🏗️ Corporate Finance: Capital and Costs
The Big Picture: Building Your Dream House 🏠
Imagine you want to build a house. You need money (capital), and that money has a price (cost). Some money comes from your piggy bank (equity), some from borrowing (debt). Smart builders figure out the cheapest way to get all the money they need!
🎯 Capital Budgeting: Should I Build It?
What Is It?
Capital budgeting is like deciding whether to buy an expensive toy. You ask: “Will this toy make me happy enough to be worth the money?”
Companies ask: “If I spend $1 million on a new factory, will I get more than $1 million back?”
How It Works
graph TD A["💡 New Project Idea"] --> B{Will it make money?} B -->|Yes!| C["✅ Build It!"] B -->|No| D["❌ Skip It"] C --> E["🎉 Company Grows"]
Simple Example
Pizza Shop Decision:
- Cost to buy pizza oven: $10,000
- Extra pizzas sold each year: $3,000 profit
- Time to pay back: About 3.3 years
- After that? Pure profit! ✅
Key Tools
| Tool | What It Asks |
|---|---|
| NPV | Is future money worth more than today’s cost? |
| IRR | What “interest rate” does this project earn? |
| Payback | How fast do I get my money back? |
🧱 Capital Structure: The Money Mix
What Is It?
Capital structure is how you split your funding between your own money (equity) and borrowed money (debt).
Think of making lemonade:
- 🍋 Equity = Lemons you already own
- 💧 Debt = Water you borrowed from a neighbor
The best lemonade needs the right mix!
Why It Matters
graph TD A["Company Needs $100"] --> B["Option 1: All Equity"] A --> C["Option 2: All Debt"] A --> D["Option 3: Mix Both"] B --> E["Safe but expensive"] C --> F["Risky but cheaper"] D --> G["✅ Just right!"]
Simple Example
Starting a Lemonade Stand:
- You have $50 (your equity)
- You borrow $50 from Dad (debt)
- Now you have $100 to start!
- Your capital structure = 50% equity, 50% debt
🐔 Pecking Order Theory: First Choice, Second Choice
What Is It?
Like a hungry chicken pecking at food, companies have a favorite order for getting money:
- 🥇 First: Use profits already in the bank (internal funds)
- 🥈 Second: Borrow money (debt)
- 🥉 Last: Sell ownership shares (equity)
Why This Order?
graph TD A["Need Money!"] --> B{Have profits saved?} B -->|Yes| C["🥇 Use savings!"] B -->|No| D{Can borrow?} D -->|Yes| E["🥈 Take a loan"] D -->|No| F["🥉 Sell shares"]
Simple Example
Buying a New Bike:
- First, check your piggy bank 🐷
- If empty, ask to borrow from parents 👨👩👧
- Last resort: sell some toys to get money 🧸
Companies do the same thing!
💰 Cost of Capital: The Price of Money
What Is It?
Every dollar you use has a price tag. Cost of capital is what you pay to use money – whether it’s your own or borrowed.
Think of it like renting a bicycle:
- Even if you own the bike, you could rent it out
- So using YOUR bike has a cost = the rent you’re missing!
The Big Idea
Cost of Capital = The minimum return a company MUST earn to satisfy everyone who gave them money.
Simple Example
- Investors expect 10% return on their money
- If your project only makes 5%… you’re losing! ❌
- Your project must beat the cost of capital to win! ✅
📈 Cost of Equity: The Owners’ Price
What Is It?
Cost of equity is what shareholders expect to earn for investing in your company.
It’s like promising your friend: “If you help me with my lemonade stand, I’ll give you half the profits!”
How to Calculate (Simple Version)
Cost of Equity = Risk-Free Rate + Risk Premium
Translation:
- Risk-Free Rate = What you’d earn with zero risk (like a savings account)
- Risk Premium = Extra reward for taking a chance
Simple Example
- Safe savings account pays: 3%
- Extra risk of your company: 7%
- Cost of Equity = 3% + 7% = 10%
Shareholders expect 10% return! If you can’t deliver, they’ll invest elsewhere.
💳 Cost of Debt: The Borrowing Price
What Is It?
Cost of debt is the interest rate you pay when borrowing money.
Like borrowing $10 from a friend and paying back $11 – that extra $1 is your cost of debt (10%)!
The Good News: Tax Savings! 🎁
When companies pay interest, they get a tax break. So the REAL cost is lower!
After-Tax Cost of Debt = Interest Rate × (1 - Tax Rate)
Simple Example
- You borrow at 8% interest
- Your tax rate is 25%
- Real Cost = 8% × (1 - 0.25) = 8% × 0.75 = 6%
You only REALLY pay 6%! The government helps with 2%.
🛡️ Tax Shield: Your Money-Saving Superpower
What Is It?
A tax shield is money you save on taxes because of certain expenses – especially interest payments!
Think of it as a coupon: “Pay less taxes when you borrow!”
graph TD A["Borrow Money"] --> B["Pay Interest"] B --> C["Interest = Tax Deduction"] C --> D["🛡️ Pay Less Taxes!"] D --> E["💰 More Money Stays"]
How Much Do You Save?
Tax Shield = Interest Payment × Tax Rate
Simple Example
- Company pays $1,000 in interest
- Tax rate is 30%
- Tax Shield = $1,000 × 30% = $300 saved!
Instead of $1,000 cost, it’s only $700. Magic! ✨
Why Companies Love Debt (A Little)
More debt → More interest → Bigger tax shield → More savings!
But careful… too much debt is dangerous! 🎢
⚖️ WACC: The Ultimate Cost Calculator
What Is It?
WACC = Weighted Average Cost of Capital
It’s the average price of ALL your money, weighted by how much of each type you use.
Like calculating the average price of your snack mix:
- 60% peanuts at $2/lb
- 40% raisins at $4/lb
- Average = (60% × $2) + (40% × $4) = $2.80/lb
The WACC Formula
WACC = (E/V × Re) + (D/V × Rd × (1-T))
Translation:
| Symbol | Meaning |
|---|---|
| E/V | % of equity in your mix |
| Re | Cost of equity |
| D/V | % of debt in your mix |
| Rd | Cost of debt |
| T | Tax rate |
Simple Example
Lemonade Company:
- 60% equity costing 10%
- 40% debt costing 5% (after tax)
WACC = (60% × 10%) + (40% × 5%)
WACC = 6% + 2%
WACC = 8%
The Rule: Any new project must earn MORE than 8% to create value! 🎯
Visual Summary
graph TD A["WACC = 8%"] --> B{New Project Return?} B -->|Returns 12%| C["✅ Do it! Creates value"] B -->|Returns 5%| D["❌ Skip! Destroys value"]
🎯 Putting It All Together
The Complete Picture
graph TD A["Company Needs Money"] --> B["Capital Structure Decision"] B --> C["How much Equity?"] B --> D["How much Debt?"] C --> E["Cost of Equity"] D --> F["Cost of Debt"] F --> G["Tax Shield Benefit"] E --> H["WACC Calculation"] G --> H H --> I["Capital Budgeting"] I --> J{Project Return > WACC?} J -->|Yes| K["✅ Accept Project"] J -->|No| L["❌ Reject Project"]
Quick Reference Table
| Concept | One-Line Summary |
|---|---|
| Capital Budgeting | Should we spend money on this project? |
| Capital Structure | How do we split between equity and debt? |
| Pecking Order | Use savings first, then borrow, then sell shares |
| Cost of Capital | What’s the price tag on our money? |
| Cost of Equity | What do shareholders expect to earn? |
| Cost of Debt | What interest do we pay (after tax savings)? |
| Tax Shield | How much taxes do we save from interest? |
| WACC | What’s our overall average cost of money? |
🌟 Remember This!
The Golden Rule of Corporate Finance:
Only invest in projects that earn MORE than your WACC!
If WACC = 8% and your project earns 12% → DO IT! 🚀
If WACC = 8% and your project earns 5% → STOP! 🛑
You’re now equipped to think like a financial manager! Every decision comes down to: Is the return worth the cost?
Happy investing! 💪🎉