10.6: Chapter Summary

In this chapter, you moved from deciding what to invest in (Chapter 9) to deciding how to fund those investments. Financing decisions shape a firm’s capital structure, influence its cost of capital, and affect how risk and return are shared between lenders and shareholders. Throughout the chapter, the central theme remained consistent: managers must balance the potential benefits of financing choices (such as the interest tax shield) against the risks they introduce (such as financial distress and reduced flexibility).

Building on time value of money (Chapter 5), valuation logic (Chapters 6 and 7), and risk–return tools (Chapter 8), this chapter developed a unified financing framework. You learned how firms estimate the cost of each capital component, combine those costs into the weighted average cost of capital (WACC), and apply WACC as a benchmark for evaluating average-risk projects. You also examined how leverage can amplify shareholder outcomes and why payout decisions influence a firm’s ability to finance growth internally.

Key Takeaways and Financing Decision Tools

• Capital structure is measured using market values: Capital structure reflects the market value mix of debt, preferred stock, and equity. Because investors and lenders make decisions based on current prices, WACC weights should be based on market values rather than book (accounting) values.
• Component costs reflect required returns: The cost of each financing source is the return demanded by its providers. The cost of debt is commonly estimated using yield to maturity (YTM), preferred stock cost is approximated by dividend yield, and the cost of equity is often estimated using CAPM or dividend-growth logic.
• WACC is the blended benchmark rate: WACC combines market-value weights with component costs: \[ \text{WACC}=w_D\,k_D(1-T_c)+w_P\,k_P+w_E\,k_E \] It serves as a hurdle rate for average-risk projects and links financing decisions directly back to capital budgeting (Chapter 9).
• Leverage magnifies outcomes: Operating leverage (fixed operating costs) amplifies changes in EBIT as sales fluctuate, and financial leverage (fixed interest costs) amplifies changes in EPS as EBIT fluctuates. Combined leverage captures the full sensitivity of EPS to sales changes.
• Debt creates a tax benefit but increases risk: Interest is generally tax-deductible, creating a tax shield that can increase firm value. However, excessive debt increases the probability and expected costs of financial distress and can raise the cost of equity and overall WACC.
• EPS–EBIT analysis compares financing plans: The EPS–EBIT indifference point identifies the EBIT level where two financing plans produce the same EPS. Above that level, leverage tends to increase EPS; below it, leverage increases risk without delivering higher shareholder earnings.
• Dividend policy affects internal financing: Dividend payouts reduce retained earnings, which are the firm’s primary source of internal equity financing. Higher payouts can increase reliance on external financing, while lower payouts increase financing flexibility and can support growth without new equity issuance.

A Unified Mental Model

By the end of this chapter, you should view financing decisions as a connected process rather than isolated formulas:

• Start with the firm’s financing mix: Identify the market value weights of debt, preferred, and equity.
• Estimate required returns: Compute component costs using current market data (YTM for debt, CAPM or DDM for equity, dividend yield for preferred).
• Build WACC: Combine weights and costs into a blended hurdle rate for average-risk projects.
• Recognize leverage effects: Understand how fixed costs and fixed interest payments magnify volatility for shareholders.
• Connect payout and financing needs: Dividend policy influences how much investment can be financed internally and how often the firm must access capital markets.

Together, these tools help managers design financing policies that support growth while maintaining acceptable risk and financial flexibility.

Looking Ahead

In the next chapter, you will extend financing logic into broader corporate financial strategy by examining how firms operate in real-world capital markets and how financing choices interact with external conditions such as interest rates, investor expectations, and financial constraints. The core goal remains the same: align financing decisions with long-term value creation.

Chapter 10 Discussion Questions

1. Why do corporate finance frameworks separate investment decisions from financing decisions? Give an example of how mixing the two can lead to poor reasoning.
2. Explain why market values are preferred over book values when estimating capital structure weights for WACC.
3. A firm’s debt-to-equity ratio increases significantly. What do you expect to happen to the firm’s cost of equity and why?
4. Why is yield to maturity (YTM) typically a better estimate of the cost of debt than the coupon rate?
5. When is WACC an appropriate discount rate for NPV analysis, and when should a project-specific discount rate be used instead?
6. Explain the difference between operating leverage and financial leverage. Provide one real-world example of each.
7. How does the interest tax shield increase firm value, and why does the tax shield not imply that firms should use unlimited debt?
8. What does the EPS–EBIT indifference point tell managers? What does it not tell managers?
9. Why might a rapidly growing firm choose a low dividend payout (or pay no dividends) even if it is profitable?
10. Describe how dividend policy can affect the firm’s need to issue new equity or increase borrowing over time.

 

Chapter 10 Problems

Note: Unless stated otherwise, assume annual rates and express percentages in decimal form in your calculations.

Part A: Capital Structure and Weights (Problems 1–5)

1. A firm has $30 million in bonds trading at 98% of par, $160 million in common equity (market value), and $10 million in preferred stock (market value).
   a) Compute \(V_D, V_E, V_P\).
   b) Compute \(w_D, w_E, w_P\).
   c) Explain which component will dominate WACC and why.
2. A firm’s book-value debt is $50 million and book-value equity is $75 million. Its bonds trade at $48 million and its equity trades at $150 million.
   a) Compute debt and equity weights using book values.
   b) Compute debt and equity weights using market values.
   c) Explain why the results differ.
3. Suppose a firm’s stock price rises substantially while its debt value stays roughly constant. All else equal, what happens to the firm’s equity weight and WACC? Explain the direction of the effect.
4. True or False (explain): “If a firm finances a new project with debt, the project’s discount rate should always equal the firm’s cost of debt.”
5. A firm repurchases $40 million of stock and finances the repurchase by issuing $40 million of new debt.
   a) Describe how the firm’s capital structure changes.
   b) Explain why the firm’s cost of equity might change even if the firm’s business risk is unchanged.

Part B: Component Costs (Problems 6–10)

6. A firm’s bonds have a YTM of 7.5%. The firm’s marginal tax rate is 24%. Compute the after-tax cost of debt.
7. Preferred stock pays a $2.40 annual dividend and trades at $30. Compute \(k_P\).
8. Use CAPM to compute the cost of equity: \(r_f=3.5\%\), \(\beta=1.3\), market risk premium \(=5.5\%\).
9. A dividend-paying firm has \(P_0=$45\), \(D_0=$1.80\), and expected dividend growth \(g=4\%\). Compute the cost of equity using the dividend growth model.
10. Explain two reasons why CAPM and the dividend growth model can produce different cost of equity estimates for the same firm.

Part C: WACC and Application (Problems 11–15)

11. A firm has weights \(w_D=0.35\), \(w_E=0.65\). The pre-tax cost of debt is 6.2%, the tax rate is 25%, and the cost of equity is 10.5%. Compute WACC.
12. A firm has \(w_D=0.30\), \(w_P=0.10\), \(w_E=0.60\). Costs: \(k_D=7.0\%\), \(T_c=21\%\), \(k_P=8.5\%\), \(k_E=12.0\%\). Compute WACC.
13. A project requires an initial investment of $600 and produces cash flows of 180, 210, 240, and 250 over four years. If the firm’s WACC is 9%, compute NPV. State accept/reject.
14. Explain why a firm’s WACC might increase after it takes on significantly more debt, even though debt has a tax advantage.
15. Give an example of a project that should be discounted at a rate higher than the firm’s WACC and explain why.

Part D: Leverage and EPS–EBIT (Problems 16–20)

16. A firm has Sales = $900,000, variable costs = 55% of sales, and fixed costs = $250,000.
    a) Compute contribution margin and EBIT.
    b) Compute DOL.
17. Using EBIT from Problem 16, suppose interest expense is $80,000.
    a) Compute DFL.
    b) Compute DCL.
18. Using your DCL from Problem 17, estimate the percentage change in EPS if sales increase by 3%.
19. EPS–EBIT comparison. Plan A: no debt, 50,000 shares. Plan B: interest expense = $120,000, 35,000 shares. Tax rate = 25%.
    a) Compute EPS under each plan at EBIT = $200,000 and $320,000.
    b) Compute the indifference EBIT.
20. Dividend policy and internal financing. A firm earns $12 million and pays $3 million in dividends. ROE is 11%.
    a) Compute payout ratio and retention ratio.
    b) Estimate \(g \approx \text{ROE} \times \text{Retention}\).
    c) Explain what happens to financing needs if the firm raises its payout ratio substantially while maintaining the same investment plan.