PRINCIPLES OF

MANAGERIAL
FINANCE
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Risk and Return Fundamentals
 In most important business decisions there are two key financial considerations: risk

and return.
 Each financial decision presents certain risk and return characteristics, and the
combination of these characteristics can increase or decrease a firm’s share price.
 Analysts use different methods to quantify risk depending on whether they are
looking at a single asset or a portfolio—a collection, or group of assets.

What is Risk?
Risk is a measure of the uncertainty surrounding the return that an investment
will earn or, more formally, the variability of returns associated with a
given asset.
 Investments whose returns are more uncertain are generally riskier.
What is Return?
Return is the total gain or loss experienced on an investment over a given
period of time; calculated by dividing the asset’s cash distributions during the
period, plus change in value, by its beginning-of-period investment value
The expression for calculating the total rate of return earned on any asset over period
t, rt , is commonly defined as

where rt = actual, expected, or required rate of return during period t

Ct = cash (flow) received from the asset investment in the time period t – 1 to t
(du)
Pt = price (value) of asset at time t (end)
Pt – = price (value) of asset at time t – 1
n = Time in years

Expected Return
 The return that an asset is expected to generate in the future, composed of
a risk-free rate plus a risk premium.
 Historical returns that are actually earned also called realized returns
 Riskier investments tend to produce higher returns.
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 Three types of investments: treasury bills, bonds, and common stocks
 Bills matures 1 year or less while bonds matures up to 30 years.
Risk preferences
Economists use three categories to describe how investors respond to risk.
 Risk-seeking is the attitude toward risk in which investors prefer investments
with greater risk even if they have lower expected returns. The realm of
gambling.
 Risk-neutral is the attitude toward risk in which investors choose the
investment with the higher return regardless of its risk.
 Risk averse is the attitude toward risk in which investors would require an
increased return as compensation for an increase in risk. They prefer less risk
and most common among financial managers.

Risk of a Single Asset : Risk Assesment

The notion that risk is somehow connected to uncertainty is intuitive. The more
uncertain you are about how an investment will perform, the riskier that
investment seems.
Scenario analysis is an approach for assessing risk that uses several possible
alternative outcomes (scenarios) to obtain a sense of the variability among returns.
 One common method involves considering pessimistic (worst), most likely
(expected), and optimistic (best) outcomes and the returns associated with them
for a given asset.
Range is a measure of an asset’s risk, which is found by the difference by subtracting
the return associated with the pessimistic (worst) outcome from the return
associated with the optimistic (best) outcome.
Probability is the chance that a given outcome will occur.
 A probability distribution is a model that relates probabilities to the
associated outcomes. Provide a more quantitative insight into an asset’s risk.
 100% is certain to occur and zero will never occur.
 A bar chart is the simplest type of probability distribution; shows only a
limited number of outcomes and associated probabilities for a given event.

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 A continuous probability distribution is a probability distribution showing
all the possible outcomes and associated probabilities for a given event. Large
number of outcomes.

Risk of a Single Asset : Risk Measurement

Standard deviation () is the most common statistical indicator of an asset’s risk; it
measures the dispersion around the expected value.
Expected value of a return (r) is the average return that an investment is expected to
produce over time.

If we all know the different returns that an investment might generate, the formula
would be:

where
rj = return for the jth outcome
Prt = probability of occurrence of the j th outcome
n = number of outcomes considered

If we don’t know every possible outcome, the formula would be:

where
rj = return for the jth outcome
Prt = probability of occurrence of the j th outcome
n = number of historical returns

Risk of a Single Asset : Standard Deviation

When outcomes and probabilities are known, the expression for the standard
deviation of returns,r , is

When outcomes and probabilities are unknown, the expression for the standard
deviation of returns,r , is

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 In general, the higher the standard deviation, the greater the risk.
 investments with higher returns have higher standard deviationns.

All Stocks Are Not Created Equal

 Stocks are riskier than bonds, but are some stocks riskier than others?
 A recent study examined the historical returns of large stocks and small stocks
and found that the average annual return on large stocks from 1926-2009 was
11.8%, while small stocks earned 16.7% per year on average.
 The higher returns on small stocks came with a cost, however.
 The standard deviation of small stock returns was a whopping 32.8%, whereas
the standard deviation on large stocks was just 20.5%

Normal Probability Distribution

 A symmetrical probability distribution whose shape resembles a “bell-
shaped”curve.

 A symmetry of the curve is the half the probability is associate

with thhe values to the left of the peak and half with the values to the
right.
 68% of possible outcomes will lie between +-1 standard deviation
from the expected return, 95% will lie between +-2 standard
deviations, and 99.7% will lie between +-3 standard deviations.
Coefficient of Variation: Trading Off Risk and Return
 Coefficient of variation, CV, is a measure of relative dispersion that is useful in
comparing the risks of assets with differing expected returns. It is for making
risk.
The equation for the coefficient of variation is

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 A higher coefficient of variation means that an investment has more volatility
relative to its expected return because investors prefer higher returns and less
risk.

Porfolio Risk and Return

• An investment portfolio is any collection or combination of financial assets.
• If we assume all investors are rational and therefore risk averse, that investor
will ALWAYS choose to invest in portfolios rather than in single assets.
 Investors will hold portfolios because he or she will diversify away a
portion of the risk that is inherent in “putting all your eggs in one
basket.”
Risk of a Portfolio
 In real-world situations, the risk of any single investment would not be viewed
independently of other assets.
 New investments must be considered in light of their impact on the risk and
return of an investor’ s portfolio of assets.
 The financial manager’s goal is to create an efficient portfolio, a portfolio that
maximum return for a given level of risk.

Portolio Return and Standard Deviation

The return on a portfolio is a weighted average of the returns on the individual
assets from which it is formed.

where
wj = proportion of the portfolio’s total dollar value represented by asset j
rj = return on asset j

Risk of a Portfolio : Correlation

Correlation is a statistical measure of the relationship between any two series of
numbers.
 Positively correlated describes two series that move in the same direction.
 Negatively correlated describes two series that move in opposite directions.

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The correlation coefficient is a measure of the degree of correlation between two
series.
 Perfectly positively correlated describes two positively correlated series that
have a correlation coefficient of +1.
 Perfectly negatively correlated describes two negatively correlated series that
have a correlation coefficient of –1.

Risk of a Portfolio : Diversification

 To reduce overall risk, it is best to diversify by combining, or adding to the
portfolio, assets that have the lowest possible correlation.
 Combining assets that have a low correlation with each other can reduce the
overall variability of a portfolio’ s returns.
 Uncorrelated describes two series that lack any interaction and therefore have
a correlation coefficient close to zero
 Combining uncorrelated assets can reduce risk, not as effectively as combining
negatively correlated assets but more effectively than combining positively
correlated assets
 The correlation coefficient for uncorrelated assets is zero and acts as the
midpoint between perfectly positive and perfectly negative correlation.
 If two assets with perfectly positively correlated returns are combined, it
results in overall portfolio risk at minimum equal less risky and maximum
equals most risky
 If two assets with less than perfectly positive correlation are combined, it can
reduce total risk.

Risk of a Portfolio : International Diversification

 The inclusion of assets from countries with business cycles that are not highly
correlated with the U.S. business cycle reduces the portfolio’s responsiveness
to market movements.
 Over long periods, internationally diversified portfolios tend to perform better
(meaning that they earn higher returns relative to the risks taken) than purely
domestic portfolios.

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 However, over shorter periods such as a year or two, internationally diversified
portfolios may perform better or worse than domestic portfolios. Currency risk
and political risk are unique to international investing.

Political Risk
 Risk that arises from the possibility that a host government will take actions
harmful to foreign investors or that political turmoil will endanger investments
 Particularly acute in developing countries where motivated governments may
attempt to block return of profits by foreign investors or even seize
(nationalize) their assets in the host country

Risk and Return : The Capital Asset Pricing Model (CAPM)

 The capital asset pricing model (CAPM) is the basic theory that links
nondiversifiable risk and return for all assets.
 The CAPM quantifies the relationship between risk and return.
 In other words, it measures how much additional return an investor should
expect from taking a little extra risk
 It is used to understand the basic risk-return trradeoffs involved in all types of
financial decisions.
 It is developed to explain the behavior of security prices and provide a
mechanism where investors could assess the impact of a proposed security
investment.

Risk and Return : The CAPM

Types of Risk
 Total risk is the combination of a security’s nondiversifiable risk and
diversifiable risk.
Total risk = systematic + unsystematic
= market risk + company specific
= non-diversifiable + diversifiable
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Causes interest rates strikes
inflation lawsuits

Impact on risk from interaction of assets A and B

 Diversifiable risk is the portion of an asset’s risk that is attributable to firm-
specific, random causes; can be eliminated through diversification. Also called
unsystematic risk.
 it is attributable to firm-specific events, such as strikes, lawsuits,
regulatory actions, or the loss of key accounts.
 Nondiversifiable risk is the relevant portion of an asset’s risk attributable to
market factors that affect all firms; cannot be eliminated through
diversification. Also called systematic risk.
 Factors such as war, inflation, the overall state of the economy,
international incidents, and political events account for
nondiversifiable risk.
 Because any investor can create a portfolio of assets that will eliminate
virtually all diversifiable risk, the only relevant risk is nondiversifiable risk

Risk and Return : The CAPM

 The beta coefficient (b) is a relative measure of nondiversifiable risk. An
index of the degree of movement of an asset’s return in response to a change in
the market return.
 An asset’s historical returns are used in finding the asset’s beta
coefficient.
 The beta coefficient for the entire market equals 1.0. All other betas
are viewed in relation to this value.
 The market return is the return on the market portfolio of all traded securities
 The beta of a portfolio can be estimated by using the betas of the individual
assets it includes.
 Letting wj represent the proportion of the portfolio’s total dollar value
represented by asset j, and letting bj equal the beta of asset j, we can use the
following equation to find the portfolio beta, bp :
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 The required return for all assets is composed of two parts: the risk-free rate
and a risk premium.
 The risk-free rate (RF ) is usually estimated from the return on 3-month US T-
bills or T-bonds
 US T-Bills are short term IOUs issued by the US treasury; considered
the risk free asset
 The risk premium is a function of both market conditions and the asset itself
 Using the beta coefficient to measure nondiversifiable risk, the capital asset
pricing model (CAPM) is given in the following equation:

where : rt = required return on asset j

RF = risk-free rate of return, measured by the return on a U.S. Treasury bill
bj = beta coefficient or index of nondiversifiable risk for asset j
rm = market return; return on the market portfolio of assets
 The (rm-rf) portion of the risk is called market risk premium because it
represens the premium that the investor must receive.
 The CAPM relies on historical data which means the betas may or may not
actually reflect the future variability of returns.
 Therefore, the required returns specified by the model should be used only as
rough approximations.
 The CAPM assumes markets are efficient.
 Although the perfect world of efficient markets appears to be unrealistic,
studies have provided support for the existence of the expectational
relationship described by the CAPM in active markets such as the NYSE.
Security Market Line (SML)
 The depiction of the capital asset pricing model (CAPM) as a graph that reflects
the required return in the marketpplace for each level of nondiversifiable risk (beta)
 The position of the slope are affected by two major forces: inflationary expectations
and risk aversion
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 changes in inflationary expectations affect the risk free rate of return. It will
result in a parallel shifts. The equation is:
Rf=r*+i
Where: r* = constant real rate of interest
I = inflation premium
 changes in risk aversion can have a steeper SML. It can result from
changing preferences of investors. Examples are stock market crash,
assassination of a key political leader, and outbreak of war.
 To summarize, greater risk aversion results in higher required returns
for each level of risk. Similarly, a reduction in risk aversion causes the
required return for each level of risk to decline.
 Analysts used historiical data to estimate a stock’s beta. The estimated data may or
may not indicate the future variability of returns.

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Chapter 6 : Interest Rates and Bond Valuation
Interest Rates and Required Returns
Interest rate – debt instruments (bank loans or bonds); the compensation paid by the borrower
of funds to the lender; from the borrower’s point of view, the cost of borrowing funds.
Required return – applied to equity instruments ex: common stock; the cost of funds obtained
by selling on ownership interest.
When demand is low and supply is high, Interest rate is low and vice versa.
Factors affecting interest/ equilibrium rate:
Inflation – A rising trend in the prices of most goods and services.
Deflation - a general trend of falling prices
Risk – investment is risker, they will expect a higher return. They prefer short term more liquid
Liquidity preference – investors to prefer short-terms securities. Treasury bills will be lower
than rates on longer-term securities.
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Real rate of interest –suppliers and demanders of funds have no liquidity preferences and there
is no risk. Increase in purchasing power
Nominal or Actual rate of interest (Return) – The actual rate of interest charged by the
supplier of funds paid by the demander. Qouted at financial institutions
Relationship between nominal, real rate, and expected inflation:
(1 + r) = (1 + r*)(1 + i) Where: r = nominal interest rate
r* ≈ r - i r* = real interest rate
i = expected inflation rate
Contains Inflation and Risk.
- Investors will demand a higher nominal rate of return if they expect inflation
- The higher rate of return is called Inflation Premium (IP)
- The investors will demand a higher nominal rate of return on risky investments
- The additional rate of return is called the risk premium (RP).
Risk Premium is compensation that investors demand for bearing the higher default risk of
lower quality bonds. It consists of a number of issuerand issue-related components
including business risk, financial risk, interest rate risk, liquidity risk, and tax risk, as well
as the purely debt-specific risks – default risk, maturity risk, and contractual provision risk.
Equation: Rf = r* +i
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rj = Rf +RPj
Debt-specific Issuer- and Issue related risk premium components
Default risk – issuer of debt will not pay the contractual interest or principal as scheduled. High
bond ratings reflect low default risk, and low bond rating reflect high default risk.
Maturity risk – The longer the maturity, the more the value of a security will change in line
with changes in interest rates. Interest rates rise = prices of long term bonds declines
Contractual provision risk – Conditions included in a debt agreement or a stock issue. Some
of these reduce risk, whereas others may increase risk. Ex: a provision allowing a bond issuer to
retire its bonds prior to their maturity under favorable terms increases the bond’s risk.
Term structure of interest rates – maturity and rate of return for bonds with similar levels of
risk.
 - A graph of this relationship is called the Yield curve
Yield Curve – Tells analysts how rates vary between short, medium, and long-term bonds,
provide information on where interest rates and the economy in general are headed in the
future.
Yield to maturity (YTM) – Compound annual rate of return earned on a debt security
purchased on a given day and held to maturity.
1. Inverted Yield Curve – A downwardsloping yield curve indicated that shortterm interest
rates (higher) than long-term interest rates. This indicated that the economy is weakening.
2. Normal Yield Curve – An upwardslopping yield curve indicates that longterm interest
rates (higher) than short-term interest rates. This indicated that the economy recover from a
deep recession and inflation was very low.
3. Flat Yield Curve - indicates that interest rates do not vary much at different maturities.
 - A financial manager who faces a downward-sloping yield curve may be tempted to rely
more heavily on cheaper, long-term financing.
 - However, A risk in following this strategy is that interest rates may fall in the future, so
long-term rates that seem cheap today may be relatively expensive tomorrow.
 - When the yield curve is upward slopping, the manager may be tempted to use cheaper
short-term financing.
 - Firms that borrow on a short-term basis may see their costs rise if interest rates go up.
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Theories of Term Structure
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Expectation theory – yield curve reflects investor expectations about the future interest rates;
rising interest rates = upward-sloping, and declining rates = downward-sloping yield
curve.
Liquidity preference theory – long-term rates are generally higher than short-term rate (the
yield is upward sloping) because investors perceive short-term investments to be more
liquid and less risky than long-term investments.
Market segmentation theory – market for loans is segmented on the basis of maturity and that
the supply of and demand for loans determine its prevailing interest rate; the slope of the yield
curve is determined by the general relationship between the prevailing rates in each
market segment.
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Municipal bond - issued by a state or local government body
Corporate bond – A long-term debt instrument indicating that a corporation has borrowed a
certain amount of money and promises to repay it in the future under clearly defined
terms.
Coupon interest rate – Represents the percentage of the bond’s par value that will be paid
annually, typically in two equal semiannual payments, as interests.
Par value, face value, principal - amount of money the borrower must repay at maturity, and
the value on which periodic interest payments are based
Legal Aspects of Corporate Bonds
Bond indenture – A legal document that specifies both the rights of the bondholders and the
duties of the issuing corporation.
- Standard Provisions – certain record keeping and general business practices that the
bond issuer must follow
- Restrictive Provisions – place operating financial constraints on the borrower. These
provisions help protect the bondholder against increases in borrower risk.
Some of the most common restrictive covenants:
1. Require a minimum level of liquidity, to ensure against loan default
2. Prohibit the sale of accounts receivable to generate cash.
3. Impose fixed-asset restrictions.
4. Constrain subsequent borrowing.
5. Limit the firm’s annual cash dividend payments to a specified percentage or amount.
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- subordination - the stipulation that subsequent creditors agree to wait until all claims of
the senior debt are satisfied
Sinking-fund requirement – A restrictive provision often included in a bond indenture,
providing for the systematic retirement of bonds prior to their maturity.
Collateral - bondholders have a claim in the event
Secured bond - bond backed by some form of collateral
Unsecured bond - bond backed only by the borrower’s ability to repay the debt
Security Interest – The protection of bond collateral to guarantee the safety of a bond issue
Trustee – A third party to a bond indenture. Can be an individual, a corporation, or a
commercial
bank trust department. A trustee is paid to act as a “watchdog” on behold of the
bondholders if the term of the indenture is violated
Major factors that affect the cost of bond financing are:
 Rate of interest paid by the bond user   The issuer’s risk
 Bond’s maturity   Basic cost of money
 The size of the offering
Cost of Bonds to the Issues
1. Impact to bond maturity 3. Impact of issuer’s risk
2. Impact of offering size

General Features of a Bond Issue

Conversion feature – change each bond into a stated number of shares of common stock.
Call feature – included in nearly all corporate bond issues that gives the issuer the opportunity
to repurchase bonds at a stated call price prior to maturity.
Call price – The stated price at which a bond may be repurchased by use of a call feature
Call premium – The amount by which a bond ‘s call price exceeds it par value. Amount = 1yr
int
Stock purchase warrants - give their holders the right to purchase a certain number of
shares of the issuer’s common stock at a specified price over a certain period of time.
Current yield - measure of a bond’s cash return for the year
CY = bonds annual interest payment/ current price
Common Types of Bonds
Unsecured:
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Debentures Income bonds.
Subordinated debentures
Secured:
Mortgage bonds equipment trust certificates.
Collateral trust bonds
Secured or Unsecured:
Zero-(or low-) coupon bonds extendible notes
Junk bonds Putable bonds.
Floating-rate bonds

International Bond Issues

Eurobond – A bond issued by an international borrower and sold to investors in countries with
currencies other than the currency in which the bond is denominated.
Foreign bond – A bond that is issued by a foreign corporation or government and is
denominated In the investor’s home currency and sold in the investor’s home market.

Valuation Fundamentals
Valuation – The process that links risk and return to determine the worth of an asset. To
determine an asset’s worth at a given point in time.
There are 3 key inputs to the valuation process:
1. Cash Flows (returns) 3. Measure of risk, which determines the
2. Timing required return.
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Basic Valuation Model

Where: V0 = value of the asset at time zero

CFt = cash flow expected in year t
r = required return/ discount rate
n = time period

Bond Valuation
Present value of annuity
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Where: B0 = value of the bond at time zero

C = annual coupon interest payment in dollars
n = number of years to maturity
M = par value in dollars
r = required return/ coupon rate
Present value of lump sum

Semi-annual interest rates and bond values

Discount – The amount by which a bond sells at a value that is less than its par value
Premium – The amount by which a bond sells at a value that is greater than its par value.
Constant Required Returns – required return is different from the coupon interest rate and is
constant until maturity, the value of the bond will approach its par value as the passage of
time moves the bond’s value closer to maturity
Changing Required Returns – The Chance that interest rates will change and thereby change
the required return and bond value is call interest rate risk
Interest rate risk – Rising rates, which result in decreasing bond values, are of greatest
concern.
 - The shorter of time until a bond’s maturity, the less responsive. Short maturities have
less interest rate risk than long maturities when all other features (coupon interest rate, par
value and interest payment frequency) are the same.
Yield to Maturity – The compound annual rate of return earned on a debt security purchased
on a given day and held to maturity.
- The YTM on a bond with a current price equal to its par value will always equal the
coupon interest rate. When the bond value differs from par, the yield to maturity will differ
from the coupon interest rate
YTM = Interest payments + (par value - PV)/ maturity period

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Chapter 9: The Cost of Capital
Cost of Capital - firm’s cost of financing and minimum rate of return must earn
Capital - firm’s long-term sources of fianncing both debt and equity
- raise capital by selling securities such as common stock, preferred stock, and bonds
Capital Structure - mix of debt and equity
Weighted Average Cost of Capital (WACC) - weighted average of the cost of debt and
equity
- weighs reflect the percentage of each type of financing used not just one cost
- expected return > WACC
Capital Budgeting - investment decisions designed to maximize shareholder’s wealth
Four basic sources of long-term capital:
1. long-term debt 3. common stock
2. preferred stock 4. retained earnings
Cost of Long-term debt (rd) - cost associated with new funds raised through long-term
borrowing
Net proceeds - funds received from the sale of a security/ initial inflow
Flotation costs - total cost of issuing and selling a security
- because of flotation costs, net proceeds < total proceeds
- It applies to all public offerings of securities : debt, preferred stock, and common stock.
- Two components :
Underwriting costs - compensation earned by bankers for selling the security
Administrative cost - issuer expenses such as legal and accounting costs
- Equation when a firm sell bonds : Total Proceeds = (Market Price) x (# of Bonds Sold)
Bonds: net proceed = total proceed - flotation
- the before-tax cost of debt is slightly higher than the required return
Before-tax cost of debt (rd) - rate of return the fm must pay on new borrowing
- without incurring flotation cost, before-tax cost of debt will be equal to return required
- can find in : quotation, calculation, and approximation
- must observe yield to maturity (YTM) on the existing bonds or similar risk by other
companies to find quickly the before-tax cost of debt
- YTM reflects the rate of return required that is why managers use it as an estimate
Approximating the cost Formula:
Where:
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I = annual interest in dollars n= number of years
Nd = net proceeds
After-tax cost of debt - interest payments paid are tax deductibles, so interest expense reduces
taxable income (do not exceed 30% of EBIT) and the tax liability.
- after-tax will be less than the stated rate of return
Formula: After-tax cost of debt = rd x(1-T)
Where: rd = before tax T = tax rate
Cost of Preferred Stock (rp) - the ratio of the preferred stock dividend to the firm’s net
proceeds from the sale of preferred stock
- their difference is interest payment is tax deductible and preferred stock is not and it is
riskier than long-term debt therefore ust pay higher return.
- Formula : rp = Dp/Np
Cost of common stock equity - is equal to the required return on the firm’s common stockk in
the absence of flotation costs. It is the same as cost of retained earnings, but it is higher and
more difficult to calcute than bonds and preferred stocks.
- two forms of common stock : retained earnings and new issues of common stock
- they are not fixed and calculated using constant-growth valuation model and CAPM
- Constant-growth (Gordon Growth) Model : does not look at risk and uses indirect
approach and is the present value of an infinite dividend stream that grows at a constant rate
Formula :
Where: P0 = curren value of cs D1= dividend expected in 1year
Rs = required return on common stock g = constant rate of growth in dividends
- Capital Asset Pricing Model (CAPM) - considers risk and is relationship between the
required return, rs, and the nondiversifiable risk of the firm measured by beta coefficient,
B.
Formula:
Where: Rf = risk free rate rm = market return, return on market portfolio
Underpricing - sell new shares at a slight discount. It represents a cost to issuers because it
requires them to sell a greater # of shares than shares that are sold in full market value.
Cost of a New Issue of Common stock (rn) - by calculating cost of cs, net of underpricing and
associated flotation costs. Nn<P0 rn>rs
Formula :
Where : rn = cost of a new issue
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Nn= net proceeds from sale of new cs
Alternative formula :
Where : f = percentage reduction alternative for Nn
Cost of Retained Earnings - have an opportunity cost means if the firm did not use them to
reinvest in investment projects, it could contribute them to shareholders as dividends
Formula:
When: rs = required return on the cs
Weighted Average Cost of Capital
Formula : rwacc = (wd x rd)(1-T) + (wp x rp) + (ws x rs or n)
Where : wd = proportion of long-term debt
Wp = proportion of preferred stock
Ws = proportion of common stock equity
Wd+wp+ws = 1.0
Important point:
1. Must be nonnegative and sum to 1.0
2. Based on market value
3. Multiply ws by either rs or rn
4. Multiply cost of debt by 1-T to capture tax deduction

Market Value Weights - use market values to measure the proportion of each type of capital
- it better reflects the value of the funds that investors hve placed
- for debt, the difference beween market value and book value is not extremely large while
in equity, it can be enormous
Target Capital Structure - mi of debt and equity that a firm desires over the long term.
- It should reflect the optimal mix of debt and equity

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