474 SELECTION OF A MINIMUM ATTRACTIVERATEOF RETURN
I
!The preceding chapters have said very little about what interest rate or minimum attractive
rate of return is suitable for use in a particular situation.Since this problem is quite complex,
there is no single answer that is always appropriate. A discussion of a suitable interest rate
to use must inevitably begin with an examination of the sources of capital, followed by a
look at the prospective investment opportunities and risk. Only in this way can an interest
rate or minimum attractive rate of return be chosen intelligently.SOURCES OF CAPITAL
In broad terms there are four sources of capital availableto a firm: money generated from
the operation of the firm, borrowed money, sale of mortgage bonds, and sale of capital
stock.Money Generated from the Operation of the Firm
A major source of capital investment money is through the retention of profits resul.ting
from the operation of the firm. Since only about half of the profits of industrial firins are
paid out to stockholders, the half that is retained is an important source of funds for all
purposes, including capital investments. In addition to profit, there is money generated in
the business equal to the annual depreciation charges on existing capital assets if the firm
is profitable. In other words, a profitable firm will generate money equal to its deprecia~on
chargesplusits retained profits. Even a firm that earns zero profit will still generate money
from operations equal to its depreciation charges. (A firm with a loss, of course, will have
still less funds.)External Sources of Money
When a firm requires money for a few weeks or months, it typically borrows from banks.
Longer-term unsecured loans (of, say, 1-4 years) may also be arranged through banks.
While banks undoubtedly finance a lot of capital expenditures, regular bank loans cannot
be considered a source of permanent financing.
Longer-term secured loans may be obtained from banks, insurance companies,pension
funds, or even the public. The security for the loan is frequently a mortgage on specific
property of the firm. When sold to the public, this financingis by mortgage bonds. The sale
of stock in the firm is still another source of money.While bank loans and bonds represent
debt that has a maturity date, stock is considered a permanent addition to the ownershipof
the firm.Choice of Source of Funds
Choosing the source of funds for capital expenditures is a decision for the firm's top
executives, and it may require approval of the board of directors. When internal operations
generate adequate funds for the desired capital expenditures,external sources of money are
not likely to be used. But when the internal sources are inadequate, external sources must
be employed or the capital expenditures will have to be deferred or canceled.