ISBN: 0-03-028931-9

Chapter 10 The Cost of Capital

This chapter showed how the component costs of capital are estimated for use in the capital budgeting process. The key concepts covered are listed below.

The cost of capital is sometimes referred to as a hurdle rate. For a project to be accepted, it must earn more than its hurdle rate.

The cost of capital used in capital budgeting is a weighted average of the types of capital the firm uses, typically debt, preferred stock, and common equity.

The component cost of debt is the after-tax cost of new debt. It is found by multiplying the cost of new debt by (1 - T), where T is the firm's marginal tax rate:

A-T k_d = k_d (1-T)

The component cost of preferred stock is calculated as the preferred dividend divided by the current price of the preferred stock:

The cost of common stock, k_s, is the rate of return stockholders require on the company's common stock. There are two sources of equity capital: (1) internal equity generated through additions to retained earnings and (2) external equity obtained by issuing new shares of common stock.

The cost of common stock can be estimated by three methods: (1) the CAPM approach, (2) the bond-yield-plus-risk-premium approach, and (3) the dividend-yield-plus-growth-rate, or DCF, approach.

To use the CAPM approach, one (1) estimates the firm's beta, (2) multiplies this beta by the market risk premium to determine the firm's risk premium, and (3) adds the firm's risk premium to the risk-free rate to obtain the firm's cost of common stock:

k_s = k_rf + ( k_m – k_rf ) βi

The bond-yield-plus-risk-premium approach calls for adding a risk premium of from 3 to 5 percentage points to the firm's interest rate on long-term debt:

k_s = Bond Yield + RP

To use the dividend-yield-plus-growth-rate approach, which is also called the discounted cash flow (DCF) approach, one adds the firm's expected growth rate to its expected dividend yield:

Companies generally hire an investment banker to assist them when they issue common stock, preferred stock, or bonds. In return for a fee, the investment banker helps the company with the terms, price, and sale of the issue. The banker's fees are often referred to as flotation costs. The total cost of capital should include not only the required return paid to investors but also the flotation fees paid to the investment banker for marketing the issue.

Two alternative approaches can be used to account for flotation costs. The first approach adds the estimated dollar amount of flotation costs for each project to the project's up-front cost--this lowers the project's expected rate of return. An alternative approach is to adjust the cost of capital. When calculating the cost of common stock, the DCF approach can be adapted to account for flotation costs. For a constant growth stock, this cost can be expressed in one of two ways. The first equation works if flotation costs are expressed as percentage, and the second if the cost is expressed in dollar terms.

Flotation cost adjustments can also be made for preferred stock and debt. The flotation-adjusted cost for preferred is calculated as D_p/P_n, where P_n is the price the firm receives on preferred after deducting flotation costs. For debt, the bond's issue price is reduced for flotation expenses and then used to solve for the after-tax yield to maturity.

Each firm has an optimal capital structure, defined as that mix of debt, preferred stock, and common equity which minimizes its weighted average cost of capital (WACC):

WACC = w_dk_d(1-T) + w_sk_s + w_pk_p

The WACC represents the marginal cost of capital (MCC) because it indicates the cost of raising an additional dollar.

Various factors affect a firm's cost of capital. Some of these factors are determined by the financial environment (like interest rates and tax rates), but the firm influences others through its financing, investment, and dividend policies.

A project's stand-alone risk is the risk the project would have if it were the firm's only asset and if the firm's stockholders held only that one stock. Stand-alone risk is measured by the variability of the asset's expected returns.

Corporate, or within-firm, risk reflects the effects of a project on the firm's risk, and it is measured by the project's effect on the firm's earnings variability.

Market, or beta, risk reflects the effects of a project on the riskiness of stockholders, assuming they hold diversified portfolios. Market risk is measured by the project's effect on the firm's beta coefficient.

Most decision makers consider all three risk measures in a judgmental manner and then classify projects into subjective risk categories. Using the composite WACC as a starting point, risk-adjusted costs of capital are developed for each category. The risk-adjusted cost of capital is the cost of capital appropriate for a given project, given the riskiness of that project. The greater the risk, the higher the cost of capital.

As an alternative to the subjective approach, other firms use the CAPM to directly estimate the risk-adjusted cost of capital for specific projects or divisions.

The pure play method and the accounting beta method can be used to estimate betas for large projects or for divisions. The pure play method of estimating beta entails identifying several comparable companies, calculating the beta of each company, and averaging the betas to approximate the subject firm's beta. The accounting method requires running a regression of the company's return on assets against the average return on assets for a large sample of firms.

Ideally, the hurdle rate for each project should reflect the risk of the project itself, not necessarily the risks associated with the firm's average project as reflected in the firm's composite WACC. Applying a specific hurdle rate to each project ensures that every project is evaluated properly.

Failing to adjust for differences in risk would lead a firm to accept too many risky projects and reject too many safe ones. Over time, the firm would become more risky, its WACC would increase, and its shareholder value would suffer.

The three equity cost-estimating techniques discussed in this chapter have serious limitations when applied to small firms, thus increasing the need for the small-business manager to use judgment.

Stock offerings of less than $10 million have an average flotation cost of 13 percent, while the average flotation cost on large common stock offerings is about 4 percent. As a result, a small firm would have to earn considerably more on the same project than a large firm. Also, the capital market demands higher returns on stocks of small firms than on otherwise similar stocks of large firms--this is called the small-firm effect.
The cost of capital as developed in this chapter is used in the following chapters to evaluate capital budgeting projects. In addition, we will extend the concepts developed here in Chapter 14, where we consider the effect of the capital structure on the cost of capital.

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