Chapter 9
The Cost of Capital
NOTE TO INSTRUCTORS: Shortly after the first press run for the 15th edition, Congress passed the Tax Cuts
and Jobs Act of 2017, which included changes in the corporate tax rate relevant to this chapter. In subsequent
printing runs, the text was updated to reflect the new tax law, but these updates may not appear in every
student’s copy of the text. Accordingly, solutions to the following problems in the instructors manual were
modified to include answers based on the old and new corporate income tax rate: P9-2, P9-4, P9-5, P9-16, P9-
17, P9-19, Spreadsheet Exercise, and Integrative Case: Eco Plastics. In addition, the following in-text items were
also updated: Example 9.5, Example 9.12, Table 9.2, and ST9-1.
Instructor’s Resources
Chapter Overview
This chapter introduces the cost of capital. The discussion begins with an overview of the sources of long-
term finance—long-term debt (bonds), preferred stock, common stock, and retained earnings—then
proceeds to specify the cost of tapping each source. Complications in determining costs are noted such as
the tax deductibility of interest on debt and the flotation costs associated with issuance of new securities.
Two approaches to computing the cost of common equity are offered—one based on the Gordon model for
valuing stock and another based on CAPM. The chapter concludes by integrating the costs of long-term
finance into a single benchmark for evaluating projects—the weighted average cost of capital—where the
weights applied to the cost of each type of finance reflect its importance in the firm’s target capital
structure.
Suggested Answer to Opener-in-Review
In the chapter opener you learned Johnson & Johnson’s weighted average cost of capital was around 6%
but its investments earned returns closer to 17%. In 2016, J&J’s capital expenditures were about $3.2
billion. Suppose J&J spends the same amount this year to expand manufacturing facilities and expects to
reap a net cash flow of $544 million (17% of $3.2 billion) every year in perpetuity. Calculate NPV using a
6% discount rate. How much value does the $3.2 billion investment create or destroy? Should J&J make
the expenditure?
The net present value (NPV) calculation includes a $3.2 initial outflow and a perpetual annual inflow of
Answers to Review Questions
9-1 The cost of capital represents the firm’s cost of long-term financing (in percentage terms). Managers
use the cost of capital (i) as a discount rate in NPV calculations when evaluating projects, (ii) as a
9-2 The cost of capital provides a benchmark for evaluating expected rates of return on potential projects.
Financial managers should only invest in projects with expected rates of return exceeding the cost of
9-3 Capital structure is the mix of debt and equity the firm employs. It represents the cumulative long-
term financing decisions the firm has made over time.
9-4 The long-term sources of capital available to firms are long-term debt, preferred stock, common
stock, and retained earnings. (Note: Few firms actually have preferred stock.) The proper measure of
9-5 Net proceeds from a bond sale are the actual funds received, which usually differs from par value.
This difference reflects (i) any movements in the interest rate on bonds with similar risk since the
and actual sales, and market rates could move during this internal.) Flotation costs have two
9-6 The three approaches to finding the before-tax cost of debt (rd) are:
a. The quotation approach, which involves observing the yield-to-maturity on the firm’s existing
where:
I=annual interest payment in dollars
9-7 Before-tax cost is converted to after-tax cost through multiplication by (1 T), where T is the firm’s
9-8 Student answers will vary because “given” values are algorithmically generated in MyFinanceLab.
9-9 The cost of preferred stock (rp) is found by dividing the annual preferred stock dividend by the net
proceeds from the sale of the preferred stock. Specifically:
9-10 The value of common stock is the present value of all future dividends. A simple way to estimate
future dividends is to assume dividends grow at a constant rate—the assumption behind the Gordon
= + g
where:
D1 = Next annual dividend payment in dollars
capital gains.
9-11 CAPM uses beta” to explicitly incorporate the firm’s non-diversifiable risk in the required rate of
expect for the firm’s non-diversifiable risk from the price the stock commands in the market.
9-12 Using retained earnings is less expensive than issuing new common stock because the firm can avoid
flotations costs (underwriting fees and administrative expenses) and receipts lost to underpricing.
9-13 The weighted average cost of capital (WACC), rwacc, is the firm’s average cost of long-term finance. It
source as a percentage of the market value of the firm’s total capital, and sum to 1.0.
9-14 Target capital structure is the mix of debt and equity financing a firm desires over the long run.
Actual capital structure reflects the firm’s past financing decisions and trends in the market prices of
9-15 Sometimes—as with Netflix from 2012 to 2016—the market value of common equity rises rapidly,
not because the firm is issuing common stock but because the price of common stock is soaring. The
run-up is stock price can be so dramatic that it is difficult for the firm to sell bonds fast enough to
structure that the firm plans to adopt over the long term. Using actual rather than target weights
Suggested Answer to Focus on Ethics Box:
“The Cost of Capital Also Rises”
Many feel only muscular government regulation––supported by severe punishment for transgressions––can
deter corporations from unethical acts. How did markets punish Wells Fargo? In your opinion, how much
of a role should markets play in policing corporate ethics?
Financial markets punished Wells Fargo through a decline in its stock price and jump in long-term
borrowing costs—in part anticipating customer decisions to open checking accounts and apply for credit
cards with other banks. Student opinions on the efficacy of markets vs. the government in deterring
Suggested Answer to Focus on Practice Box:
“Uncertain Times Make for an Uncertain WACC”
Why is having a hurdle rate above the cost of capital bad for shareholders? Is there a flaw in the argument
that if interest rates may rise in the near term, the hurdle rate for an investment should be above the
WACC?
If the cost of capital is properly measured, any project with a higher expected return will also have a
positive net present value. Accordingly, to maximize shareholder wealth, a financial manager should
Other things equal, a rise in market interest rates will increase the cost of capital. Any bonds issued will
have to offer a higher coupon rate, and higher rates will increase the required return on equity through the
Answers to Warm-Up Exercises
E9-1 Cost of Long-Term Debt
Answer: The pre-tax cost of long-term debt is the bond’s yield to maturity, when par value is adjusted for
flotation costs. The firm is selling $20,000 worth of bonds, so this is the par value. The coupon
Bn = + + + … + +
where:
Bn = Net proceeds from bond sale M=
N = periods to maturity
Note: Net proceeds from sale (third term in parentheses) must be entered as a negative number.
E9-2 Cost of preferred stock
Answer: The cost of preferred stock (rp) is the ratio of annual preferred stock dividends in dollars (Dp) to
the firm’s net proceeds from the sale of the preferred stock (Np). A 9% annual dividend and $55
E9-3 Cost of common stock equity
Answer: The next expected dividend (D1) is $6.50, stock price is $78, and expected dividend growth is
capital gains.
E9-4 Weighted average cost of capital
Answer: The weighted average cost of capital (rwacc) is given by (wd rd) + (ws rs), where rd is the
before and after-tax cost of debt, wd the weight of debt in the firm’s capital structure, ws the
E9-5 Weighted average cost of capital
Answer: The weighted average cost of capital (rwacc) is given by (wd rd) + (wp rp) + (ws rs), where rd
is the before and after-tax cost of debt, wd the weight of debt in the firm’s capital structure, wp