Write a 3 page paper on word document of the chapter below from the perspective of the CFO: you are starting a new company and are trying to come up with your optimal capital structure. Describe the nature of your business and why you believe your capital structure to be the best fit for your company. An example mayb be that you are attempting to open an online shoe company or perhaps a neighborhood coffee shop. Please mention key concept of WACC, NPV, CAPITAL BUDGETING, IRR, etc.

Class Material Cost of Capital and Capital Budgeting Focus Business firms add value to their shareholders' wealth (as measured by share price) by investing in income-producing capital projects or assets which yield a return which exceeds the cost of the financial capital used to acquire these assets. The primary sources of investor- supplied financial capital are debt (bonds) preferred stock, and common equity (retained earnings and the flotation of new stock ) These investor-supplied funds will be made available only if investors expect to receive a risk-adjusted return commensurate with the returns on similar investment alternatives. The firm's cost of capital funds mirrors investors' required rates of return. L The cost of capital reflects the principal forms or components of capital (debt and equity) supplied by investors. Consequently, the cost of capital is a weighted-average of these components Accounts payable and accruals, which arise spontaneously when capital budgeting projects are under taken are not included as part of investor-supplied capital because they do not come directly from investors. Investors are concerned with a firm's current market value of interest-bearing debt, preferred stock, and equity. So, market-value weights of investor-supplied capital rather than accounting- based weights are used in calculating a firm's weighted average cost of capital (WACC) What ultimately matters to the firm are target weights of investor-supplied capital based on the firm's target capital structure. A firm's overall cost of capital is a weighted average of the costs of the various types of investor-supplied capital it uses, where the weights correspond to the company's target capital structure. The target capital structure is the mix of debt, preferred stock, and common equity the firm plans to raise to fund its future projects A company's target capital structure reflects that there is an optimal capttal structure-one where the percentages of debt, preferred stock, and common equity maximise the firm's value. eviewView Page width II. Determining the firm's cost of capital, or the relevant discount rate used in calculating the present value of the cash inflows from the firm's proposed projects, is a key element of the capital budgeting process a Capital components are the investor-supplied items on the right-hand side of the balance sheet used by firms to raise funds such as debt, prefered stock, and common equity Increases in assets must be financed by imcreases in these capital components Each element of capital has a component cost that can be identified as follows . Reinterest rate on the firm's nnw debt, before taxes RII-M = after-tax or net component cost of new debt where Ts the firm's marginal tax rate RcOmponent cost of preferred stock "R component cost of retained enings o iterad egur most capital asse funding by coatemporary US busimess funms comes firotm cetained eanings R-coponient cost of exserreal squtga cemmon equity ratsed br issuing stock esternal equity by most establistied matiuse U'S fms is not a widely used source of asset fandinig WACC is the weighted average, or overall, cost of capital; a weighted average of the component costs of debt, preferred stock, and common (internal and external) equity The optimal capital structure is the percentages of debt, preferred stock, and common equity that minimizes the firm's cost of capital and maximizes the firm's value. Debt The after-tax or net cost of debt, R(1-T, is the gross interest rate on new debt, Ri, less the tax savings that result because the firm's interest expenses are tax deductible. It is the relevant cost of new debt, taking into account the tax deductibility of interest, used in the firm's WACC calculation. Acknowledge the preferred tax treatment of issuing debt by focusing on its net or after tax value. If a firm has a tax rate of 7-40% and can borrow at a rate of 10%, then its after-tax cost ofdebt is Rd 10%(1-040)-10%(0.60)-6.0%. In effect, the government, ie. taxpayer, pays part of the cost of debt because interest on debt is tax deductible. Re is the interest rate on new debt (the marginal cost of debt) not on already outstanding debt The yield to maturity (YTM) and coupon rates on debt issued several years ago may be higher or even lower than current rates The rate at which the firm has borrowed in the past is irrelevant because capital budgeting decisions on new or future projects must use the cost of new capital in the analysis The YTM on outstanding debt (which reflects current market conditions) is a better measure of the cost of debt than the coupon rate. On any given bond, the yield to maturity is market-driven while the bond s coupon rate is fixed The YTAt on the company's long term debt is gerneraly used to calculate the cost of debe because, more often than net, the capital is being raised to fund long-term projects Preferred Stork The component cost of prefered stock R. is the prefered cash dridend. D, dirided by the current market price Po of the preferred stockRDP eWidth Ir a tirm's preterred stock pays a STO dividend per share and sells for 5yT.50 per share, the firm's cost of preferred stock, z. is calculated as: Ba: $10 00S9750-10.3%. Retained Earnings The cost of retained earnings, R, is the rate of retun stockholders require on the company's common stock. If a firm can produce a rate of return on a capital project which is less than the rate which suppliers of financial capital (i financed. New common equity is raised in two ways: (1) by retaining some of the firm's current year's earnings Gintenal finance) and (2) by issuing new common stock (external finance). Whereas debt and preferred stocks are contractual obligations whose costs are clearly stated on the contracts themselves, stocks have no comparable stated cost rate The cost of retained earnings may seem to be "costless". However, retained earnings have an opportunity cost. The firm's after-tax earnings belong to its stockholders. These earnings serve to compensate stockholders for the use of their financial capital. Stockholders could have received the eamings as dividends and invested this money themselves in other stocks, in bonds, in real estate, or in anything else. The firm should earn on its retained earnings at least as much as the stockholders themselves could earn on alternative investments of comparable risk If the firm cannot invest retained earnings and earn at least R, it should pay those funds to its stockholders and let them invest darectly in stocks or other assets that will provide that return inv estors require The cost of new common stock R, is the cost of extermal equity, at is based on the cost of retained earnings, adjusted for flotation costs, the costs with issuing new shares such as fees paid to in estment banks or nderwriters, see Part VI below A good estimates of the cost of equity from retained earnings Required rate of retum Expected rate of retun D. Security analysts regularly forecast earnings and dividend growth rates, looking at such factors as projected sales, profit margins, and competition. Intuitively, firms that are more profitable and retain a larger portion of their earnings for reinvestment in the firm will tend to have higher growth rates than firms that are less profitable and pay out a higher percentage of their eanings as dividends Example: if a firm's next expected dividend is S1.25, if its expected growth rate is 83% per year, and if its stock is selling in the market for S23 06 per share, then $1.25 +33% S23.06 = 5.4% + 8.3% = 13.7% All three approaches are used in estimating the required rate of returm on common stock. When the methods produce widely different results, judgment must be used in selecting the best estimate. In the three above examples, estimates of R, range from 13% to 14%, so a reasonable estimate might be the staple average of this range which is 13.5%. CAPM BH RP DCF 130% 140% 13.7% Capital Budgeting Notes(3) (1)-Saved View e Width Companies generally use investment bankers to assist them when they issue common stock, preferred stock, or bonds. In return for a fee, the investment banker helps the company structure the terms, sets a price for the issue, and then sells the issue to investors. The banker's fees are called flotation costs, and the total cost of capital raised reflects the investors' required return plus the flotation costs Flotation costs must be included in a complete analysis of the total cost of capital Two alternative approaches can be used to account for flotation costs. The first approach simply adds the estimated dollar amount of flotation costs for each project to the project's up-front cost. Because of the now-higher investment cost, the project's expected rate of returm and NPV are decreased The second approach involves adjusting the cost of capital rather than increasing the project's cost. If the firm plans to continue to use the capital in the future, as is generally true for equity, then this second approach is better. When calculating the cost of common equity, the DCF approach can be adapted to account for flotation costs. For a constant growth stock, the cost of new common stock R can be expressed as follows: . . P (1-F) Component Weight x Afur-TaxCast= Wrigine/Cost Debt Preferred Common 0.45 x 002 x 0.53 x 60% 10.3 2.700% 0.206 13.57155 In more general terms VIII. The cost of capital is affected by a variety of factors Some of these factors are beyond the control of the firm such as interest rates, the general level of stock prices in the financial market tax rates, inflation and the foreign currency value of the dollar If market interest rates rise, the cost of debt increases becase fixms must pay bondholders more when they borrow: If stock prices in general decline, puling the fim's stock price down its cost of equity will rise There are ways n which taves can affect the cost of caital Wen tax rates on dividends and capital gains yuere lowered relatrre io rates on interest income, stocks become reatively more attractse dnn debi, consequentty, the cest of egaury and thie WACC tend to decline A fns can affect its cost of capeat by chanenne sts canital structiza changing its ividensd pasyour satio, and boy alserieng ats capital bradgetimng decison rabes te sooept projacts uadh more or less rink than projects peenjoasty undertaken The fim can cihange is capital structire and ch a chanee can aifect its cost of capita!. If a fem decides to use more debe and less coramon equary this change in the weights used in the WACC equation wil tend to lower dhe WAcc Hower er, an increase in the use of debr waill increase the risk of borh debt and equity, and these changes suill lend to uacrease the WAcc, ind tes offiet the effects of the chunge