Principles of Managerial Finance

472 PART 4 Long-Term Financial Decisions

firm’s fixed-asset investments.^1 We assume throughout the chapter that such

investments are selected by using appropriate capital budgeting techniques.

There are four basic sources of long-term funds for the business firm: long-

term debt, preferred stock, common stock, and retained earnings. The right-hand

side of a balance sheet can be used to illustrate these sources:

Although not every firm will use all of these methods of financing, each firm is

expected to have funds from some of these sources in its capital structure.

Thespecific costof each source of financing is theafter-taxcost of obtaining

the financing today,not the historically based cost reflected by the existing

financing on the firm’s books. Techniques for determining the specific cost of

each source of long-term funds are presented on the following pages. Although

these techniques tend to develop precisely calculated values, the resulting values

are at bestrough approximationsbecause of the numerous assumptions and fore-

casts that underlie them. Although we round calculated costs to the nearest 0.1

percent throughout this chapter, it is not unusual for practicing financial man-

agers to use costs rounded to the nearest 1 percent because these values are merely

estimates.

Review Questions

11–1 What is the cost of capital?What role does it play in long-term investment

decisions?

11–2 Why do we assume that business riskand financial riskare unchanged

when evaluating the cost of capital? Discuss the implications of these

assumptions on the acceptance and financing of new projects.

11–3 Why is the cost of capital measured on an after-tax basis?Why is use of a

weighted average cost of capital rather than the cost of the specific source

of funds recommended?

11–4 You have just been told, “Because we are going to finance this project

with debt, its required rate of return must exceed the cost of debt.” Do

you agree or disagree? Explain.

Balance Sheet

Long-term debt

Assets Stockholders’ equity

Preferred stock

Common stock equity

Common stock

Retained earnings

Current liabilities

Sources of

long-term funds

1. The role of both long-term and short-term financing in supporting both fixed- and current-asset investments is
   addressed in Chapter 14. Suffice it to say that long-term funds are at minimum used to finance fixed assets.