From the course: Corporate Finance Foundations

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Cost of capital: Split debt-equity financing

Cost of capital: Split debt-equity financing

From the course: Corporate Finance Foundations

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Cost of capital: Split debt-equity financing

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- When it comes to the financing of a company's operations, rarely is it all or nothing. In most cases, owners have put money in and there's some borrowing as well. So let's understand the trade-offs between debt and equity financing and why the proper mix can make all the difference. Let's look at Lily's Ice Cream business. Lily needs $200 million to finance her project, and the project is expected to generate cash flows of $220 million. Let's now analyze a mix of two financing options. First, let's split the financing 50/50. Lily borrows a hundred million dollars and she finds investors to provide the other $100 million. The investors insist on a rate of return of 16%. The lenders accept a rate of return of 5%. In this case, the total cost of capital is $100 million plus 5%, or 105 million for the lenders, and a hundred million plus 16% or 116 million for the investors. The total cost of capital is $221 million. Now, first of all, why is this 16% required rate of return by the…

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