CHAPTER 17
The Corporate Form and the Cost of Capital
CHAPTER SUMMARY AND TEACHING OBJECTIVES
As seen in earlier chapters, entrepreneurs seek out economic profits. This creates movement in the
economy as resources move to their highest valued use. Entrepreneurs need financial capital. This can
be raised with stocks or bonds. Each has their unique characteristics are the holders of them are often at
odds. It is important to see the need for regular cash flows to service bonds. A firm’s decision to have a
mixture of bonds and stock creates its capital structure. Also, entrepreneurs must select the proper
discount rate – cost of capital – so as to value future revenues and costs properly. Finally, the
underlying structure of the financing needs of a firm is the corporate form of business.
IMPORTANT TERMS
Weighted average cost of capital (WACC) this is the cost of capital across all formats used to raise
capital
Dividend A payment of a shareholder
TOPICS AND TEACHING SUGGESTIONS
1. Economic Profit and the Capital Markets
2. Capital Structure
3. Internal Use of Capital
4. The Corporate Form
The corporate form of business represents a choice that has cost and benefits. It is necessary
Chapter 17: The Corporate Form and the Cost of Capital 79
ANSWERS TO EXERCISES
1. The Benly Company needs to raise funds for a major expansion. The company is debating
whether to issue stock or to issue bonds. If the company issues bonds, then its debts will
increase and it will be under additional stress to ensure that its revenues can cover the costs of
its debt. If it issues stock, the current owners will lose power and influence. What should the
company do? Explain your answer.
2. Explain how the corporate form is more efficient than a form where the owner is also the manager.
3. What is the creditor-owner conflict? Explain why 100 percent equity might be inefficient.
Explain why 100 percent debt might be inefficient.
Corporate decision can, at times, adversely affect stockholders and not bondholders and, at
4. Middleton Steel Co. is considering whether to temporarily close one of its manufacturing
plants. If it does close the plant, it faces costs of shutting down and then starting back up, the
costs of criticism from the city in which the plant is located, and the costs of customer
abandonment as some customers purchase products elsewhere. If it does not close the plant, it
will experience substantial losses because revenues will not cover variable costs.
a. What would a net present value analysis say about the decision?
b. What other strategies might be used?
5. The marketing director of National Midland Mortgage has been arguing with senior management
about building a $50 million publishing facility. Other managers worried about the assumptions in
the analysis that support the investment—an increase in the number of mortgages processed and a
reduction in processing costs. What if the mortgage market did not grow as expected?
a. Should National Midland invest in the publishing facility?
b. What assumptions might the marketing director have made to make the investment look
worthwhile?
6. Bob Davies must decide whether to invest $100,000 in his own business or in another local
business. Both investment projects have an expected life of five years. The cash flow of each
is as follows:
Year
Davies
Other
1
$20,000
$10,000
2
30,000
10,000
3
40,000
30,000
4
10,000
40,000
5
5,000
50,000
Suppose the risk of the projects is the same and is accounted for by a risk premium of 6
percent per year. Would either investment make sense? Which would be better?
7. An oil company recently evaluated a proposed investment for improvements in a particular
type of refining equipment. According to the analysis, such improvements would require an
investment of $15 million and would result in an incremental after-tax cash flow of $2 million
per year for nine years following the year of the investment.
a. If the discount rate is 10 percent, what is the net present value of this project?
b. If the discount rate is 15 percent, what is the net present value of this project?
c. What discount rate would you argue makes most sense in evaluating this project?
8. What discount rate is most appropriate for net present value calculations of large scale projects?
Of small projects? Of the quantity of inventories to hold?
9. What would the effect be of a law that makes shareholders personally liable for debt the firm
acquires?
10. In 2009, the U.S. government took over Chrysler. It gave about 25% of the equity to the
UAW and kept the rest. It eliminated the claims of the bondholders. The corporate form
provides bondholders first claim on assets if the firm goes under; stockholders receive what is
left after everyone else is paid off. What do the Government’s actions mean? What effect is
the action likely to have on other firms that might be struggling?
11. Explain what the incentives of bondholders and stockholders are. Are they the same?
How do they differ? Will a firm with no debt act differently than a firm with a significant
amount of debt?
The incentive of bondholders is to make sure that the cash flow of a corporation is sufficient
12. Unlike equity, debt is unforgiving if the firm performs poorly. If a firm goes bankrupt, debt
holders have the right to repossess funds and exercise their residual control rights about how
the funds will be spent. Thus, under debt financing, debt holders possess a larger set of
control rights than managers. Does this mean that a manager that wants to maintain control
should finance more with equity?
13. What is the effect on a firm’s cost of capital when a CEO is found to have engaged in unethical
behavior? Explain
14. How would country risk affect a firm’s cost of capital?
15. Use the CAPM to explain whether a firm that is diversified to perform exactly as the stock market
16. In 2010 few firms were investing in new projects or expanding. Yet, interest rates were
extremely low. Why, with this very low cost of capital would firms not be investing in new
projects?
17. What happens to the cost of capital when inflationary expectations are high? Explain
(Inflationary expectations are high when expectations that inflation in coming months and
years will increase)
18. What happens to the cost of capital when expectations of deflation are high? Explain
(Deflation occurs when prices decline).