thumb for measuring the cash flow is reported earnings for the period plus
depreciation, depletion, and any other noncash charges.
In calculating the leverage a firm might carry, the financial decision
makers must estimate not only the average level of the cash flow over time,
but also the likelihood and extent of deviations from the norm. Where fluc-
tuations from the average are not expected to be either deep or sustained,
the firm may safely carry a high percentage of debt.
The inclusion of depreciation charges in the cash flow helps explain
why firms with a good proportion of fixed assets may also carry more
long-term debt. The fact that firms having a considerable fixed plant usu-
ally float bonds is not related to any physical attribute of the fixed plant; it
is not dependent on any presumed safety that bricks and mortar bring to
the bond mortgage. The affinity of fixed assets and long-term debt rests on
the fact that the cash flow of firms holding considerable fixed assets must
exceed their reported earnings. The depreciation charges taken against the
fixed assets act as an extra cushion, which, added to the accounting net
earnings, may help the firm meet its interest and principal obligations. A
firm may show zero accounting profits after depreciation, yet have a posi-
tive flow of cash. As long as reported losses do not exceed depreciation and
depletion charges, some cash flow will be available to pay debt obligations.
In other words, some cash is always generated as long as operating rev-
enues are greater than out-of-pocket operating costs, no matter what the
depreciation charges may be.
Cost of Capital
Let us find the cost of capital for a firm with the following capital structure:
Long-term debt $ 5,647
Equity 9,063
Total capital $14,710The firm has a bond rating of AA3 (Moody’s AA) and a beta of 0.84 versus
the S&P 500 index.
The cost of capital, kc, can be calculated by using an acceptable market
risk premium and the current AA bond yield of 5.6 percent. The Ibbotson
and Sinquefield (1976, and annual editions thereafter) market risk pre-
mium of 8.15 percent was based on the 1926–2003 period. If we use the
Ibbotson and Sinquefield data for the 1951–2002 period, found on WRDS,
we find an average annual rate of return on equities of 12.53 percent, and
a corresponding average Treasury bill yield of 5.15 percent, implying a