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The cost of capital for Disney, based on these inputs, is 9.14%. This means, on average, it costs
Disney 9.14% to raise a dollar of long-term capital from external investors to fund investment
projects. As discussed earlier in this chapter, all companies calculate their own cost of capital as a part
of the investment analysis process. If an investment project is expected to earn a rate of return in
excess of the firm‟s cost of capital, it should be accepted. If an investment project is expected to earn a
rate of return less than the firm‟s cost of capital, it should be rejected. This is why a firm‟s cost of
capital is often called the hurdle rate. If a project‟s expected return clears the hurdle rate it should be
accepted, and if it fails to clear the hurdle rate, it should be rejected.
You will observe that a firm with a lower cost of capital or hurdle rate will be able to accept more
projects than a firm with a higher cost of capital or hurdle rate. Financial managers are similarly aware
of this fact, so they try to raise capital in a manner that minimizes the cost of capital. The relative mix
of debt finance versus equity finance used when raising funds, which impacts cost of capital, is called
the capital structure of a firm, and we discuss this topic in the next section.
Capital Structure Theory
One critical decision financial managers must make when raising funds for internal investment is the
relative mix of debt and equity finance. We have seen in the previous section that this mix of debt and
equity finance impacts the firm‟s cost of capital, as debt finance is less costly than equity finance.
Recall that the cost of debt for the Walt Disney Company in November 2008 was 6.96% while the
cost of common equity for Disney at the same time was 10.375%. This cost differential is driven by
the nature of the claims by debt holders and equity holders on the cash flows of the firm. Debt is a
contractual claim that takes priority in times of financial distress. Equity, in contrast, is a residual
claim, meaning the cash flows available to stockholders are what are left over after the claims of debt
holders, the contractual priority claimants, have been met. This makes debt finance safer for investors,
and since debt is less risky to investors it has a lower required rate of return. This also makes equity
finance riskier for investors, and since equity finance is more risky to investors, it has a higher
required rate of return. Our previous work on the cost of capital for Disney reflects the lower risk and
cost of debt finance, and the higher risk and cost of equity finance.
From the point of view of the firm, however, debt finance is actually more risky than equity finance.
The reason is that debt finance creates contractual obligations that the firm must meet, specifically
regular payments of interest and principal, which together are called debt service. When a firm uses
debt finance it commits to paying its debt service, and if the firm cannot meet its debt service it will
fall into financial distress and possibly bankruptcy. In contrast to debt finance, equity finance does not
create contractual obligations that the firm must meet. Unlike payments of interest and principal,
dividends are not legal obligations of the firm.