table fi rm decides to change its dividend 
policy, this will aff ect future additions to retained earnings and the 
ability of the fi rm to rely on internal equity fi nancing for future capital 
budgeting projects. To summarize: all else equal,