The Cost of Capital
After reading this chapter, students should be able to:
• Explain what is meant by a firm’s weighted average cost of capital.
• Define and calculate the component costs of debt and preferred stock.
• Explain why retained earnings are not free and use three approaches to estimate the component cost of retained earnings.
• Briefly explain why the cost of new equity is higher than the cost of retained earnings, calculate the cost of new equity, and calculate the retained earnings breakpoint--which is the point where new equity would have to be issued.
• Briefly explain the two alternative approaches that can be used to account for flotation costs.
• Calculate the firm’s composite, or weighted average, cost of capital.
• Identify some of the factors that affect the overall, composite cost of capital.
• Briefly explain how firms should evaluate projects with different risks, and the problems encountered when divisions within the same firm all use the firm’s composite WACC when considering capital budgeting projects.
• List and briefly explain the three separate and distinct types of risk that can be identified, and explain the procedure many firms use when developing subjective risk-adjusted costs of capital.
• Use the CAPM to directly estimate the cost of capital for specific projects or divisions.
• Identify and explain the two approaches that have been used to estimate individual assets’ betas.
• List some problem areas in estimating the cost of capital. 1. LECTURE SUGGESTIONS
Chapter 10 uses the rate of return concepts covered in previous chapters, along with the concept of the weighted average cost of capital (WACC), to develop a corporate cost of capital for use in capital budgeting. We begin by describing the logic of the WACC, and why it should be used in capital budgeting. We next explain how to estimate the cost of each component of capital, and how to put the components together to determine the WACC. We go on to discuss factors that affect the WACC, how to adjust the cost of capital for risk, and estimating project risk. Then, we discuss how to use the CAPM to estimate the risk-adjusted cost of capital, and we discuss techniques for measuring beta risk. We conclude the chapter with a discussion on some problem areas in the cost of capital. The details of what we cover, and the way we cover it, can be seen by scanning Blueprints, Chapter 10. For other suggestions about the lecture, please see the “Lecture Suggestions” in Chapter 2, where we describe how we conduct our classes.
DAYS ON CHAPTER: 3 OF 58 DAYS (50-minute periods)
ANSWERS TO END-OF-CHAPTER QUESTIONS
10-1 Probable Effect on kd(1 - T) ks WACC
a.The corporate tax rate is lowered. + 0 +
b.The Federal Reserve tightens credit. + + +
c.The firm uses more debt; that is, it
increases its debt/assets ratio. + + 0
d.The dividend payout ratio is
increased. 0 0 0
e.The firm doubles the amount of capital
it raises during the year. 0 or + 0 or + 0 or +
f.The firm expands into a risky
new area. + + +
g.The firm merges with another firm
whose earnings are counter-cyclical
both to those of the first firm and
to the stock market. - - -
h.The stock market falls drastically,
and the firm’s stock falls along with
the rest. 0 + +
i.Investors become more risk averse. + + +
j.The firm is an electric utility with a...