Cost of Capital Specifications arid Capital Structure Decisions: Some Conceptual Propositions for Practising Managers

Ashok Korwar and V Raghunathan

The practising managers face two major sets of financial decisions: how to discount the various cash flows in any capital budgeting decision and how to decide the overall financing mix for the company. More often than not, the two sets of decisions are treated both by text books and by practitioners as if they are entirely independent. At the academic level, this may be due to the fact that capital budgeting is considered to be a 'solved' and therefore not a very live issue, whereas capital structure continues to be an unsolved puzzle. At the level of practice, the management levels at which the two decisions are made are entirely differentcapital structure, dividend policy, etc. belong to the rarefied world of Chief Executive Officers and Chief Financial Officers, whereas capital budgeting is for/the analysts in the controller's or treasurer's office. Since the early 70s, there have been tremendous advances in our understanding of capital structure theory which has, to some extent, influenced the way capital structure decisions are actually being made today by the managers. In this paper, we point out that these advances in capital structure theory have implications for managers engaged in taking capital budgeting decisions as well. In fact, we propose a two-step solution to the overall capital structure cum capital budgeting problem which explicitly dovetails with the fact mat the two kinds of decisions are made at different levels in the organization.

Recent advances in our understanding of capital structure decisions have not yet made their mark upon our capital budgeting techniques and practices. This paper by Korwar and Raghunathan attempts to bridge this gap. In doing this, it offers a simple approach for managers taking financial decisions.

Ashok Korwar and V Raghunathan are both members of the faculty in the Business Policy Area and Finance and Accounting Area respectively of the Indian Institute of Management, Ahmedabad.

Weighted Average Cost of Capital

Underlying the valuation framework in the theory of finance is the fundamental concept of the weighted average cost of capital (WACC). WACC, as the phrase implies, is simply the weighted average of the specific costs of various sources of finances, the weights being the proportion of each source of capital in the total capital. In general, the weights are computed using market values.

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Illustration 1 Let us consider a firm with only debentures and equity in its capital, valued at 100 in the market, of which the value of debentures and equity is 60 and 40 respectively. Let its pre-tax cash earnings be 28.98 per annum in perpetuity. Further, let us assume that the market capitalization rate for its debt and equity are 18% and 25% respectively. By market capitalization rate, we mean the rate of return which the investors expect on their investments in the form of debt or equity. Let the marginal tax rate be 45%. Given these parameters, WACC may be specified in one of the two following ways: Alternative 1 (WACC of K0 Type): Ko = 0.4 x 25 + 0.6 x 18 = 20.8%, and Alternative 2 (WACC of K0' Type): Ko' = 0.4 x 25 + 0.6 x 18 x (1 - 0.45) = 15.94%. It can be seen that K0' (Alternative 2) differs from Ko (Alternative 1) in that the former captures the cost of debt on a post-tax basis to reflect the fact that interest is tax deductible to the firm. How can both these alternatives be acceptable as the WACC? How can the cost of capital be 20.8% as well as 15.94% for the same firm? It so happens that cost of capital is not defined uniquely. What you call as the cost of capital depends on what cashflows you will discount with it, for valuing your firm or one of its projects. Valuation of the Firm or a Project Let us assume that we wish to determine the value of the firm in illustration 1. We may do so by either of the following two alternatives: When Ko (20.8%) is used as the discount rate The interest bill for the firm = 60 x 0.18 = 10.8 Now, the cashflows to be discounted will be given by: Aftertax operating cashflows + tax shield on debt = 28.98 x (1 - 0.45) + 10. 8 x 0.45 = 20.8 Capitalizing the cashflow of 20.8 in perpetuity at the rate of 20.8% yields a value of 100 for the firm. When Ko' (15.94%) is used as the discount rate The cashflows to be discounted will be given by: After-tax operating cashflows = 28.98 x (1 - 0.45) = 15.94 Capitalizing the cashflow of 15.94 in perpetuity at the rate of 15.94% also yields a value of 100 for the firm. 4

At the project level, the WACC is used to discount the future cashflows of a projectthe initial investment is then subtracted from the value of future cashflows to arrive at a Net Present Value (NPV) for the project. If the NPV exceeds 0, the project is said to be a good one, since it adds value to the firm. Thus, in general, in order to arrive at the value of a firm or a project, the future cashflows of the firm or the project have to be discounted at the WACC. When K0 is used for discounting, the firm's cashflows must include the tax shield on interest. On the other hand, when Ko' is used for discounting, tax shield on interest is excluded from the cashflows, since the discount rate already accounts for the same. The general specifications for the discount rates and the associated cashflows are given in Box 1. Box 1: The Weighted Average Cost of Capital (WACC)
When WACC is used as the discount rate, one is faced with two alternative choices. One may capture the tax shield on interest rate either in the discount rate or in the cashflows. The alternative pairs of cashflow and discount rate specifications are (see Modigliani and Miller (1963), Nantell and-Carlson (1975), Raghunathan and Srinivasan (1987), etc.): Alternative 1:

Vm x&tRt
Ko where:

... (1)

V is the value of the firm, X are the operating cashflows of the firm,t is the marginal corporate tax rate, r is the interest rate on debt, R is the interest bill on debt and Ko is the cost of capital (WACC), which is specified by the expression:
K

" = I^^E+r^E

.......<2>

where: Ke is the cost of equity, E is the market value of equity, and D is the market value of debt. It may also be noted that R = rD. Two points are worth noting here: the tax shield from debt is captured in the cashflows (numerator of Eq 1); and not in the discount rate or the WACC (denominator of Eq 1), which has the cost of debt incorporated at r, and not r(l-f). In other words, the discount rate used is not the 'after-tax cost of debt' but the 'cost of debt/ plain and simple. Note also that the entire cashflow, including the tax shield on debt is discounted at the WACC. Contd.

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will have to worry about without contaminating the concept of the lender's expectation of return. Conceptually, the tax shield arising from debt is a cash saving and should be reflected as such in the cashflows by the manager, and not in the discount rate as some kind of adjustment to the expectation of the investor, which is what the cost of capital is. The simplest and most intuitively direct way to think about cost of capital is to think of it as the rate of return demanded by the investor this is simply 18% for debt in our example above.
In other words, if the cashflow incidence of debt is ignored, the value of the firm can be arrived at by discounting the operating cashflows at the WACC given by (3). Note: Theoretically, according to Nantell and Carlson (1975), it is possible to say that the two specifications are equivalent. However, as Raghunathan and Srinivasan (1987) point out, in practice they yield different NPVs for non zero NPV projects because the non zero NPV of the marginal project changes the implied assumption of the target debt to equity ratio. In other words, the resulting debt to equity ratio of the firm following the acceptance of the project with a non zero NPV is no longer the debt to equity assumed in the computation of the WACC. If, however, a project is financed such that the resulting debt to equity ratio of the firm is the same as the ratio assumed in the WACC, then this problem disappears. However, this problem is more theoretical than real. The more practical (and interesting) differences between these alternative specifications lie elsewhere, as explained in the text of the paper. In this paper, we argue that the specifications in (1) and (2) are to be preferred to those in (3) and (4).

The concept of cost of capital should logically be derived directly from demands made by those external agents who supply finance to the firm: the cost of debt and the cost of equity are best thought of as being independently determined by the marketplace. The investor who supplies debt capital, for instance, has a rate of return he demands as compensation for his capital this should directly be specified as the cost of debt. In other words, we argue that Figure 1 is the correct way to think about costs of capital.

Theoretically, under certain conditions, it is possible to say that the two specifications are equivalent (see Box 1). However, we would recommend the use of Ko with concomitant cashflows (as given by Equations 1 and 2 in Box 1) rather than K0'. There are a number of reasons for this. For one, in order to prove that the two specifications are equivalent, it is necessary to define WACC as that cost of capital which would yield a value of the firm equal to the market value (Nantell and Carlson, 1975). While this is algebraically correct, we consider this an odd and roundabout way of thinking about cost of capital. Figure 1 describes the essence of our argument. We argue here that the notion of an 'after-tax cost of debt' is intuitively unappealing. This is because, if the cost of debt to the firm is1 the return which the lender to the firm expects on his lending, his expected return of interest does not halve merely because the firm has a tax rate of 50%. The tax rate of the firm is a problem which the firm
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At the same time, we believe that even when K0 is used for discounting the associated cashflows of the firm, merely including the tax shield of debt in the cashflows is not enough. Since debt is subsidized by the state through a tax shield, the optimal capital structure point would be achieved at some point where debt is extremely high. Indeed, only the existence of bankruptcy costs could yield optimal debt levels below 100%. Even if bankruptcy costs are significant, should they not be included explicitly in the cashflows? (The usual reason they are not included explicitly is because they are so small!) Miller (1977) derides the traditional concept of balance between the tax advantages of debt and costs associated with bankruptcy as a 'horse and rabbit stew one horse and one rabbit.' 5

In order to understand why firms might rationally take on much less than 100% debt, it is necessary to digress to a brief review of recent advances in the theory of optimal capital structure.

Determinants of Corporate Borrowing

Broadly, the models which attempt to explain what prevents a firm from taking on excessive debt fall into two general categories. For the purposes of this paper, we typify them by referring to the works of DeAngelo and Masulis (1980) and Myers (1977,1984). The first set of models, which we shall refer to as the DM approach, short for DeAngelo and Masulis, hinges on the argument that debt tax shields are not the only tax shields available to the firm. Other tax shields such as investment tax credits, depreciation, and so on, are also available. In this class of models, the firm strives to approach the point where the expected value of an additional unit of debt is balanced by the expected incremental cost of having to waste a unit of unused tax shield. The incremental cost of wasting a unit of tax shield arises from the fact that to the investor in the market, the personal tax rate on debt earnings is generally higher than on earnings from equity. If the firm faces a significant probability of not being able to use the additional unit of tax shield from an additional unit of debt, it faces a significant probability of not being able to compensate the investor for holding its debt, in which case the return demanded by the investor will be too high for the company to pay. Thus, the optimal capital structure point obtains when: Expected value of incremental debt tax shield = Expected cost of foregone tax shield. In practice, of course, these values and costs are not easy to work out, but the principles of decision making in this regard should revolve around these considerations. The second class of models, which we shall refer to as the Myers class, in honour of Myers, argues that there are real costs to taking*on debt in that the levered firm will make suboptimal investment decisions in future because of the debt burden it has to carry. This argument hinges on the notion that any investment by a firm is often merely a purchase of an option on future investments, where the ultimate payoffs are not only distant but also highly uncertain. This might especially be the case with R&D intensive firms, for instance. When the time comes to exercise the option, it may be that exerting it will result in a cashflow which is less 6

than the promised payment to debtholders, thereby leaving nothing for the shareholders. In other words, even though the project may have a positive NPV, the initial cashflows may continue to be very small or even negative if the project is heavily debt financed, which may become a source of anxiety to the shareholders. In such a case, the firm's management, which has the interests of shareholders closest to its heart, may let even a positive NPV option go unused. Thus, the presence of debt imposes costs on the firm by reducing the value of its investment options in the future. Consequently, rational investors will constrain the firm to go in for lower debt levels. The optimal capital structure point then may be written as the point where:

Expected value of incremental debt tax shield = Expected value of investment option passed up. In both the above formulations, an optimal capital structure at debt less than 100% would arise.

Completing the WACC Specification

We believe that the usual specification of cashflows associated with WACC of K0 type is incomplete because it leaves out all the negative values of debt, as described in the preceding section (see Box 2 for a generalized specification).
Box 2: A Complete Specification for WACC
A complete formulation to replace Eq 1 in Box 1 would be: V = X(1-t) + Rt Expected loss from debt Ko (5)

where the expected loss from debt would include items such as the cost of providing debtholders with a return r which does not bring the firm any further tax shield (as in the DM approach), and the cost of passing up investment options (the Myers approach). The optimal capital structure point would be given by: D/(D+E) such that the value of the incremental tax shield from the next unit of debt equals the value of the loss from an additional unit of debt.

The important point to note here is that the approach embodied in the WACC of the Ko type allows scope for applying such corrections, since the cashflows to be discounted would include all the cashflows to the firm from all possible sources and influences. On the other hand, the approach embodied in the WACC of the Ko' type does not allow for such adjustments. There are some more adjustments to cashflows one has to be concerned about.
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Further Adjustments to Cashflows Equally important, especially in the Indian context, are a number of other cashflow considerations associated with debt and equity. Again, the WACC of K0 type proves to be superior. The first specification enables a manager to intro duce the marginal tax shield on interest in the specific period in which the tax shield is expected to be absorbed. The second specification, on the other hand, imposes the rigid assumption that the firm's profitability in each period will be adequate to absorb the firm's marginal interest tax shield applicable to that period. Since the first scenario is more general, the first specification is preferable. The tax outflows in the initial years of a project may be nil or low due to the heavy capital allowances or tax holidays, which may affect the marginal cor porate tax outflows significantly, especially if the project is large. In such cases, the project cashflows are best discounted by K0 rather than K0'. In general, particularly in India, the coupon rate of interest on public debt differs from its Yield to Maturity (YTM), which is the required rate of return of the debtholders. This is mainly because either the company might not have matched the expectations of the debenture holders to begin with or because the interest rates in the economy might have changed for various reasons. Consider a situa tion where the coupon rate of interest for a deben ture issued with a par value of 100 is 15%, while its yield to maturity or the required rate of return of the debenture holders is 18%. This may explain why such a debenture will be quoted at a discount at, say, 83> so that an interest stream of 15 on this debenture valued at 83 yields a return of about 18%. WACC of Ko type allows the flexibility of incor porating in the cashflows the tax shield on interest on the basis of the coupon rate of interest of 15%, while allowing the use of the YTM at 18% as the discount rate, since the YTM is the capitalization rate used by the debenture holders. Since, in general, the two are different, using a single rate for discounting as well as for tax purposes is bound to introduce some inaccuracies. WACC of Ko' type does not allow the flexibility of recognizing this difference. If the cost in the WACC is specified as the coupon rate of 15%, the market's expectation of return on the debt at 18% is ignored and the value of debt is overstated. If the cost in the WACC is specified as 18%, it implies absorption of tax shield on 18%. This ignores the fact that the tax shield is actually available only on the 15% interest,, and thus

discounting at 18% overstates the tax shield on interest and hence the value of debt. Further, the traditional approach to project evalua tion and shareholders' value analysis skirts the issue of loss in current shareholders' value when a public issue of equity is made below the market value. This aspect is particularly relevant in the Indian context, notwithstanding the current free pricing climate. Many recent issues were found to have been priced at levels higher than the market prices prevailing at the time of the issue (probably through price drops subsequent to the decision of issue pricing), and understandably they were not subscribed fully. In due course, we expect that the firms would revert to pricing the issues below market to ensure their subscription. This form of marketing discount is commonly employed in the US as well. We do not address the problem of pricing of rights issues, since the shareholders' wealth, at least theoretically, is independent of the issue price of the issue, so long as the issue price is below the market price. The loss in current shareholders' wealth when a public issue is made by a firm below market price may be illustrated as follows: Let the current market price per share = 100 Current number of shares outstanding = 30 Let us assume that the amount to be raised for financing a new project is 600, and the NPV of the project is 100. Let issue price per share Number of shares that ought to have been issued Number of shares actually issued Ex-issue price = 60 = 600/100 = 6 = 600/60 = 10 = (30 x 100 + 600)/40 = 90

Loss in wealth per share held for the current shareholder = 100 - 90 = 10 Total loss in current shareholders' value = 30 x 10 = 300 From the point of view of existing shareholders, this amount must be deducted from their proportion of the NPV of the project, being the loss in the shareholders' value as a consequence of the firm deciding to issue a share worth 100 at 60. Given an NPV of 100, the number of shares with the existing shareholders 30 and the number of shares with the new shareholders 10, the existing shareholders' share of the
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NPV will be 75 (being 100 x 3/4). Since the loss in the existing shareholders' value is 300, the net value to them of undertaking the new project is -225 (being 75 - 300). The net value of undertaking the new project to the new shareholders is 325 (being 25 + 300). The above are fundamentally cashflow adjustments. They cannot be reduced to equivalent discount rate adjustments. Because WACC of the K0 type works through adjustments to the cashflows rather than adjustments to the discount rate, we consider it superior for all practical purposes.

about leases, although there appears to be a general consensus that a lease contract is very similar to a debt contract and therefore should be discounted at the aftertax cost of debt. Table 1 details the cashflows from a debt contract and the NPV of its flows, both on a before-tax and an after-tax basis. The table shows that, if the before-tax cashflows of debt are discounted at the before-tax interest rate, the NPV of the debt cashflows is 0 hardly a surprising result, considering that was how the annuity payments were worked out in the first place. Similarly, when the after-tax cashflows of the debt contract are discounted at the 'after-tax interest rate on debt/ the NPV of the cashflows is again found to be 0. The 'after-tax rate on debt' is defined as r (1-f), where r is the interest rate on the debt, 10% in our numerical example, t is the marginal corporate tax rate, 60% in our numerical example. Thus, in our numerical example, r(l-f) works out to 4%. The mantra which is often invoked to explain this result is: 'Discount before-tax flows at a before-tax rate and after-tax flows at an after-tax rate.' Applying this result to project evaluation, it is usually argued that, since debt has a zero NPV anyway,

Valuation of Debt and Lease Cashflows

We now turn to two specific issues of some importance to theorists and practitioners alike: at what rate should we discount the cashflows from debt and from leases? So far as debt is concerned, the standard answer in finance theory [for instance, Brealey and Myers (1981)] is that after-tax cashflows of debt should be discounted at the after-tax interest rate on the debtand some similar basis should be employed for discounting leases. Generally, one then proceeds to say that debt being a financing decision, it should be left out of the project evaluation per se and taken to have an NPV of zero. Curiously, the same argument is not always made

we can afford to ignore it and proceed to do our project evaluation as if it did not exist at all (notice that the same argument cannot be made for the lease contract because generally the NPV of a lease works out to be something other than 0). One may also question how it can be said that the NPV of debt is always 0. Taking NPV of debt to mean the marginal contribution of the debt to the value of the firm, surely NPV of debt is 0 only if adroit financial management on the part of the firm's managers has brought the firm to the optimal capital structure point by managing all the costs and benefits we have described in the section on corporate borrowings above. Facile calculations such as in Table 1 and the invocation of mantras like 'discount after-tax cashflows at after-tax rates' cannot justify ignoring the net value of debt. In the following paragraphs, we outline our recommended approach for treating debt, based upon the arguments we have advanced thus far in this paper.

we agree with the traditional approach insofar as the project-level decision is concerned, it is for a different reason. Leasing: We shall restrict our comments here to financial leases as opposed to short-term, cancelable, operating leases. Financial leases are, it may be noted, the more common of leases in India. It is generally argued that a lease contract is like a debt contract and, hence, it should be treated just like debt. The standard argument goes on to say that since a lease is like debt, cashflows associated with it should be discounted at the 'after-tax debt rate/ i.e., at r (1-t) (for example, Mitchell, 1970, Johnson and Lewellen, 1972, Wyman, 1973, etc.). A subtle distinction is often made between the discount rate to be employed in making the incremental lease versus buy decision (the after-tax debt rate is generally employed here) and the rate to be used in projects (the WACC). In this paper, however, we propose an alternative approach which does not call for use of the after-tax debt rate because we propose to avoid the lease versus buy incremental decision altogether. There are other views, however, in the literature, where the use of the after-tax debt rate has been questioned. Raghunathan (1984,1987), for instance, argues that in many respects a lease is like an operating cost rather than like debt; so it should be discounted at WACC. Based on our analysis so far, we answer this question here at two distinct levels: at one level, we recommend that, since K0 type discounting represents the correct valuation approach, the only candidate for lease discount rate is the WACCin fact, the only candidate for discounting any cashflow at all is the WACC. This is because, our WACC specification (the modified version represented by Equation 5 in Box 2) applies equally to all cashflows not excluding debt or lease flows. Having said that, we proceed to note that a lease is indeed like debt in the following important dimensions: Its outflows are fixed over time. It is an obligation to be met by the corporation as a whole whether or not the project does well, i.e., the repayment obligation is not tied to any particular project in any way. It provides tax shields just like debt.

Deciding on Debt and Lease Levels

Debt: One clear implication from the theories of optimal capital structure described in the section on corporate borrowings is that the value of debt depends very much upon the debt level of the corporation as a wholeat the project level, it is impossible to specify what the value of debt is. Interestingly enough, this theoretical finding is in consonance with the practical reality we have noted in the first section itselfthat capital structure decisions tend to be made at a very high level in the organization, whereas capital budgeting decisions tend to be made lower down. We suggest that the ideal way to deal with debt is as follows: leave it out of the cashflows of the project financed with the debt (in this we agree with the traditional approach), and value it depending upon the balance of costs and benefits of additional debt at the corporate level. We must point out that this argument is not identical with the standard call to 'separate investment decisions from financing decisions.' The reasons for leaving out the debt cashflows at the project level are twofold: one, the debt is an obligation of the firm as a whole to outsiders who will expect to be paid whether the project does well or not; and two, the value of debt cannot be calculated at the project level at all because the costs and benefits can only be figured out at the corporate level, with due regard to all the investments and tax shields of the firm and all the considerations we have described in the previous section. Thus, although
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However, as Raghunathan (1984) points out, characteristics 1 and 3 above are not peculiar to lease alone 9

several operating cashflows have similar properties. There are, however, other similarities to debt. The risk of interest rate changes affects the lease and debt decisions alike, so that the duration management of assets and liabilities of both poses more or less identical problems. Also, the optimal lease point for a firm depends upon factors exactly like those discussed in the section on corporate borrowings in the case of debt. Owing to its close resemblance to debt, there may be considerable interaction between the debt and lease decisions since one displaces the other. Thus, we argue that, conceptually, optimal capital structure at the corporate level not only involves setting the target debt:equity ratio, but setting the target debt:lease:equity ratio. The most important point we would like to make here is that the optimal amount of leasing can only be calculated by reference to the corporation as a whole. Indeed, the decision whether to lease or to buy an asset is a decision best made at the corporate level, not at the project level. Even if the firm has no new projects at all, it ought to keep evaluating whether it ought to convert some purchased assets into leased assets, just as it should constantly keep evaluating whether to adjust its debt/equity ratio. In practice, what does this all mean? How should a firm evaluate a debt contract or a lease contract? Ideally, one may calculate the value of the incremental tax shield from the debt or lease to the firm as a whole, and attempt to balance this benefit against the costs of taking on such contracts (as described earlier). This can be done only at the corporate level; not at the project level. The point at which these incremental costs and benefits are equal is the point up to which debt and lease should be taken on. Any discounting which needs to be done to weigh the costs and the benefits should be done at WACC. How does this procedure differ from the conventional approach? In the conventional approach, acquisition of each asset will involve a "lease or purchase" decision. However, we suggest that once the optimal debt and lease levels have been fixed for the firm, how a specific asset is acquired is immaterial. The expected loss from a unit of debt or lease may not be always easy to compute precisely. Until such precise computations can be reliably made, the computations will have to be complemented by the managers' business judgement. What we have pointed out in this paper is that there are myriad complications
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which must be considered in determining the optimal debt or lease level, and indeed this is a decision which can only be made at the very highest levels in the corporation's finance function. Once the optimal debt level is fixed, how is the practising manager to decide whether the price at which a given debt or lease contract is being offered is correct? He should attempt to determine the 'correct' rate for his company, given the risk level of the firm, and accept the debt or lease contract if the rate is better or equal to that 'correct' rate. One could use debt ratings and look at comparable debt instruments, for instance, to estimate the risk of one's debt. Thus, in bur view, determining the optimal capital structure point, that is, how much debt and lease to have on the firm's source mix, is the more significant decisionto be taken at the highest level. Shopping around for the 'correct' or best' rate on debt or lease is the routine treasury function. Needless to say, managers will have to keep in mind even at the first stage a 'ballpark' estimate of the rates which the firm may be reasonably called upon to pay on various forms of financing.

Separating the Decisions

Raghunathan (1984) points out that simply because a lease affects the optimal capital structure of the firm, that is not enough to classify it as a financing decision. According to him, there are several investment decisions which have the same effect. In agreeing with this view, we do believe we have made a case here for a different kind of distinction. The usual practice is to classify decisions as investment decisions or financing decisions and then attempt to keep them separate on the assumption that they do not affect each other. This assumption, we hold, is not valid, as 'financing' decisions like borrowing depend crucially upon tax shields from investment decisions (as in the DM approach). Again, debt levels can distort investment decisions (as in the Myers approach). We propose instead to distinguish between corporate-level decisions and project-level decisions. We could think of these as 'overhead' decisions and 'project' decisions. Corporate-level or 'overhead' decisions would include decisions about debt levels and lease levels, because they are to be made without reference to specific projects. As the firm's overall portfolio of projects changes, as its horizon of future investment options changes, it should adjust its debt
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level, lease level and WACC continuously. The decision to take on further debt or lease can then be made. At this point, it is pointless to 'evaluate' individual debt or lease contracts except in relation to each other or to other competing debt or lease opportunities. Project-level decisions include conventional capital budgeting decisions: these should be made without reference to specific financing arrangements of the project. Indeed, firms should eliminate the practice of making lease/borrow decisions asset by asset, and focus instead on balancing a corporate portfolio of leasing and borrowing. The crucial factor driving the lease or buy decision is probably the risk of technological obsolescence of equipment, rather than purely financing considerations. Such risks are best managed using a portfolio approach similar to the ones used by investment managers for financial assets. One of the authors has instituted such a system in an organization the risk of obsolescence of a particular kind of equipment the firm used rather heavily was managed by judiciously changing the mix of leased and purchased equipment on a monthly basis. For example, if in a given month, debt to lease proportion exceeded a given target, the excess was corrected in the forthcoming month by taking on more lease than debt. Thus, there was no project-level lease/purchase decision made at allthis was a corporate-level decision only. The project manager was charged a fixed rate for using an asset, regardless of how the asset was financed. There should be no assumption that project-level decisions cannot affect corporate-level decisionsif the project is big enough, it certainly will, if it changes the overall project portfolio of the firm significantly. This is

what makes the optimal capital structure point a moving target. Such a view appears difficult to deal with in practice, but it corresponds with the realities faced by managers in a dynamic world.
References
Brealey, R and Myers, S (1981). Principles of Corporate Finance. New York: McGraw-Hill. DeAngelo, H and Masulis, R (1980). "Optimal Capital Structure under Corporate and Personal Taxation," Journal of Financial Economics, March. Johnson, R W and Lewellen, W G (1972). "Analysis of the Buy or Lease Decision," Journal of Finance, September. Miller, M (1977). "Debt and Taxes," Journal of Finance, May. Mitchell, G B (1970). "After Tax Cost of Leasing," Accounting Review, April. Modigliani, F and Miller, M H (1963). "Corporate Income Taxes and the Cost of Capital: A Correction," American Economic Review, No 53. Myers, S (1977). "Determinants of Corporate Borrowing," Journal of Financial Economics. __________ (1984). "The Capital Structure Puzzle," The Journal of Finance, July. Nantell, T and Carlson, C (1975). "The Cost of Capital as Weighted Average," Journal of Finance, December. Raghunathan, V (1984). Lease Evaluation - Yet Again. IIMA Working Paper No 535. __________ (1987). "Better Evaluation of a Lease," Vikalpa, April-June. -------------- and Srinivasan, G (1987). Target Debt Main tenance under Alternative NPV Specifications and Im plications for Investment and Financing Decisions, IIMA Working Paper No 669. Wyman H E (1973). "Financial Lease Evaluation under Conditions of Uncertainty," Accounting Review, July.

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