BUSINESS AND ECONOMIC FORECASTINC 157

V4ues for the two indices for each month are shown in the following table.
Both indices suggest that economic conditions shorrld imProve in future months.

Dillusinn Index

1 100.00
2 65.70 104.31
3 100_00 120.00

Ref: Petersen, H.G.,Managerial Economics,

3rd Edition
Input/Output Analgsis
Economekic models can be used to forecast changes in demand in one sector,
but such models seldom have the detail necessary to ass€ss the imPacts of those
cltanges on other sectors, But modem economic systems ate highly interelated.
Changes in demand in one seajtor of lhe economy can have si8nificant imPacts
on demand in other secto$. Siome of these impacts arc immediate and obvious.
For example, steet rubbei, glass, and plastics are all impo*ant inputs in the
production of motor vehicles. Thus an increase in the demand for automobiles
would cause an incease in the demand for those four products.
The direct impact that automobile sales have on the demand for steel, rubber,
glass, and plastics is augmented by secondary effects generated in still other
sectors. Consider the iesulting increase in demand for steel. As steel outPut
inoeases to meet the requirements for producing automobiles, steel industry
managers will find it necessary to purchase additional inputs. These may include
iron ore, coal, and electricity. If the increase in demand iE expected to be permanen t,
management may also decide to expand the capacity of their production facility
by acquiring additional capital goods such as blast furnaces.
In tum, these secondary impacts will affect other parts of the economy. Over
time, the increase in automobile demand may be the cause of change in huldreds
{rf dilferent industries. To the casual observer, many of these changes n'ould seem
u$elated to the production of automobiles.
Input/output_ {u-tysis is a useful technique for sorting out and quantiring
sector-by-sectol iirrpaits. This approach captures not only the direct effects but
also related impdcts iri other parts of the economy. For example, an input/output
i
makix developed by the U.S. Department of Labor can estimate the impact of
increased automobile sales on nearly 500 individual sectots in the U.S. e.onomy.

Transactions Matrix
Input/output analysis is based on a table that indicates historic pattems of pur-
chases and sa-les between industrier Data for this table are usually generated
from surveying a sample of firms. A simple two-sector version of such a table i9
shown in Table 5-6. The two secto$ identified in the table are manufactudng and
agriculturc. Within each sector are firms producing specific products. For example,

..r--!-;-r :;..r!::.:.**;:=:;:::]:::l_-:i:i1:lt_,-l:j:_-
-r-@li:.@---,- ;jt5:;.=*:;,,ii;_;-;1:;:;_;;

N
158 DEMAND

rABLE S5 Two-Sector ftrput/Output Table

Eitul Totnl
+ Dmnd = S,l?s

Pu€has froh Mula.ruin8 8 +10 +2 = 2tl

lu.hi$ lrom agdolture 6 +12 +12 :30

8
:
20 30

the manufactudng sector might include 6rFs making electronic components and
also firms that produce television sets and computers. Similarly, the agriculture
sector could indude firms producing cotton and wool.
The rows of Table t6 show the disPosition of each sectols output. Consider
fust the manufacturing sector that is depicted in the 6rst row. If the numbers
represent billions of dollarc, the first element in the fust row indicates that ffrms
engaged in manufacturing sold $8 billion of their product to other manufacturing
firms. An example of these "within-sectol' transactions might be the sale of
elechonic components to a television manufacturer. The second element of the
first row shows that $10 billion of manufactured goods were sold to firms in
the aBricultual sector. Together, tllese 6rst two elements indicate total sales by
manufacfuring to other fimrs. Such sales are sometimes called iflteflnediate sales
because they represent output tlut is used as inputs for maling products sold to
aonsumels. The 6rst two elements of the second row are interpreted in a similar
manner. They show intermediate sales by the a8riculture sector.
The third element of each row is designated as fiIIal demand and shows sales
to ullimate consumers. Finally, the last element is total sales. This number is the
sum of the intermediate sales and final demand and represents the total sales by
the sector. Thus the $20 billion of total sales in manuJacturin8 were made up of
$18 bilion in intermediate sale6 to other 6rms and $2 in sales to 6nal consurners.
The columns of Table 5-6 indicates the use of revenues by each of the secto$.
The elements in the first column show tllat firms in the manuJacturing sector
spent $8 billion to puchas€ intermediate goods from other manuJactwing 6rEls
arld $5 billion on good$ ftom the agriculture sector. Subtracting that $14 billion
amount from total sector sales of $20 billion leaves a residual of $6 billion. This
amount is referled to as value added because it represents the ditference between
the value of inputs purchased and the product finally sold. Value added consists
of pa)'ments to workers, owne6 of capital, and Bovemment.
lhe elements of the table indicating intermediate sales and purchases are of
partiolar interest for input/output analysis. Together, they make up the bansac-
tions mahix of the model. Based on the numbers in Tabte 46, the hansactions
matrix is as shown in Table 5-7. In matrix notatio& let this matrix be designated
as & where

[:is]
 BUSINESS AND ECONOMIC FORECASTING 159

TAH.E 5-7 Transactionr Mahix

Saks to Sales to
Manufartu*q Agri.ulture

Pwchases Irom manulacturing 8 10

Purchases from agicdture 6 12

Direct Requirements Matrix

If mch element in a colusn of the tEnsactions matrix is divided by the total sales
of that sectols product, the result is the direct requirements mah.ix of an input/
output model. The elements of each column of the dircct requirements rrakix
canbe interpreted as indicating the immediate or direct chan8e in tevenue for a
sector generated by a $1 change in demand for the Prcduct of the sector lePre'
sented by the column. The direct requirements matdx for the samPle problem is
shown in Table 5{,

rABLE 5-8 Dfu€ct Requuements Matrix

Ma ufactlling ASri!:ulture

Manufacturing sales per dollar 0_40 0.33

Agricultural saleB per dolar 0.30 0.40

Consider the elements of the manuJactuting column. They were computed by

dividing the Iirst column of the trarsactions matrix by total sales in manufactul-
ins-$20 billion. The fust element indicates tltat fo! each dollar of manufacturil8
ies, $0.4O of intermediate sales to other 6lms in the manuJacturing seclol aie
initially genemted. The second element shows that $0 30 in sales by a8ricultural
firms will be the direct result of each dollar of sales in the manuJacturing sector.
The elements of the second column have a similar interPretation with rcsPect to
each dollar of sales by the agiicdtural sector. Let the direct requirements matdx
be designated as A. Thus

, _- fo.+o o.:sl
" lo.ao o.+o l
Direct and Indirect Requirements Matrix
The dfuect requirements matrix shows the immediate o! direct impact of changes
in demand in a s€ctor. But the elements of this matrix do not incorPorate secondary
and other impacts. For er.ample, Table 5-8 indicates that the direct rcsult of a
g1 increase in agricuttural sales would be a $0.33 increase in the demand for
ma uJactured goods. However, such an increase would require that maNfactur-
ing firms pEchase additional goods from other fiims in the manufacturing and

-E+EBl8!+.-*-.1i- --.* :::-r::j:i-1-r;i:*:;Aiai.r::;:.:::;:. _ :_

 IABIj t9 Direct and Indirect RequireEenb Matdx

Mafiufaclltring Agricult re

Change in totai 2.30 1.:26

demand in manufacturing
Change in total r.ts 2.30
demand in agiculture

airicultural secto$. These purchases would stimulate stilt other purchases by

firms in the two sectors. Thus the ultimate impact would be greatei than predicted
by the coefficient of the direct requirements mat x.
To take into account secondary impac.ts of changes in demand, input/output
analysis requires cornputation of a direct and indircct requirements mahix. The
de.ivation and calculation of this matrix are beyond the scope of this book, but
conventionally it is designated by the notation (I - A) 1, wiere ,4 is the direct
rcquirements matrix, I is the identity matrix, and the exponent denotes the inverse
of a matrix.l For the example being considered, the direct and indirect require-
ments matrix is shown in Table 5-9.
The direct and indirect requ ements matrix has a straightforward interpleta-
tion. The elements of each column indicate the change in total demand in each
sector that would result form a $1 change in 6nal demand for the sector designated
by the column. For example, consider the fust column. The first element ihows
that a{ter all direct and secondary effects have been taken into account a 91
change in fina.l deflrand for manuJactured goods will cause a 92.30 change in total
demand in the manufacturing sector. The second element of the first column
estimates that change in total demand in agiiculture resulting from a $1 change
in final demand for manufactured goods. In this case, the number is $1.15. Simi-
larly, the elements of the second column show changes in total demand in each
sector caused by a $1 change in final demand in the agricultural sector.

Forecasting with an Input/Output Model

The diiect and indirect requirements matdx calr be used to forecast sector-by-
sector impacts of changes in final demand. For example, suppose that an increase
in exports causes a $5 billion increase in final demand in the agricultuial sector-
AJter taking into account all the direct and se.ondary effects, what impact would
this change have on total demand for manufactured and agriculturaLgoods?
With respect to manuJacturing, Table 5-9 shows that each g1 change in agricul-
tural final demand causes a $1.26 change in the total demand for manufactured
goods. Thus a $5 billion increase would increase total demand in manulacturin8

rAn idenlity matrix has 1s on ils main diagonal and 0s for its oiher
et€ments.Ir is anatogous ro
the numbs 1 in tuithmeti.. Th€ inv.ne of 5 nar.ix is a mtrix that iI nultipti€d by rhe originai
letds
the idetity mtrix. The concept is analogous ro rhe reiPlocal in dithmetic.

I
_l
 161
BUSINESS AND ECONOMTC FORECASTTNG

in
hv g'5hillio( x or $630 billion. Simitarly, the in€rease in totat demand
'1.26,
ii"-roricrrltt ." would be $5 billion < 2 30, ot $11'50 bilion
"'irrrtii".,iil;rysis
"""tot can also.be used to forecast emPloyment-imPa.cts .Thh -
ic.l^nphv assumine a constant rat o ot employment to total demand' To iuustrate
:ff;'"ii;, ;;il:;*J * ii"
^"""r"ti"ii.'g '"'to'
i" $s00 birion and the total
;;;;;;tk"; L that s€ctol is 5,000,000: Hence the emPlorment tatio is.l
i"liri oni rr,.t is, one iob exists for each $100,000 in total demand'
-; ;#;;;;;;;;'iantl te
one ad<litional iob in the manufacturing.*ctor. wiu
increase in total demand Thus if $5 a billion increase
..irJf- *"f, UOOpOOjg.,""r*ral Products causes a $6 3 bitlion increase -total
i"lLi i"-."i i.i -in
i"fria ," ,rt" sectir, the employment imPact would be $6 3 billion
ffiffi; *
"*""f"&r""g
$r,npot ea,fio
"e*
pu""l similar mmPutation could be made
to tt inc!€ase in the agricultural sector'
""ti-uti " "-pfoyo,""t

EXAMPLE
Automobile Sales and the Demand for Glass
bv 1992 automobrle sales to consume$ are forecast to be $10
billion
As,sume that
ting a Plant e{Pansion
;;;;;ih- "i;;;,. A manuJacturer of Elass is contemPla on
ind wans to lLow the Probable effect of the increase in automobiletodeErand
;i; #"ft;;; f", giu"". uttioo leaders in the industry want know the
employment imPact.
that includes
iheiorecasts ire to be based on a five-sec{or inPut/outPut model
and indiect rcquircm€nts.matrx rs
sectors for glass and automobiles' The direct
will be the total demand
*1ft"*". ffi" ".pf"y-*r ratios are also shown' Whatproiected increase in (hal
ffi;;;ilyd ffiJ
in the glais industry of the
demand for automobiles?

Direct ond lfidire.i Requiefiqts Mntr*

Skgl A tomofiles CorflWters Elecfiicity

Steel 1.034 0334 0.008 0.010 0.010

Automobiles 0.008 1.010 0.009 0.002 0.007
Computels 0.003 0.0(x 1.110 0,001 0.100
Glass 0.009 o090 0.048 1.001 0.005
Electricity 0.142 0.045 0.010 0.086 1.009
Entdoyne Ratios

Sterl Autonlobibs Etectricity

Jobs per milior dollars 2fi 10.m 8.00 4.50 1.00

of total sales
510
!,I LONG.TERM PLANNING

mented and the remaining $200,000 in the capital budger left in the firm's
account.
An equivalent but less cumbersome approach uses thE concept of the profil
ity mtio (&) to rank proiects. The profitability ratio is compud as one plur
present value of all future cash flows divided by the initial cost of the
that is,

&=r*ffi or R.t=
cosT + NPv
cosT
If firm ranked the plojects A through F in Table 15.5 by the profftabili9
tl1e
projects F, A, and D would be identified directly as those to be implemert!4
That is, F has the highest ratio (1.24); A and D are next, both having a ratia €f
1 .20. The total cost of these three proiects is $i million, which exhausts the caSI[

budget. Infhen project G is included, it has the highest profitability ratio (i.e., LS
and has an NPV greater than any other feasible combination of the other proie<l*
Thus, it should be setected even though it doed not exhaust the available budg*
of $1 million. The profitability mtio approach is much more efficient than tht
altemative of determining the cumulative net prcsent value of each feasible {od!"
bination of ploiects.

KEY CONCEPTS
. If the number of efficient capital projects exceeds the fuIds availabte, the firn
faces capital ntioning. In this case, the firm must select that .ombinatior a{
proFcts that maximizes the sum of the net present values.
. lihe profitability ratio, computed as one plus the net present value divided by
initial cost, can be used to rank alternative investments whm the fum is subj€fi
to capital rationing.

The Cost of Capital Ref: Petersen, H.G.,Managerial Economics, 3rd Edition

The use of the net present value and intemal rate of retu-rn methods requir$ thsl
future cash flows be discounted by the firm's cost of the funds us€d to pay r# r

the costs o{ the project. The cost of such funds is referred to as the cost of capitil
In genemf the cost of capital is the return required by investors in the debt qial
equity securities of the 6rm. Basically, there are three sources of funds to the flm
foi capital spendingi retained earnings, debt, and equity. In the followin& lla
cost of debt financing and the cost of equity financing though the sale of commo|t
stock arc considered. The cost of using retained earnings for capital spendin8 b r

approximately the same as the cost of common stock, so the cost of iet8in€d
earnings is not discussed explicitly.s

A naive manage. might view llE mst of retained eamings s being zero. This cl@ly is rrsa
s
*t
thd that there is a significant oppo unity cost to the olvner8 of
case, if Jor no other rerson
busines, who coutd x-se thos€ fih& for personal coNmption or for investment in some
 CAPITAL BUDGETING 511

Cost of Debt CaPital

l- There is little contlove$y about the cost of caPital rais€d by borrowing Irom
banks or bv sellinq bond; That cost is the net or after-tax interest rate Paid on
re

that debt. Ifucause'interest, unlike dividends on stock is deductible from income

when computing income taxes, it is the aJter-tax cost that is imPortant For a
('d) is
given inteiest r;e (0 and rnarginal tax rate (t), the a{tel-tax cost of debt
given by
o, rd:i(l -t) (1 )
d. i$ percent
For example, if the firm borrows at a 10 Percent iitelest late and faces a
of marginal tax rate, is after-tax cost of debt caPital is
al
8)
0.10(1 - 0.40) = 0.06

ts, or 6 percent.6
pt Trio important consideations should be mentioned FiEt. iI the fir:m is not
he eaming proffts, the pletax and after_tax interest rates will be the same kause
I- it" -..irruf tax rate is zero. Second, the concem is with the matSinal cost of
caoital a'nd nol the average cost of capital for the firm For examPle, that the
avLaee cost of debd in the-firm's balanci sheet is I Irrcent is irrelevant The only
impofiant consideration i5 the cost of raisinS new caPital' This is because-the
iniestment decision requires comparing the rate of leturn on new Proiects G e''
(i
the rnarginal tetum1 *itil the cost of acquiring additional caPitat e ' the marginal
m cosl of capital).
of

)y
Cost of Equity CaPital
lct In general, determining the cost of equity caPit-dl from retained-eamings or cale
of i'ommon stock is more comPlicated and morc controversial than determining
the cost of debt. In the followin& three aPP.oaches to estimating thrE cDst are
Dresented. Note that dividends are not deductible from income when comPuting
income taxes, so the firm's tax rate does not Play a direct role in determining the
cost of equity caPital.
:ut
for METHOD I: THE RISK-FREE RATE PLUS RISK PREMIUM Genemlly, investment
ial. in common stock is considered to be riskier than inv€stment in bonds- fhe firm
nd has a contractual obligation to make interest and princiPal payments to bondhold-
rlN ers, and such pa;.merits must be made before dividelds can be Paid to stockhold-
the If profits rise and Ia[, it is likely that dividends also will fluctuate' However,
"rs.
ron except in the case of severe financial problems, bondholders will be paid Thus
1is it is 'thoueht that investo$ will demand a retum on equity (/) comPosed of a
red risk-free ietum (r), usualty considered to be the rate of letum on lonS-term
sovemment bonds, plus a premium for accepting additional risl This Premium
iefleas the two sources of risk. First, there is lhe isk associated with investing
in the secudties oI a Private comPany as oPPosed to buying federal government

6
Note that in th€ e.Iahons, the d€imal equivale* of rhe interest mte is used That it a 10 Per'et
Ete of l erst appeaE as 0 10 in an equation.

t-
 LONG.TERM PLANNIT'iC DECISIONS

(1Fs)

: 6, - rr) + 0.04
For exa-mple, suPPooe that the rist-free -rate- is 8 Percent and
the firrt's bo.nds
; F"Idi"g 10Pd";nt Therefore, the totalrisk Femiumwould
be 5 Percentage
poinfs, that rs,

and the 6rm's cost of equity caPital would be

L: \+ e = O.Og + 0.06:0.14
or 14 Percent.
but f+ to
METHoD U: DISCoUNTED CASH ELoW M€thod I indud$,risk
.""lii*-ti" **tfltiw of Prowth in dividends and the valueflow of common shares
ai^". ai rfa"-"tive i'pproach is the'discormed cash method' Just as
"i,-
th;J;; th" fit- tsrhe desbnr value of all tuture profis' the value of a share
li-*rn-o" i" ttt" pdent ralue of al'l future dividerds usinglhe ir]vestor's
.i t"t r- (;) as the discount rate That b, one share oI stock entitl€s
"to"t
'*-JJi"i"
;il;;.; ;;" a series of paymmts (i'e', dividends) roughly equi-valent to
;;^";;;d"; ttr" value oi tini ehare should {ual the Present value of the
annuitv. Ii the current dividend per thare (Do) is ixPected to remain constant
the vaiue or price'(P) of a share 1vi.-[ be^

- -a
Do

. "0+t')'
t_l \- ..,
ol

':"[aitt.J
telteduc€8 to
It can be shown that the bracketed
. 1
f.
i
I
I
I
 1

513 I
CAPITAL BUDCETING

so that the value of a share of stock is simPly

tlle dividend rate divided bY the
rcquired Iate of return, that is.
P =Do
)
at an annual mte oI
However, if the dividend is exPected to increase over time
t g, ii that the Prici per share will be given by
"-L "ft.r,t,r, Do
I
I
. r,'g o*n
I Solving equation (1$7) ior r, yields an €quation for
the cost of equity caPital:
e
I _ ,a
-,. -D"." os-8)
n
P
to the current.dividend yield
That is, the retum required by the investor is equal
i&/p) ptus "n exP"cted Brou'th rate for dividend- Payments'
""lil" ""-*"".t*t
The estimate of that growth mte miSht be the historic
rate ot Srowth lor.tne urm
:

;:;;;Ji; ;:'Asu'gr"wth ;te being used bv financial anaivsts who studv

"'i.ifirm.7
the
suppoee that a firm is Paying a dividend of $8
per share on
lr
F -^ *".:<r-"f.,
"tk
,ui Lus Ior $1m Per share and that therc is agreement among
;;;;i;riiystsE;i the growth iate of dividends oI this firm will be 6 Percent
be
the firm's cost of equitv capital is estimated to
#;;;.tililhr";;t":ch, '!
14 percent. That is,
,'' =A+0-06=0.14 or 14Vo
100
of caPital
ohviouslv. vadations in the price of the stock will change the furrls cost
i"r'".#"r", rf ^"*iors bid ,p the Pdce of thisThat stock f'om $100 to $120 Per
is'
to share, the cost of capital will fal to 12 Percent
7
e3
at ''' = -!- + 0.06 = 0.127 or 12.7q"
120
trP
(, (CAPM) ThE CAPit I ASSCT PdC-
METHOD III: CAPITAL ASSET PRICING MODEL
es
to ffi i"Hli,ffiiiy;"i i""t *o'ia or q"untitative fioance' empha:Y-"1i?:^t"1"
" govemment bonds but also tlte
the risk differential between common stock and
govem-
ltg
i"-l aiii"*",iJ .^."*stocks.s The risk differential between stocks and
common
nt, by (r. - rr, wherc /- is the leturn on [he average
-""t u."i. " *rrlr"a&
utta ,1i" tft" Iat" onrisk-free U'S' Sovernment securities'
"to"t
, MGt firms that have issued.omlrron sto* thataqt'velv t'aded in organized lwker".1'" 9.n::'d
is
rstrrunons'
U".""- -or" *ry"t" i. Sunls,brckeraBe comp6rie6' mutual tunds' d other finnoal
what th*
riJi-*"t" "* 'i"a,rv and MnaSs usuatly male ir a Poinr to keeP trad of
n(tr
there n;v anarv'ts who
n... r"'
"vailable ru'g" be hundreds or
"ffi;;;;il#.ir'.i, "o"i"
tultow each comPany.
-",-ri"*ri-.v ,i"ai,rvi.g rhe de!"etopmmL of rhe.ip il alser pricin8 model wis an inegral Parl
'^"r"med rurteL m lhe ra70s and lo8os' williim
tl,.''*J"i- ,r"it rh'e wortd s Gnaniial
work
",
;il;il;;il;;, -J r'4,'"" ul* "r'"'a
the 1ee0 Nobel Prize ror thet Pione€rins
514 LONG-TERM PLANNING DECISTONS

Rrilative risk among stocks is measued using the Ma coefficient, B, as a risk

index. The beta coefficient is the ratio of vaiiability in return on a given stock to
vailabfity in return for all stocks, Return on a stock for a peiiod of tihe, t)?ically
one year, iE the dividend plus the change in tlle value of the stock during the
period, U6ing ti as the total return in the ith pedod on an investment in one sharc
of commort stock of company 5 and ti
as the total return on all common stocks
(or a representative sample) in the ith period, the beta coefficient is deterrdned
by estimating the paramete$ of the following regression equation:
- ki=a+ Bki
The estimated value of B i$ the beta coefficient.
A stockwith average risk will have a beta value of 1.0, meaning that the retums
on :hat stock mry in proportion to returns on all stocks. A higher-risk stock might
have a beta of 2.0, meaning that the variatiofl in returns on that stock is twice
:
that of lhe averaSie stock. For example, iI B 2, when the retums on an aveiage
stock inqease 10 percent the retums on thie risky stock increase by 20 percent.
Conversel, a beta of 0.5 wou.ld be associated with a low-risk stock whele retums
varied only one-half as much as for the average stock.
Using the capital asset pricing model, the cost of equity capital is the fisk-free
rale (ry' plus a weighH ri.sk componmt, that is,
t,:\+ (t.-f)F ore)
In this mdel, the overall risk premium for common stock is measued by (/, /y' -
and the beta weight (P) then adiusts for the risk asbociated with the specific film
in question.
For example, suppose that the risk-ftee rate (/, is 8 percent and the average
retum on common stocl is 11 peicent. For a firlrl having a ka
of 1.0 (i.e., the
dsk for the firm is the same as that for the market average), the cost of equity
capital is
r. = 0.08 + 1.0(0.11 - 0.08) = 0.11 or 11 percent
Conversely, the cost of capital for a 6rm having a beta of 2.0 would be significantly
higher. That is,
r, = 0.08 + 2.0(0.11 - 0.08) : 0.14 or 14 percent
. Estimates of beta fol many publidy haded companies are available from vatious
financial service companies. For example, the Value Line Investment Survey
reports estimated betas for severl thousand firms.e Recent estimates for some
maior U.S. corpora[ons are listed here.
American Telephone & Telegaph (0.85) BankAmerica Corp. (1.25)
Consolidated Edison (0.65) Delta Air Lines (1.10)
Ford Motor Corp. (1.10) General Mills (1.00)
Nike (1.25) Pepsico (1.05)
Sears, Roebuck (1.05) Zenith ElecEonics (1.45)

'Value Line Publishitrs Company, N* York

CAPITAL BUDGETING
515

Note that Arnerican Telephone and Consolidated Edison offer below-aveEge risk,
while Nike. BankAme ca, and Zenith carry significaritly above-average risk.

Composite Cost of Capital

Many firms attempt to maintain a constant or target capital struchrre. Fot example,
managemmt of a manufacfuring business may prefer a capital structure that is
30 percent debt and 70 percent equity. In conhast managers of an electric utility
company may prefer a 60 percent debt and 40 percent equity structure. In either
case, capital would be raGed periodically both by incurring debt and by selling
stock. The differences in capital skrctule reflect the preference for rist on thl
pa* of owne$ and managers and the nature of the business. A capital structure
heavily weighted toward deb,t impLies 6reater risk because of the greater interest
and principal payments that are required. public utilities tend tthave a higher
percentage ofdebt than most other fums because they have a monopoly position
and usually the product they setl is a necessity. This means that ihe fum will
have a reasonably stable and dependable flow of revenue and profit, and this
offsets part of the high risk associated with a large proportion of debt in their
capital skucture.
-listAoffum with a target capital skucturc may maintain two separate ledgers_a
capital Fojects and a list of financing plans (borrowing, iale of stoc! etc.).
A particular financing option, say selling bonds having a c;st of 10 percent, is
not tied to one capital project. Rather, the 6rm uses an overall or composite cost
of capital as the evaluation critedon Ior each capital proiect.
This composite cost of capital (/.) is a weighted average of the after_tax cost of
debt (/, and equity (r,) capital. The weights are the proportions of debt (ta) and
equity (ro,) in the 6rm's capital structue. That is,
(1r13)
For example, suppose that a firm's target capitalization structure is 410 percent
debt and 60 percent equity. Over the next twelve months it plans to raiie $100
mfllion by selling $40 million in bonds at a cost of 8 percent and issuing $60
million of stock at 960 per sharc at a cost of 12.5 percent. ,i,hus the firm,s wei[hted
or composite cost oI capital would be 10.7 percmt- That is,
r" = (0.40X8) + (0.60)(12.5)
r. = tO.Z
The compogite late of 10.7 percent would be used to evaluate all the proposed
capital expenditure requests to ensure that they are profitable.

CONCEPTS
. The cost of capital is the rcturn required by investors in the debt and equity
securities of the firm.
. The cost of debt capital is the after-tax interest rate on the firm,s tonds or
borrowing.