Module 7: Background Transcripts
We have reflected on a firm’s use of financial resources and its cost of capital using comparisons to an activity that is likely to be more familiar than a firm’s capital budgeting decision process is to most individuals. Firms incur interest and other capital costs to receive project returns. A family or individual may similarly invest in education hoping to obtain a “pay off” or “earnings premium” exceeding the cost of invested funds. By looking at an individual or family’s decision to invest in education and a firm’s decision to invest in projects generally, using debt and perhaps also savings or equity, we expect you will gain a better understanding of both decisions.
A firm’s cost of capital is called its “weighted average cost of capital” (WACC) because it is made up of the costs of all previous project financing in the proportions or “weights” of each type of financing vehicle (debt or equity) used, multiplied by the vehicle’s cost. A firm’s WACC depends on the riskiness of projects the firm has undertaken in the past and economic factors. A firm’s WACC also depends on the mix of debt and equity chosen, because these “instruments” carry different costs. A firm is willing to undertake required capital costs, including interest on debt, because it expects project returns to exceed the cost of invested capital. A project’s gain will exceed its cost. The same is true of a family or individual investing in education.
When investing in education, individuals and families may use debt to cover a portion of a training or degree program. Like a firm, a family uses debt, even though it is associated with a visible cost. Statistics in a later part of this section indicate that an individual or family’s willingness to undertake costs of educational debt increases as payoffs or earnings premiums rise, if we assume that more advanced degrees or programs result in higher earnings on average. Most programs yielding high earnings “premiums” over no education are lengthy or expensive.
Traditionally, education has been one of the most significant drivers of individual earnings. Education is associated with earnings growth over a person’s lifetime, as well as the rate of pay in one’s first professional position. Families and individuals will weigh educational expenses against an increase in income associated with a training or educational program. On average, the cost of a college education has risen roughly eight times as fast as wages have grown, since approximately 1990 (Maldonado, 2018). Thus, while an earnings premium is expected, it is risky. A family or individual’s investment in education faces risk, just as a firm faces risk associated with its investments. A family or individual investing in education weighs a risky return against cost, just as a firm weighs a risky return against cost when it invests in a new project, in other words.
Firms and individuals or families choose a mix of financing vehicles (savings, debt, or a combination of both) to accomplish an objective. For a family or individual, an alternative to spending cash on a training or educational program might be depositing funds in a savings account, investment in a home, or paying down high-interest credit accounts. Families and individuals consider these “opportunity costs” (the next best alternative) as they calculate the returns to education. An individual might be able to invest in a savings account with a 1.5% return, for instance. This 1.5% return is an opportunity cost of using savings to pay for education. On the other hand, savings can be paid to a mortgage-holder to reduce mortgage loan principle, decreasing interest costs in the longer term. If mortgage interest is 4%, a reduction in interest paid on existing principle can be thought of as the opportunity cost of using savings to pay educational expenses. So, while debt is costly, use of savings can also be thought of as costly. Firms similarly face opportunity costs given that funds might be invested in multiple alternative projects.
Approaching the decision to attend college, approximately 43% of all higher education attendees, including those who attend a technical college or do not complete a bachelor’s degree, choose to accept student loans in order to finance their education. 60% who obtain a bachelor’s degree and 73% who obtain a graduate degree take on student loans (Federal Reserve Board of Governors, 2020). In part, this is determined by the rate of return or “earnings premium” associated with each type of education. Individuals with professional degrees (medical doctors, dentists, or attorneys, for instance) earn more than individuals completing a certificate or bachelor’s degree program. This earnings premium is evidently expected to more than cover associated costs.
Assume education is financed with a mix of debt (loans) and savings, and the yearly cost of interest on a student’s loans does not exceed deductible amounts. All interest paid will be tax-deductible. The payer is assumed to have a tax liability, and a family’s or individual’s credit has no influence on loan rates or availability.
In this discussion, we compare individuals’ and families’ willingness to undertake debt versus relying on equity (savings) in financing investment in an educational training or degree program to a firm’s decision to mix financing vehicles as it determines how to approach an upcoming project. We assume, for the purposes of this discussion, that a new tax policy will soon be passed that lowers the limit on deductibility of interest expense on student loans, increasing their effective cost to the borrower. Consider how this will influence educational decisions.
Review the introduction of Chapter 11, section 11.1, and p. 397 of Chapter 12 of our required text before you start.
Section 1: Comparing Personal and Corporate Finance
While comparing an individual or family investing in education to a firm investing in a project of any type, discuss what cost of capital means by comparing personal cost of capital with corporate cost of capital.
[Hint: See p. 367-367, 377, and 379-381 of our required textbook.]
Section 2: Choice of Financing Tools
Focusing on both tax issues and income issues, discuss how these factors influence whether debt or savings (equity) is a more viable option for the family and the firm.
[Hint: Consider deductibility in relation to cost of capital and required reading covering after-tax cost of debt. See p. 372 of required readings. With respect to income issues, recall that the risk premium required by investors is the reward an investor requires for taking on risk. See p. 339 of our required textbook. Also see p. 399 of your required text for information on Opportunity Costs.]