Capital Budgeting Techniques..

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In question 6, the reference is between the cost of capital and capital structure. First let's define and identify the elements associated with the capital structure. Capital structure consists of the combination of debt and equity (in all its forms) relative to the financial framework of the firm. For example, let's say that Home Depot has a total capitalization of $50 billion. Now let's review their financials in terms of the amount of debt and the amount of equity which comprises this amount. For conversation purposes, let us assume that there is $20 billion of debt; $3 billion of preferred equity; and the balance or $27 billion in equity via common shares. The makeup of the capital structure then is as follows:

Total capitalization = $50 billion = 100%

Total debt = $20 billion = 40%

Total preferred equity = $3 billion = 6%

Total common equity = $27 billion = 54%

So the total capitalization of the firm is 50 billion, consisting of 40% debt, and 60% equity, with 6% of the equity in the form of preferred stocks, and the balance of 54% in common stock. Now each one of these categories will have a cost associated with them. For instance, debt carries the need for regular interest payments over the maturity period --- this represents the cost of carrying the debt (let's assume it is 6%).

Preferred shares carry a cost associated with the payment of dividends because this is one of the features of preferred stock in order to make it more attractive as an investment alternative for the average investor. And common shares carry a cost consisting of EITHER the cost of dividends attributed to the common shares, or in the absence of dividend payments, the opportunity cost of investing this same amount in another investment opportunity yielding the best return we (as shareholders) can gain.

Now let's make some assumptions so we can tie all of this together === assume that preferred shares carry a cost of 9%; and assume that common equity carry a cost of 12%. We would then make the following calculation to determine the relative weighted average cost of capital in this instance as follows:

Debt = 40% x 6% = 2.4
Preferred = 6% x 9% = .54
Common = 54% x 12% = 6.48%

Total = 100% = 9.42 in this instance (as an example of how the relationship exists between the capital structure and the cost of capital). What we are trying to gain between the two items is not only the makeup of the capital structure, but also the cost of the capital which is comprised (usually) of these three items.

Why do we need this information? Because from an investment standpoint, it is necessary to understand the costs associated with the necessary funding for investment purposes. Firms need funding for investing because they usually do not have enough capital on hand for capitalizing ...