Introduction to Finance

FIGURE 18.2
Corporate Debt as a Percentage of GDP, 1951–2014
Source: 
Author calculations from FRED data, St. Louis Federal Reserve Bank.
1
Matt Wirz, “As Corporate Bond Yields Sink, Risks for Investors Rise,” 
The Wall Street Journal
, (August 13, 2012), 
p. C1; Vipal Monga, “Companies Feast on Cheap Money,” 
The Wall Street Journal
, (October 9, 2012), pp. B1, B7; 
Patrick McGee and Katy Burne. “The New Haven for Investors,” 
The Wall Street Journal
, (November 7, 2012), 
p. C1; David Wessel, “Fed’s Easing Yields a Hidden Benefi t,” 
The Wall Street Journal
, (November 29, 2012), p. A4.

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18.2 Required Rate of Return and The Cost of Capital
569
overall business borrowing (short-term and long-term) rose from pre-recession levels. Total 
business debt issuance rose from 2007 to 2015, and in 2015 it was over $1.5 trillion, a record.
2
But lower interest rates hit savers hard, as interest rates on savings accounts fell to nearly zero, 
on average, and fi ve-year certifi cates of deposit (CDs) off ered, on average, interest rates below 
1 percent in 2012 and have stayed below 1 percent through 2016. With the Fed’s aggressive 
monetary policies, interest rates fell to near-record low levels on several fronts.
The U.S. debt rating downgrade by Standard & Poor’s (S&P) from AAA to AA+ in 
August 2011 meant some corporate borrowers had higher credit ratings than the U.S. govern-
ment. In late 2012, short-term debt of AAA-rated fi rms ExxonMobil and Johnson & Johnson 
had 
lower 
yields than comparable maturity U.S. debt. 
Many companies took advantage of the low interest rates. Corporations issued debt to 
store funds for later use, or they opted to issue debt rather than equity since debt was so inex-
pensive. As one analyst said, “No treasurer or CFO wants to be the one treasurer or CFO who 
didn’t get cheap long-term money when it was available.”
3
But what a windfall; that is, low-cost borrowing for some is a danger for others. Investor 
demand was high for securities that could off er higher yields than bank savings or Treasuries. 
Long-term investors (such as pension funds) were seeking long-term assets in which to invest. 
But investors seeking higher yields were making several investment decisions that over time 
may hurt their returns. 
First, investors seeking higher bond returns started buying more “junk” or high-yield bonds 
(we discussed these below-investment-grade bonds in Chapter 10). Yields on bonds rated BB 
fell from over 16 percent in 2008 to under 5 percent in 2013. Remember from Chapter 10, bond 
prices and bond yields move in opposite directions (the seesaw eff ect). So, as investor demand 
rose for riskier securities, the prices on junk bonds rose, lowering their yields. The danger for 
investors is to ignore risk at their own peril. Seeking higher yields can occur only at higher risk, 
and low-rated corporate bonds have higher default risk than investment-grade bonds.
Second, investors sought higher yields by buying longer maturity securities. The Fed’s 
Operation Twist during 2011–2012 had the goal of buying longer-term bonds. This increase 
in demand raised bond prices and lowered yields on long-term bonds and mortgages. The 
operation was successful, since 30-year Treasury yields fell below 3 percent in late 2012. The 
danger for investors, however, is interest rate risk. Long-term bond prices are more sensitive 
to changes in interest rates than are short-term bond prices. A small rise in long-term interest 
rates could lead to falling bond prices and lower returns.
Third, related to the above risk, is the risk of rising infl ation and interest rates. Should 
the economy begin to recover more strongly than it has, infl ation may rise and interest rates 
may rise as well. Rising interest rates lead to falling bond prices and losses to bond investors 
who sell their bonds prior to maturity. Even if investors hold a bond to maturity, they may face 
declines in purchasing power as the infl ation rate may exceed the low coupon rate on the bond. 
Recall from Table 12.4, the long-term average infl ation rate in the U.S. economy is about 
3 percent. Should infl ation average 3 percent in the future, investors buying long-term bonds 
with yields below this will lose money on a real, or after-infl ation, basis. And if investors have 
to pay taxes on their coupon income, the after-tax return will likely fall below the infl ation rate 
as well, giving investors a negative real return.
18.2
Required Rate of Return 
and The Cost of Capital
Investors in a project expect to earn a return on their investment. This expected return depends 
on current capital market conditions (for example, levels of stock prices and interest rates) and 
the project risk. The minimum acceptable rate of return of a project is the return that generates 
suffi
cient cash fl ow to pay investors their expected return.
2
SIFMA, accessed March 9, 2016, http://www.sifma.org/research/statistics.aspx.
3
Mark Gray, an analyst with Moody’s, as quoted in Vipal Monga, “Companies Feast on Cheap Money,” 
The Wall 
Street Journal
, (October 9, 2012), pp. B1, B7.

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570
C H A PT E R 1 8 Capital Structure and The Cost of Capital
To illustrate, suppose a fi rm wants to spend $1,000 on an average risk capital budget-
ing project, fi nancing the investment by borrowing $600 and selling $400 worth of 
common stock. The fi rm must pay interest on the debt at a rate of 9 percent while share-
holders expect a 15 percent return on their investment. To compensate the fi rm’s investors 
adequately, the project should generate an annual pretax expected cash fl ow equal to the 
following:
Lender’s interest + Shareholders’ return = Annual expected cash fl ow
= (0.09)($600) + (0.15)($400)
= $54 + $60 = $114
The project’s pre-tax minimum rate of return must then equal the following:
Minimum cash fl ow∕Investment = Minimum rate of return
= $114∕$1,000 = 11.4 percent
As another means to determine this, the expected return of each fi nancing source could be 
weighted by its relative use. The fi rm is raising 60 percent of the project’s funds from debt 
and 40 percent from equity. This results in a minimum pretax required return of the following:
(0.60)(9%) + (0.40)(15%) = 11.4 percent
Thus, the required rate of return on a project represents a weighted average of lenders’ and 
owners’ return expectations. Since a cash fl ow, or return, to an investor represents a cash 
outfl ow, or a cost, to the fi rm, the minimum required rate of return is a weighted average of 
the fi rm’s costs of various sources of capital.
 
Thus, the required rate of return on a project is 
equivalent to the project’s cost of capital. It is this number that should be used as a discount 
rate when evaluating a project’s NPV. 
Required rate of return, cost of capital, 
and 
discount 
rate
are diff erent terms for the same concept.
It is fair to ask, why is the minimum required return equal to a 
weighted 
average of 
fi nancing costs? If a fi rm can fi nance a project using all debt at an interest cost of 8 percent, 
shouldn’t the project be accepted if it has a positive NPV using an 8 percent discount rate or 
if its IRR exceeds 8 percent? The answer is, not necessarily. Suppose this week, a project of 
average risk is fi nanced by borrowing at 8 percent and has an IRR of 9 percent, so the board of 
directors votes to accept the project. Next quarter, because the fi rm’s debt ratios are high, the 
fi rm’s board decides to fi nance all new projects with equity. If the cost of equity is 15 percent 
and a potential project with average risk has an IRR of 12 percent, it will be turned down. It 
is hard to envision a board maximizing the fi rm’s value by accepting projects with 9 percent 
expected returns while rejecting projects with the same risk that have expected returns of 12 
percent. That is why the WACC is used, so project acceptance is not subject to, specifi cally, 
how it is to be fi nanced.