- The issue of capital structure is important,
because it impacts the cost of a company's capital.
Cost of capital is the cost of obtaining external financing,
which is a combination of the cost of borrowing
and the cost of equity investment.
The cost of borrowing
is just the interest rate on the loans.
The cost of equity investment, is return that investors
need to expect to encourage them to invest in a project.
The cost of equity investment is what we compute
using the capital asset pricing model.
Well, who cares about the cost of capital?
Well, the cost of capital is critical,
because it determines which projects
are going to be profitable, and which projects are not.
For example, let's say my cost of capital is 11%.
And I'm looking at a project
that will generate returns of 15%.
How beautiful!
I get my external financing at a cost of just 11%.
I use that to launch a project that is going to generate
returns of 15%, I've of generated a surplus of 4%.
That's a great project.
On the other hand, if my cost of capital is 11%,
and it looks like a project is only going to generate
returns of 7%, that's a horrible project.
So the cost of capital, determines for a company,
which projects are good, and which projects are bad.
Let's illustrate the importance of the cost of capital,
with some numbers.
So, case one, simple capital structure.
100% debt financing.
Lily borrows the entire $200 million that she needs.
Potential lenders look at this and demand
an interest rate of 12%.
In other words, the lenders give you $200 million now,
and at the end of one year,
you need to give them back $200 million plus 12%.
That's $224 million.
Now let's look at the projected cash flow
that will be generated by this ice cream business,
that creates lots of strawberry ice cream.
The cash flows are only going to be $220 million.
From the standpoint of the lenders,
if this project is only going to generate $220 million
in cash flow, it's no good.
it will not generate enough cash flow to repay the lenders,
for the risk that they bear in loaning the money.
The cost of capital is higher than the returns,
that are going to be generated by the project.
So this capital structure doesn't work.
So let's try something else, case two.
100% equity financing.
Lily finds investors who will provide the $200 million
as an investment, not a loan.
These investors have used the capital asset pricing model,
and are demanding an expected return of 15%.
In other words, at the end of one year,
there has to be $230 million available,
to give to the investors.
Now, why is this 50% equity financing return
higher than the 12% interest rate,
in the 100% debt financing scenario?
It's because debt financing is supported, protected
by the laws of every country in the world.
If you loan money to a company the law is on your side,
if the company doesn't pay you back.
Investors, on the other hand are at greater risk.
If investors can't get back their investment,
the courts won't help them.
Owners accept the risk of a business.
Lenders have the support of the courts behind them,
so lenders always get repaid, if there's anything there.
Investors just have to take their chances.
So, it's more risky to invest in a company,
than it is to loan money to a company.
That's why this 50% equity investment return,
is higher than the 12% for the lending.
In either case, the cost of capital is too high.
So, this project is not going to happen.
The high cost of capital is preventing
Lily's dream of an ice cream company
from becoming a reality.