The Weighted Average Cost of Capital (2)
by MaestriAlthough NCC and other firms try to stay close to their target capital structures, they frequently deviate in the short run for several reasons. First, market conditions may be more favorable in one market than another at a particular time. For example, if the stock market is extremely strong, a company may decide to issue common stock. The second, and probably more important, reason for deviations relates to flotation
costs, which are the costs that a firm must incur to issue securities. Flotation costs are ddressed in detail later in the chapter, but note that these costs are to a large extent fixed, so they become prohibitively high if small amounts of capital are raised. Thus, it is inefficient and expensive to issue relatively small amounts of debt, preferred stock, and common stock. Therefore, a company might issue common stock one year,
debt in the next couple of years, and preferred the following year, thus fluctuating around its target capital structure rather than staying right on it all the time.
This situation can cause managers to make a serious error in selecting projects, a process called capital budgeting. To illustrate, assume that NCC is currently at its target capital structure, and it is now considering how to raise capital to finance next year’s projects. NCC could raise a combination of debt and equity, but to minimize flotation costs it will raise either debt or equity, but not both. Suppose NCC borrows
heavily at 8 percent during 2003 to finance long-term projects that yield 10 percent. In 2004, it has new long-term projects available that yield 13 percent, well above the return on the 2003 projects. However, to return to its target capital structure, it must issue equity, which costs 15.3 percent. Therefore, the company might incorrectly reject these 13 percent projects because they would have to be financed with funds costing 15.3percent.
However, this entire line of reasoning would be incorrect. Why should a company accept 10 percent long-term projects one year and then reject 13 percent long-term projects the next? Note also that if NCC had reversed the order of its financing, raising equity in 2003 and debt in 2004, it would have reversed its decisions, rejecting all projects in 2003 and accepting them all in 2004. Does it make sense to accept or reject projects just because of the more or less arbitrary sequence in which capital is raised? The answer is no. To avoid such errors, managers should view companies as ongoing concerns, and calculate their costs of capital as weighted averages of the various types of funds they use, regardless of the specific source of financing employed in a particular year.
Taken From : Five-Minute MBA – Corporate Finance
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