Dealing with Adverse Selection

292 Part IV: Anticipating Surprises: Risk and Uncertainty

You decide to fund a capital investment through a combination of equity and debt capital. You plan to fund 25 percent of your capital investment through equity and 75 percent through debt. To determine the composite cost of capital, start by separately calculating the cost of equity capital and the cost of debt capital. Assume your firm’s β coefficient is 2.1 and the average stock return is 6 percent. The return on U.S. Treasury bills is 1 percent, which is the risk-free rate of return. Your firm can borrow funds at 9-percent interest and its marginal tax rate is 34 percent.

1. Determine the cost of equity capital.

In this example, I’m using the capital-asset-pricing method.

2. Determine the cost of debt by using the marginal tax rate.

3. Determine the composite cost of capital.

Remember to weight each component by the percentage of funds raised through that method — equity or debt.

Thus, the composite cost of capital is 7.33 percent.

Cashing in on opportunity

In his biography Andrew Carnegie and the Rise of Big Business (Pearson), author Harold C. Livesay notes that improvements in technology make existing capital investments obsolete. In addition, improvements in technology often require even greater capital investments. This was the case for Andrew Carnegie and the steel industry at the end of the nineteenth century. Because the steel industry experienced tremendous technology improvements that required large capital investments, Carnegie had to use his profits to purchase new equipment rather than give dividends to stockholders. This situation clearly indicates an opportunity cost of investing equity capital — Carnegie didn’t issue very many dividends to partners and owners of the firm. But one advantage of this policy that’s less apparent is a benefit that results from avoiding external funds. By avoiding external funds, Carnegie was able maintain greater control of future costs and production by not having a future cash outlay associated with payments on external debt. This lack of external debt is especially important if national economic conditions, such as a recession, adversely affect your firm’s cash flow.