PART 4 Investing in Long-Term Assets: Capital Budgeting
plans to use a small amount of preferred in the future, and its common equity costs
about 13.5%. (This is the return that stockholders require on the stock.)^3 Now
assume that Allied has made the decision to! nance all of next year’s projects with
debt. The argument is sometimes made that the cost of capital for next year’s proj-
ects will be 10% because only debt will be used to! nance them. However, this
position is incorrect. If Allied! nances this set of projects with debt, it will be using
up some of its future borrowing capacity. As expansion occurs in subsequent years,
the! rm will at some point have to raise more equity to prevent the debt ratio from
getting too high.
Our concern is with capital that must be provided by investors—interest-
bearing debt, preferred stock, and common equity. Accounts payable and accruals
increase automatically when capital budgeting projects are taken on, so increases
in these items are deducted from projects’ costs. This point is discussed in detail in
Chapter 12, but the result is that we are concerned only with investor-supplied
capital when we calculate the cost of capital.
To illustrate, suppose Allied borrows heavily at 10% during 2009 and, in the
process, uses up its capacity to borrow, to! nance projects yielding 11%. In 2010, it
has new projects available that yield 13% (well above the return on 2009 projects),
but it could not accept them because they would have to be! nanced with 13.5%
equity. To avoid this problem, Allied and other! rms take a long-run view; and the cost of
capital is calculated as a weighted average, or composite, of the various types of funds used
over time, regardless of the speci! c! nancing used in a given year.
We explore the weights in more detail in the capital structure chapter, where we
see how the optimal capital structure is estimated. As we will see, there is an optimal
capital structure—one where the percentages of debt, preferred stock, and common
equity maximize the! rm’s value. As shown in the last column of Table 10-1, Allied
Foods has concluded that it should use 45% debt, 2% preferred stock, and(^3) We estimate this 13.5% later in the chapter. It di! ers slightly from the number we found in an earlier chapter. As
you will see, there are several ways to estimate rs and those methods generally produce di! erent estimates. Allied
concluded that its rs is somewhere in the range of 13% to 14%, and it compromised by using 13.5%. The costs of
debt and preferred stock are set by contract, so they can be estimated with relatively little error; but the cost of
equity cannot be measured precisely.
Tabl e 10 - 1 Allied Food Products: Capital Structure Used to Calculate the WACC
REGULAR BALANCE SHEET: at 12/31/08
All Liabilities
& Equity
Actual
Investor-Supplied
Capital
Target
Capital
Structure
Cash $ 10 Accounts payable $ 60 3.0%
Receivables 375 Accruals 140 7.0
Inventories 615 Spontaneous debt $ 200 10.0%
Total C.A. $1,000 Notes payable 110 5.5 $ 110
Total C.L. $ 310 15.5%
Net fixed assets $1,000 Long-term debt 750 37.5 750
Total debt $1,060 53.0% $ 860 47.8% 45.0%
Preferred stock 0 0.0 0 0.0 2.0
Common stock 130 6.5 130
Retained earnings 810 40.5 810
Total equity $ 940 47.0% $ 940 52.2 53.0
Total $2,000 Total $2,000 100.0% $1,800 100.0% 100.0%