Chapter 14 – Cost of Capital
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Chapter 14
COST OF CAPITAL
CHAPTER WEB SITES
Section
Web Address
CHAPTER ORGANIZATION
14.1 The Cost of Capital: Some Preliminaries
14.2 Cost of Equity
14.3 The Costs of Debt and Preferred Stock
14.4 The Weighted Average Cost of Capital
14.5 Divisional And Project Costs of Capital
14.6 Flotation Costs and the Weighted Average Cost of Capital
14.7 Summary and Conclusions
Chapter 14 – Cost of Capital
ANNOTATED CHAPTER OUTLINE
14.1. The Cost of Capital: Some Preliminaries
A. Required Return Versus Cost of Capital
Lecture Tip: Students often find it easier to grasp the intricacies of
cost of capital estimation when they understand why it is
Lecture Tip: EVA (“Economic Value Added”) is discussed more
later in the chapter. It is a metric of firm and managerial
B. Financial Policy and Cost of Capital
Capital structure – the firm’s combination of debt and equity. The
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14.2. The Cost of Equity
A. The Dividend Growth Model Approach
According to the dividend growth model,
Implementing the Approach
Example:
Year
Dividend
$ Change
2001
2002
2003
2004
2005
Advantages and Disadvantages of the Approach
Chapter 14 – Cost of Capital
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Lecture Tip: It is noted in the text that there are other ways to
Lecture Tip: Some students may question how you value the stock
for a firm that doesn’t pay dividends. In the case of growth-
B. The SML Approach
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Betas are widely available, and T-bill rates or the rate on long-
Advantages and Disadvantages of the Approach
Lecture Tip: Students are often surprised when they find that the
14.3. The Costs of Debt and Preferred Stock
A. The Cost of Debt
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Lecture Tip: Consider what happens to corporate bond rates and
Lecture Tip: It is beneficial to reemphasize the distinction between
Real-World Tip: “Corporate Treasurers Rush to Sell Bonds” – so
B. The Cost of Preferred Stock
14.4. The Weighted Average Cost of Capital
A. The Capital Structure Weights
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V = combined market value of the firm’s equity and debt = E + D
Lecture Tip: It may be helpful to mention and differentiate
Lecture Tip: The cost of short-term debt is usually very different
B. Taxes and the Weighted Average Cost of Capital
Lecture Tip: If the firm utilizes substantial amounts of current
liabilities and has issued preferred stock, equation 14.7 from the
text should be modified as follows:
Chapter 14 – Cost of Capital
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C. Calculating the WACC for Eastman Chemical
Several web sites are utilized to find the information required to
compute the WACC.
D. Solving the Warehouse Problem and Similar Capital Budgeting
Problems
Lecture Tip: The warehouse problem employs the WACC as the
discount rate in an NPV calculation. This is only appropriate if the
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14.5. Divisional and Project Costs of Capital
A. The SML and the WACC
The WACC is the appropriate discount rate only if the proposed
investment is of similar risk as the firm’s existing assets.
Lecture Tip: Ask the class to consider a situation in which a
company maintains a large portfolio of marketable securities. Now
B. Divisional Cost of Capital
When a firm has different operating divisions with different risks,
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If you do use the firm’s WACC across divisions, then riskier
divisions will receive the bulk of the funding and less risky
divisions will have to forgo what would be good projects if the
appropriate discount rate were used. This will lead to an increase in
risk for the overall firm.
Lecture Tip: It may help students to distinguish between the
average cost of capital to the firm and the required return on a
Lecture Tip: You may wish to point out here that the divisional
concept is no more than a firm-level application of the portfolio
C. The Pure Play Approach
D. The Subjective Approach
Assigns investment to “risk” categories that have higher or lower
risk premiums than the firm as a whole.
International Note: The difficulty in arriving at an appropriate
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Making these adjustments requires a great deal of judgment and
Lecture Tip: What an individual firm considers a risky investment
14.6. Flotation Costs and the Weighted Average Cost of Capital
A. The Basic Approach
B. Flotation Costs and NPV
If a project requires an investment of $I before flotation costs, then
compute the gross capital requirement as I/(1 – fA) and use this
figure as the investment cost in calculating NPV.
Example:
Suppose ABC Company is considering opening another office.
Chapter 14 – Cost of Capital
C. Internal Equity and Flotation Costs
14.7. Summary and Conclusions