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(^28) Financial Management
of the cost of capital developed in this chapter is valid only for projects that do not
change the firmís business risk.
Financial risk is affected by the mixture of long-term financing, or the capital
structure, of the firm. Firms with high levels of long-term debt in proportion to their
equity are more risky than firms maintaining lower ratios of long-term debt to equity.
It is the contractual fixed-payment obligations associated with debt financing that make
a firm financially risky. The greater the amount of interest and principal (or sinking-
fund) payments a firm must make in a given period, the higher the operating profits
required to cover these charges. If a firm fails to generate sufficient revenues to cover
operating charges, it may be forced into bankruptcy.
As a firmís financial structure shifts toward suppliers of funds recognize a more highly
levered position the increased financial risk associated with the firm. They compensate
for this increased risk by charging higher rates of interest or requiring greater returns,
In short they react in much the same way as they would to increasing business risks.
Frequently the funds supplied to a firm by lenders will change its financial structure,
and the charge for the funds will be based on the changed financial structure. In the
analysis of the cost of capital in this chapter, however, the firmís financial structure is
assumed to remain fixed. This assumption is necessary in order to isolate the costs of
the various forms of financing. If the firmís capital structure were not held constant,
it would be quite difficult to find its cost of capital, since the selection of a given source
of financing would change the costs of alternate sources of financing. The assumption
of a constant capital structure implies that when a firm raises funds to finance a given
project these funds are raised in the same proportions as the firmís existing financing.
The awkwardness of this assumption is obvious since in reality a firm raises funds in
ìlumps,î it does not raise a mixture of small amounts of various types of funds.í For
example, in order to raise Rs. l million a firm may sell either bonds, preferred stock,
or common stock in the amount of Rs. l million; or, it may sell Rs. 400,000 worth of
bonds, Rs. 100,000 worth of preferred stock, and Rs. 500,000 worth of common stock.
Most firms will use the former strategy, but our analysis of cost of capital is based on
the assumption that the firm will follow the latter strategy. More sophisticated approaches
for measuring the cost of capital when a firmís capital structure is changing rare
available.
The key factor affecting financing Costs
Since the cost of capital is measured under the assumption that both the firmís asset
structure and its capital (financial) structure are fixed, the only factor that affects the
various specific costs of financing is the supply and demand forces operating in the
market for long-term funds. In other words, as a firm raises long-term funds at
different points in time, the only factor affecting their cost is the riskless cost of the
particular type of financing. Regardless of the type of financing used, the following
relationship should prevail:
kj = rj + b + f ...(2)
where
kj = the specific cost of the various types of long-term financing, j