- We've considered 100% debt financing,
we've considered 100% equity financing.
Now let's split the financing 50/50.
Lily borrows 100 million dollars and she finds investors
to provide the other 100 million dollars.
The investors insist on a rate of return of 17%.
The lenders accept a rate of return of just 5%.
In this case the total cost of capital
is 100 million dollars plus 5%,
or 105 million dollars for the lenders.
And 100 million dollars plus 17%
or 117 million for the investors.
The total cost of capital 222 million dollars.
Well, let's look and see if this capital structure
will give a cost of capital low enough
so that Lily's business will work.
Total cost of capital we've computed is 222 million dollars.
The forecast is that the cash flow
will be 222 million dollars, it's still not going to work.
The cost of capital is too high.
The cost of capital determines
whether a project is going to occur or not.
Now first of all, why is the 17% required rate of return
by the investors in this case higher
than the 15% we already considered?
It's because these investors are in a more risky position
because they are not paired up with lenders.
We know that the courts favor lenders.
Let's say that this project
generates only 150 million dollars during the year.
People are losing money here.
Well who gets to collect cash first?
The lenders do.
The investors get whatever's left.
They are called the residual claimants.
The investors in this case are in a more risky position
because of the existence of the priority claimants,
the lenders.
The lenders on the other hand are in a safer position.
So they'll accept an interest rate of just 5%.
The lenders benefit from an equity cushion.
If things don't go well,
the lenders aren't going to lose anything,
because the investors have put their 100 million dollars
into the company and the lenders get to take some of that
if the business doesn't do so well.
Alright, let's try one more case.
Case four.
Lily is going to borrow a lot of money.
180 million dollars, 90% debt.
Only 10% equity, investors provide only 20 million dollars.
Will this capital structure result
in a cost of capital that's low enough
so that Lily can have her ice cream company?
In this case the equity holders are all going to expect
a return of 20% and the lenders are going to expect
an interest rate of 11%.
These rates are higher.
Why is this a more risky position
for both the lenders and the investors?
Well from the standpoint of the investors,
who are providing 10% of the equity,
remember in the eyes of the law, the lenders collect first.
So with this case, the investors see the 180 million dollars
in loans in front of them and they realize
that those large loans must be paid in full
before they, the investors, get anything.
The lenders are also in a more risky position in this case.
Remember the thing that reduced the risk of the lenders
before was the big 100 million dollar equity cushion.
Well here, there's only a 20 million dollar equity cushion.
If Lily's company does poorly,
it's going to burn through that equity cushion
pretty fast and the lenders might also lose money.
The total cost of capital is 224 million dollars.
But the project is expected to return
just 220 million dollars.