Chapter 10 The Cost of Capital

Learning Objectives

After reading this chapter, students should be able to:

Explain what is meant by a firms weighted average cost of capital. Define and calculate the component costs of debt and preferred stock. Explain why the
cost of debt is tax ad usted and the cost of preferred is not.

Explain why retained earnings are not free and use three approaches to estimate the
component cost of retained earnings.

!riefly explain the two alternative approaches that can be used to account for flotation
costs.

!riefly explain why the cost of new common e"uity is higher than the cost of retained
earnings, calculate the cost of new common e"uity, and calculate the retained earnings breakpoint#which is the point where new common e"uity would have to be issued.

$alculate the firms composite, or weighted average, cost of capital. %dentify some of the factors that affect the &A$$#dividing them into factors the firm
cannot control and those they can.

!riefly explain how firms should evaluate pro ects with different risks, and the problems
encountered when divisions within the same firm all use the firms composite &A$$ when considering capital budgeting pro ects.

'ist some problems with cost of capital estimates.

Chapter 10: The Cost of Capital

Learning Objectives 243

Lecture Suggestions

$hapter () uses the rate of return concepts covered in previous chapters, along with the concept of the weighted average cost of capital *&A$$+, to develop a corporate cost of capital for use in capital budgeting. &e begin by describing the logic of the &A$$, and why it should be used in capital budgeting. &e next explain how to estimate the cost of each component of capital, and how to put the components together to determine the &A$$. &e go on to discuss factors that affect the &A$$ and how to ad ust the cost of capital for risk. &e conclude the chapter with a discussion on some problems with cost of capital estimates. &hat we cover, and the way we cover it, can be seen by scanning the slides and %ntegrated $ase solution for $hapter (), which appears at the end of this chapter solution. ,or other suggestions about the lecture, please see the -'ecture .uggestions/ in $hapter 0, where we describe how we conduct our classes. D !S O" C# $T%&: 3 O' () D !S *(0+ ,inute perio-s.

244 Lecture Suggestions

Chapter 10: The Cost of Capital

ns/ers to %n-+ Of+ Chapter 0uestions

10+ 1

1robable r d *( 2 3+ a1 3he corporate tax rate is lowered. b1 3he ,ederal 5eserve tightens credit. c1 3he firm uses more debt6 that is, it increases its debt7assets ratio. -1 3he dividend payout ratio is increased. e1 3he firm doubles the amount of capital it raises during the year. or 4 f1 3he firm expands into a risky new area. 4 4 4 ) ) or 4 4 rs ) 4 4 )

Effect

on &A$$ 4 4 ) ) ) 4

) or 4 4

g1 3he firm merges with another firm whose earnings are counter8 cyclical both to those of the first firm and to the stock market. h1 3he stock market falls drastically, and the firms stock falls along with the rest. i1 j1 %nvestors become more risk averse. 3he firm is an electric utility with a large investment in nuclear plants. .everal states propose a ban on nuclear power generation.

2 ) 4

2 4 4

2 4 4

10+ 2

An increase in the risk8 free rate will increase the cost of debt. 5emember from $hapter 9, r : r 5, 4 D51 4 '1 4 ;51. 3hus, if r 5, increases so does r *the cost of debt+. .imilarly, if the risk8 free rate increases so does the cost of e"uity. ,rom the $A1; e"uation, r s : r 5, 4 *r ; 2 r 5,+b. $onse"uently, if r 5, increases r s will increase too. Each firm has an optimal capital structure, defined as that mix of debt, preferred, and common e"uity that causes its stock price to be maximi<ed. A value8 maximi<ing firm will determine its optimal capital structure, use it as a target, and then raise new capital in a manner designed to keep the actual capital structure on target over time. 3he target proportions of debt, preferred stock, and common e"uity, along with the costs of those components, are used to calculate the firms weighted average cost of capital, &A$$. 3he weights could be based either on the accounting values shown on the firms balance sheet *book values+ or on the market values of the different securities. 3heoretically, the weights should be based on market values, but if a firms book value weights are reasonably close to its market value weights, book value weights Answers and Solutions 24(

10+ 3

Chapter 10: The Cost of Capital

can be used as a proxy for market value weights. $onse"uently, target market value weights should be used in the &A$$ e"uation. 10+ 4 %n general, failing to ad ust for differences in risk would lead the firm to accept too many risky pro ects and re ect too many safe ones. =ver time, the firm would become more risky, its &A$$ would increase, and its shareholder value would suffer. 3he cost of capital for average8 risk pro ects would be the firms cost of capital, ()>. A somewhat higher cost would be used for more risky pro ects, and a lower cost would be used for less risky ones. ,or example, we might use (0> for more risky pro ects and ?> for less risky pro ects. 3hese choices are arbitrary. 3he cost of retained earnings is lower than the cost of new common e"uity6 therefore, if new common stock had to be issued then the firms &A$$ would increase. 3he calculated &A$$ does depend on the si<e of the capital budget. A firm calculates its retained earnings breakpoint *and any other capital breakpoints for additional debt and preferred+. 3his 57E breakpoint represents the amount of capital raised beyond which new common stock must be issued. 3hus, a capital budget smaller than this breakpoint would use the lower cost retained earnings and thus a lower &A$$. A capital budget greater than this breakpoint would use the higher cost of new e"uity and thus a higher &A$$. Dividend policy has a significant impact on the &A$$. 3he 57E breakpoint is calculated as the addition to retained earnings divided by the e"uity fraction. 3he higher the firms dividend payout, the smaller the addition to retained earnings and the lower the 57E breakpoint. *3hat is, the firms &A$$ will increase at a smaller capital budget.+

10+ (

242 Answers and Solutions

Chapter 10: The Cost of Capital

Solutions to %n-+ Of+ Chapter $roble,s

10+ 1 10+ 2

r d *( 2 3+ : ).(0*).9@+ : A.B)>. 1p : CDA.@)6 D p : CE.B)6 r p : F rp :

Dp 1 p

CE.B) : B>. CDA.@)

10+ 3

D)> Debt6 9)> $ommon e"uity6 r d : ?>6 3 : D)>6 &A$$ : ?.?9>6 r s : F &A$$: *w d +*r d +*( 2 3+ 4 *w c+*r s+ ).)??9 : *).D+*).)?+*( 2 ).D+ 4 *).9+r s ).)??9 : ).)0(9 4 ).9r s ).)AB : ).9r s r s : (E>.

10+ 4

1) : CE)6 D ( : CE.))6 g : @>6 r s : F a1 r s :

D( CE.)) 4 g: 4 ).)@ : (@>. CE).)) 1)

b1 , : ()>6 r e : F re :

D( 4 g 1) *( ,+
:

CE.)) 4 ).)@ CE)*( ).()+

CE.)) 4 ).)@ : (9.((>. C0A.))

10+ ( 1ro ects A, !, $, D, and E would be accepted since each pro ects return is greater than the firms &A$$.

10+ 2

a1 r s :

D( C0.(D 4 g: 4 A> : ?.E> 4 A> : (9.E>. C0E 1)

b1 r s : r 5, 4 *r ; 2 r 5,+b : ?> 4 *(E> 2 ?>+(.9 : ?> 4 *D>+(.9 : ?> 4 9.D> : (@.D>. c1 r s : !ond rate 4 5isk premium : (0> 4 D> : (9>. -1 .ince you have e"ual confidence in the inputs used for the three approaches, an average of the three methodologies probably would be warranted.

Chapter 10: The Cost of Capital

Answers and Solutions 243

rs :

(9.E> + (@.D> + (9> : (@.?>. E

10+ 3

a1 r s : :

D( 4 g 1)

CE.(B 4 ).)9 CE9 : (D.BE>.

b1 , : *CE9.)) 2 CE0.D)+7CE9.)) : CE.9)7CE9.)) : ()>. c1 r e : D ( 7G1 ) *( 2 ,+H 4 g : CE.(B7CE0.D) 4 9> : ?.B(> 4 9> : (@.B(>. 10+ ) Debt : D)>, $ommon e"uity : 9)>. 1) : C00.@), D ) : C0.)), D ( : C0.))*(.)A+ : C0.(D, g : A>. rs :

D( C0.(D 4 g: 4 A> : (9.@(>. C00.@) 1)

&A$$: *).D+*).(0+*( 2 ).D+ 4 *).9+*).(9@(+ : ).)0BB 4 ).)??( : (0.A?>. 10+ 4 $apital .ources 'ong8 term debt $ommon E"uity Amount C(,(@0 (,A0B C0,BB) $apital .tructure &eight D) .)> 9) .) ()) .) >

&A$$: w d r d *( 2 3+ 4 w cr s : ).D*).(E+*).9+ 4 ).9*).(9+ : ).)E(0 4 ).)?9) : (0.A0>. 10+ 10 %f the investment re"uires C@.? million, that means that it re"uires CE.@D million *9)>+ of common e"uity and C0.E9 million *D)>+ of debt. %n this scenario, the firm would exhaust its C0 million of retained earnings and be forced to raise new stock at a cost of (@>. Ieeding C0.E9 million in debt, the firm could get by raising debt at only ()>. 3herefore, its weighted average cost of capital is: &A$$ : ).D*()>+*( 2 ).D+ 4 ).9*(@>+ : ((.D>. 10+ 11 r s : D ( 71) 4 g : C0*(.)A+7C0D.A@ 4 A> : B.9@> 4 A> : (@.9@>. &A$$ : w d *r d +*( 2 3+ 4 w c*r s+6 w c : ( 2 w d . (E.?@> : w d *((>+*( 2 ).E@+ 4 *( 2 w d +*(@.9@>+ ).(E?@ : ).)A(@w d 4 ).(@9@ 2 ).(@9@w d 8).)(A : 8).)B@w d w d : ).0) : 0)>.

24) Answers and Solutions

Chapter 10: The Cost of Capital

10+ 12 a1 r d : ()>, r d *( 2 3+ : ()>*).9+ : 9>. D7A : D@>6 D ) : C06 g : D>6 1) : C0)6 3 : D)>. 1ro ect A: 5ate of return : (E>. 1ro ect !: 5ate of return : ()>. r s : C0*(.)D+7C0) 4 D> : (D.D)>. b1 &A$$ : ).D@*9>+ 4 ).@@*(D.D)>+ : ().90>. c1 .ince the firms &A$$ is ().90> and each of the pro ects is e"ually risky and as risky as the firms other assets, ;E$ should accept 1ro ect A. %ts rate of return is greater than the firms &A$$. 1ro ect ! should not be accepted, since its rate of return is less than ;E$s &A$$. 10+ 13 %f the firmJs dividend yield is @> and its stock price is CD9.A@, the next expected annual dividend can be calculated. Dividend yield : D ( 71) @> : D ( 7CD9.A@ D ( : C0.EEA@. Iext, the firmJs cost of new common stock can be determined from the D$, approach for the cost of e"uity. r e : D ( 7G1 ) *( 2 ,+H 4 g : C0.EEA@7GCD9.A@*( 2 ).)@+H 4 ).(0 : (A.09>.

10+ 14 r p :

C())* ).((+ C(( : : ((.?D>. C?0.(@ C?0.(@

10+ 1( a1 Examining the D$, approach to the cost of retained earnings, the expected growth rate can be determined from the cost of common e"uity, price, and expected dividend. Kowever, first, this problem re"uires that the formula for &A$$ be used to determine the cost of common e"uity. &A$$: w d *r d +*( 2 3+ 4 w c*r s+ (E.)> : ).D*()>+*( 2 ).D+ 4 ).9*r s+ ().9> : ).9r s r s : ).(A99A or (A.9A>. ,rom the cost of common determined. r s : D ( 71) 4 g ).(A99A : CE7CE@ 4 g g : ).)?)?@0 or ?.()>. Chapter 10: The Cost of Capital Answers and Solutions 244 e"uity, the expected growth rate can now be

b1 ,rom the formula for the long8 run growth rate: g : *I%7E"uity+ ).)?)?@0 : ).)?)?@0 : ).D?9()D : Div. payout ratio *( 2 Div. payout ratio+ 5=E : *( 2 Div. payout ratio+ *( *( *( : 2 Div. payout ratio+ *C(,()) million7C9,))) million+ 2 Div. payout ratio+ ).(BEEEEE 2 Div. payout ratio+ ).@)EB?9 or @).E?>.

10+ 12 a1 &ith a financial calculator, input I : @, 1L : 8D.D0, 1;3 : ), ,L : 9.@), and then solve for %7M5 : g : B.)0> B>. b1 D ( : D ) *( 4 g+ : C0.9)*(.)B+ : C0.B(. c1 r s : D ( 71) 4 g : C0.B(7CE9.)) 4 B> : (@.B(>.

10+ 13 a1

rs : ).)? :

D( 4 g 1)

CE.9) 4 g C9).)) ).)? : ).)9 4 g g : E>.

b1 $urrent E1. C@ .D)) 'ess: Dividends per share E .9)) 5etained earnings per share C( .B)) 5ate of return ) .)?) %ncrease in E1. C) .(90 1lus: $urrent E1. @ .D)) Iext years E1. C@ .@90 Alternatively, E1.( : E1.) *( 4 g+ : C@.D)*(.)E+ : C@.@90. 10+ 1) a1 r d *( 2 3+ : ).()*( 2 ).E+ : A>. r p : C@7CD? : ().0>. r s : CE.@)7CE9 4 9> : (@.A0>. b1 &A$$: $omponent Debt G).()*( 2 3+H 1referred stock $ommon stock &eight ).(@ ).() ).A@ After8 tax $ost A.))> () .0) (@ .A0 &eighted $ost (.)@> (.)0 (( .A? &A$$: (E .B9 > :

2(0 Answers and Solutions

Chapter 10: The Cost of Capital

c1 1ro ects ( and 0 will be accepted since their rates of return exceed the &A$$.

Chapter 10: The Cost of Capital

Answers and Solutions 2(1

10+ 14 a1 %f all pro ect decisions are independent, the firm should accept all pro ects whose returns exceed their risk8 ad usted costs of capital. 3he appropriate costs of capital are summari<ed below: 1ro ect A ! $ D E , N K 5e"uired %nvestment CD million @ million E million 0 million 9 million @ million 9 million E million 5ate of 5eturn (D .)> (.@ ?.@ ?.) (0 .@ (0 .@ A.) (( .@ $ost of $apital (0 > (0 B () (0 () B B

3herefore, Oiege should accept pro ects A, $, E, ,, and K. b1 &ith only C(E million to invest in its capital budget, Oiege must choose the best combination of 1ro ects A, $, E, ,, and K. $ollectively, the pro ects would account for an investment of C0( million, so naturally not all these pro ects may be accepted. 'ooking at the excess return created by the pro ects *rate of return minus the cost of capital+, we see that the excess returns for 1ro ects A, $, E, ,, and K are 0>, (.@>, ).@>, 0.@>, and E.@>. 3he firm should accept the pro ects which provide the greatest excess returns. !y that rationale, the first pro ect to be eliminated from consideration is 1ro ect E. 3his brings the total investment re"uired down to C(@ million, therefore one more pro ect must be eliminated. 3he next lowest excess return is 1ro ect $. 3herefore, OiegeJs optimal capital budget consists of 1ro ects A, ,, and K, and it amounts to C(0 million. c1 .ince 1ro ects A, ,, and K are already accepted pro ects, we must ad ust the costs of capital for the other two value producing pro ects *$ and E+. 1ro ect $ E 5e"uired %nvestment CE million 9 million 5ate of 5eturn ?.@> (0 .@ $ost of $apital B> 4 (> : ?> (0 > 4 (> : (E >

%f new capital must be issued, 1ro ect E ceases to be an acceptable pro ect. =n the other hand, 1ro ect $Js expected rate of return still exceeds the risk8 ad usted cost of capital even after raising additional capital. Kence, OiegeJs new capital budget should consist of 1ro ects A, $, ,, and K and re"uires C(@ million of capital, so CE million of additional capital must be raised. 10+ 20 a1 After8 tax cost of new debt: r d *( 2 3+ : ).)?*( 2 ).D+ : @.D>. $ost of common e"uity: $alculate g as follows: &ith a financial calculator, input I : ?, 1L : 8E.?), 1;3 : ), ,L : A.B), and then solve for %7M5 : g : B.)(> B>. rs :

D( * ).@@+*C A.B)+ CD.0? 4 g: 4 ).)B : 4 ).)B : ).(D9 : (D.9>. C 9@.)) C9@. )) 1)

Chapter 10: The Cost of Capital

2(2 Answers and Solutions

b1 &A$$ calculation: $omponent Debt G).)?*( 2 3+H $ommon e"uity *5E+ &eight ).D) ).9) After8 tax $ost @.D> (D .9 &eighted $ost 0.(9> B .A9 &A$$: () .?0 > :

Chapter 10: The Cost of Capital

Answers and Solutions 2(3

Co,prehensive5Sprea-shee t $roble,

Note to Instructors: The solution to this proble, is not provi-e- to stu-ents at the bac6 of their te7t1 8nstructors can access the Excel file on the te7tboo69s :eb site or the 8nstructor9s &esource CD1 10+ 21 a1 /0P1T DATA 2P3 P0 Pp Dp D0 ( B-T rd 3k&e4s bet' 5'rket r%sk pre!%$!6 r5 - r77%sk free r'te6 r7T'x r'te -8ot't%o" cost for co!!o"
Cost of debt B-T rd 10% x (1 ; T) 65% = A-T rd 6.50%

$ .*0 $55.00 $ 0.00 $ . 0 $*.10 +% 10% 1.516 5.0% 6.0% 5% 10%

Cost of preferred stock Dp $ . 0 / Pp $ 0.00 = rp 11.00%

Cost of co!!o" e#$%t& fro! ret'%"ed e'r"%"(s D1 $*.*+ / P0 $55.00 ) ( +% = rs 1 .16%

Cost of co!!o" e#$%t& fro! "e, co!!o" stock D0 (1 ) () $*.*+ / P0 < (1 ; -) $.+.50
)

( +%

re 1 .6*%

b1 rs
rs

= =
=

r7-

b 9 7P5 = :.5;%
) ) D%ffere"t%'8 0..6%

6.0%
rs 1 .5;%

=
=

1 .5;%
1..0.%

c1

re

2(4 Comprehensive Spreadshee t !roblem

Chapter 10: The Cost of Capital

-1

<ACC $s%"( ret'%"ed e'r"%"(s ,d ,p ,c *+. % 6.1% 6..6% 100.0% ,d A-T rd ) 1.+0% ,p rp 0.6:% )

Iote that we used the capital structure based on long8 term capital as calculated above.
,c r s ;.6.% = <ACC 11.**% Iote that we used the average of the 0 methods used to calculate r s.

<ACC $s%"( "e, co!!o" stock ,d ,p ,c *+. % 6.1% 6..6% 100.0% ,d A-T rd ) 1.+0% ,p rp 0.6:% ) ,c re ;.+.% =

<ACC 11.51% Iote that we used the average of the 0 methods used to calculate r s.

.kyeJs &A$$ will be ((.00> so long as it finances with debt, preferred stock, and common e"uity raised as retained earnings. %f it expands so rapidly that it uses up all of its retained earnings and must issue new common stock with a cost of (E.BE> *average of D$, and $A1; estimates+, then its &A$$ will increase to ((.@(>.

Chapter 10: The Cost of Capital

Comprehensive Spreadshee t !roblem 2((

8ntegrat e- Case

10+ 22

Cole,an Technologies 8nc1 Cost o" Capital

Cole,an Technologies is consi-ering a ,ajor e7pansion progra , that has been propose- b= the co,pan=9s infor,a tion technolog= group1 >efore procee-ing /ith the e7pansion? the co,pan= ,ust esti,a te its cost of capital1 cost of capital1 ssu,e that =ou are an assistant to @err= Leh,an? !our first tas6 is to esti,a te Cole,an9s the financial vice presi-ent1

Leh,an has provi-e- =ou /ith the follo/ing -ata?

/hich he believes ,a= be relevan t to =our tas6: 11 21 The fir,9s ta7 rate is 40A1 The current price of Cole,an9s 12A coupon? se,iannual

pa=,ent ? noncallable bon-s /ith 1( =ears re,aining to ,aturit= is B1?1 ( 3 1 3 2 1 Cole,an -oes not use short+ ter, interest+ bearing -ebt on a per,ane n t basis1 "e/ bon-s /oul- be privatel= place- /ith no flotation cost1 31 The current price of the fir,9s 10A? B100 par value? Cuarterl= -ivi-en-? perpetual preferr e- stoc6 is B11111 0 1 41 Cole,an9s co,,on stoc6 is currentl= selling for B(0 per share1 8ts last -ivi-en- *D 0 . /as B411 4? an- -ivi-en-s are e7pecte- to gro/ at a constant rate of (A in the foreseeable future1 Cole,an9s beta is 112? the =iel- on T +bon-s is 3A? an- the ,ar6e t ris6 pre,iu, is esti,a t e - to be 2A1 'or the bon-+ =iel-+ plus+ ris6+ pre,iu, approach? the fir, uses a ris6 pre,iu, of 4A1 (1 Cole,an9s targe t capital structur e is 30A -ebt? 10A preferre stoc6? an- 20A co,,on eCuit=1
2(2 Integra te d Case Chapter 10: The Cost of Capital

To structure the tas6 so,e/ ha t? Leh,an has as6e- =ou to ans/er the follo/ing Cuestions1 1 *1. :hat sources of capital shoulbe inclu-e/hen =ou

esti,a t e Cole,an9s : CCD ns/er: ESho/ S10+ 1 through S10+ 3 here1F The : CC is use-

pri,aril= for ,a6ing long+ ter, capital invest,ent -ecisions? i1e1? for capital bu-geting1 Thus? the : CC shoul- inclu-e the t=pes of capital use- to pa= for long+ ter, assets? anthis is t=picall= long+ ter, -ebt? preferre- stoc6 *if use-.? an- co,,on stoc61 Short+ ter, sources of capital consist of *1. spontaneous? noninterest+ bearing liabilities such as accounts pa=able an- accrue- liabilities an- *2. short+ ter, interest+ bearing -ebt? such as notes pa=able1 uses short+ ter, interest+ bearing -ebt to 8f the fir, fi7eacCuire

assets rather than just to finance /or6ing capital nee-s? then the : CC shoul- inclu-e a short+ ter, -ebt co,ponent1 "oninterest+ bearing -ebt is generall= not inclu-e- in the cost of capital esti,ate because these fun-s are nette- out /hen -eter,ining invest,ent nee-s? that is? net operating rather than gross operating /or6ing capital is inclu-e- in capital e7pen-itures1 1 *2. Shoul- the co,ponent costs be figure- on a before+ ta7 or an after+ ta7 basisD ns/er: ESho/ S10+ 4 here1F Stoc6hol-ers are concerne- pri,aril= /ith those corpora te cash flo/s that are available for their use? na,el=? those cash flo/s available to pa= -ivi-en-s or for reinvest, e n t 1 Since -ivi-en-s are paifro, an-

Chapter 10: The Cost of Capital

Integra te d Case 2(3

reinvest, e n t is ,a-e /ith after+ ta7 -ollars? all cash flo/ an- rate of return calculations shoul- be -one on an after+ ta7 basis1 1 *3. Shoul- the costs be historical *e,be--e - . *,arginal. costsD ns/er: ESho/ S10+ ( an- S10+ 2 here1F involve raising ne/ capital1 costs are costs1 >1 :hat is the ,ar6et interest rate on Cole,an9s -ebt an- its co,ponent cost of -ebtD ns/er: ESho/ S10+ 3 through S10+ 4 here1F Thus? its =iel- to ,aturit= is 10A: 0 G +1?1( 3 1 3 2 1 G 20 2 G 20 3 G 20

costs or ne/

8n financial ,anage , e n t ?

the cost of capital is use- pri,aril= to ,a6e -ecisions that Thus? the relevan t co,ponent costs rather than historical to-a=9s ,arginal

Cole,an9s 12A bon-

/ith 1( =ears to ,aturit= is currentl= selling for B1?1 ( 3 1 3 2 1

24 G 20

30 G 20 1?00 0

%nter " H 30? $I H +11(31 3 2 ? $JT H 20? an- 'I H 1000? anthen press the 85!& button to fin- r - 52 H 85!& H (10A1 rate? r - H 10A? the pre+ ta7 cost of -ebt1 Since interest is ta7 -e-uctible? Kncle Sa,? in effect? pa=s part of the cost? an- Cole,an9s relevant co,ponent cost of -ebt is the after+ ta7 cost: r - *1 L T. H 1010A* 1 L 0140. H 1010A* 0 1 2 0 . H 210A1
2() Integra te d Case Chapter 10: The Cost of Capital

Since

this is a se,iannual rate? ,ultipl= b= 2 to fin- the annual

Optional 0uestion
Shoul- =ou use the no,inal cost of -ebt or the effective annual costD ns/er: Our 10A pre+ ta7 esti,a te is the no,inal cost of -ebt1 Since the fir,9s -ebt has se,iannual coupons? its effective annual rate is 1012 ( A: *110 ( .
2

L 110 H 1110 2 ( L 110 H 0110 2 ( H 1012 ( A1 The reason is assu,eto

#o/ever ? no,inal rates are generall= use-1 capital bu-geting cash flo/s are generall=

that the cost of capital is use- in capital bu-geting? anoccur at =ear+ en-1 Therefore? using no,inal rates ,a6es

the treat , e n t of the capital bu-geting -iscount rate ancash flo/s consistent1

C1

*1. :hat is the fir,9s cost of preferr e- stoc6D

ns/er: ESho/ S10+ 10 an- S10+ 11 here1F Since the preferr e- issue is perpetual? its cost is esti,a te - as follo/s: rp H "ote *1.
Dp $p

0 1 1 *B 100 . B 10 H B 111 1 10 H 0104 0 H 410A1 B 111 1 10

that to

since the

preferr ethere that

-ivi-en-s is no

are

not for a

ta7 ta7 the

-e-uctible a-just, e n t ?

issuer?

nee-

an- *2.

/e coul- have

esti,a t e -

effective annual cost of the preferre -? but as in the case of -ebt? the no,inal cost is generall= use-1 C1 *2. Cole,an9s preferre - stoc6 is ris6ier to investors than its -ebt? =et the preferre -9s =iel- to investors is lo/er than the

Chapter 10: The Cost of Capital

Integra te d Case 2(4

=iel- to ,aturit= on the -ebt1

Does this suggest that =ou

have ,a-e a ,ista6eD *#int: Thin6 about ta7es1. ns/er: ESho/ S10+ 12 an- S10+ 13 here1F Corporate investors o/n ,ost preferre - stoc6? because 30A of preferr e- -ivi-en-s receivepreferr e"ote? b= corporations has that are nonta7able1 before+ ta7 =iel=ielto a Therefore? than the often a lo/er the

before+ ta7 =iel- on -ebt though?

issue- b= the sa,e co,pan=1 after+ ta7 corporate

investor an- the after+ ta7 cost to the issuer are higher on preferr e- stoc6 than on -ebt1 D1 *1. :h= is there a cost associate- /ith retaine- earningsD Cole,an9s earnings

ns/er: ESho/ S10+ 14 through S10+ 12 here1F pai- out as -ivi-en-s1

can either be retaine- an- reinveste - in the business or 8f earnings are retaine-? Cole,an9s sharehol-ers forgo the opportunit= to receive cash an- to reinvest it in stoc6s? bon-s? real estate? an- the li6e1 Thus? Cole,an shoul- earn on its retaine- earnings at least as ,uch as its stoc6hol-ers the,selves invest coulearn on o/n :e alterna tive co,pan=9s invest, e n ts of eCuivalent stoc6hol-ers coulris61 'urther? the

in Cole,an9s

co,,on stoc6? /here the= coul- e7pect to earn r s1

conclu-e that retaine- earnings have an opportunit= cost that is eCual to r s? the rate of return investors e7pect on the fir,9s co,,on stoc61 D1 *2. :hat is Cole,an9s esti,a t e - cost of co,,on eCuit= using the C $J approachD

220 Integra te d Case

Chapter 10: The Cost of Capital

ns/er: ESho/ S10+ 13 here1F The C $J esti,a te for Cole,an9s cost of co,,on eCuit= is 1412A: r s H r &' M *r J L r &' .b H 310A M *210A. 1 1 2 H 310A M 312A H 1412A1 %1 :hat is the esti,a te - cost of co,,on eCuit= using the DC' approachD ns/er: ESho/ S10+ 1) through S10+ 20 here1F use-:
rs H N rs

Since Cole,an is a

constant gro/ th stoc6? the constant gro/ th ,o-el can be

D 0 * 1 + g. B 4 1 14 * 1 1 0( . D1 + + 0 1 0( H $0 + g $0 B (0

H 131)A1 '1 :hat is

B 4 1 40 B (0

M 010( H 010) ) M 010( H )1)A M (10A H

the

bon-+ =iel-+ plus+ ris6+ pre,iu,

esti,a te

for

Cole,an9s cost of co,,on eCuit=D ns/er: ESho/ S10+ 21 here1F The bon-+ =iel-+ plus+ ris6+ pre,iu,

esti,ate is 14A: r s H >on- =iel- M &is6 pre,iu, H 1010A M 410A H 1410A1 "ote that -ifficult the ris6 pre,iu, reCuirein this ,ethoonl= provi-es is a

to esti,a te ?

so this approach

ballpar6 esti,a t e of r s1 8t is useful? though? as a chec6 on the DC' an- C $J esti,a tes? /hich can? un-er certain circu,stances? pro-uce unreasonable esti,a t es1 O1 :hat is =our final esti,a t e for r sD

Chapter 10: The Cost of Capital

Integra te d Case 221

ns/er: ESho/ S10+ 22 here1F esti,a t es: JethoC $J DC' r- M rp verage t this point? then it

The follo/ing table su,,ariPes the r s

%sti,ate 14 12A 13 1) 14 10 14 10 A ju-g,ent given little is reCuire-1 /eight or 8f a

consi-erable ,ight be

,etho- is -ee,e- to be inferior -ue to the QCualit=R of its inputs? even -isregar-e -1 average? 8n our e7a,ple? though? the three ,etho-s as our esti,a t e for Cole,an9s cost of

pro-uce- relativel= close results? so /e -eci-e- to use the 14A? co,,on eCuit=1 #1 %7plain in /or-s /h= ne/ co,,on stoc6 has a higher cost than retaine- earnings1 ns/er: ESho/ S10+ 23 here1F The co,pan= is raising ,one= in or-er to ,a6e an invest, e n t 1 The ,one= has a cost? an- this cost is base- pri,aril= on the investors9 reCuire- rate of return? consi-ering ris6 an- alterna tive invest, e n t opportunities1 So? the ne/ invest, e n t 8f the co,pan= ,ust provi-e a return at least capital b= selling stoc6? the eCual to the investors9 opportunit= cost1 raises co,pan= -oesn9t receive all of the ,one= that investors contribute1 'or e7a,ple? if investors put up B100?0 0 0 ? an- if the= e7pect a 1(A return on that B100?0 0 0 ? then B1(?0 0 0 of profits ,ust be generate -1 >ut if flotation costs are 20A *B20?0 0 0 . ? then the co,pan= /ill receive onl= B)0?0 0 0 of the B100?0 0 0
222 Integra te d Case

investors

contribute1

That

B)0?0 0 0

,ust

then

Chapter 10: The Cost of Capital

pro-uce a B1(?00 0 profit? or a B1(5B) 0 H 1)13(A rate of return versus a 1(A return on eCuit= raise- as retaineearnings1 81 *1. :hat are t/o approaches that can be use- to a-just for flotation costsD ns/er: The first approach is to inclu-e the flotation costs as part of the project9s up+ front cost1 This re-uces the project9s esti,a t e - return1 The secon- approach is to a-just the cost of capital to inclu-e flotation costs1 This is ,ost co,,onl= -one b= incorpora ting flotation costs in the DC' ,o-el1 81 *2. Cole,an esti,a t es that if it issues ne/ co,,on stoc6? the flotation flotation cost costs /ill into be 1(A1 DC' Cole,an incorpora tes :hat is the the the approach1

esti,a t e - cost of ne/l= issue- co,,on stoc6? consi-ering the flotation costD ns/er: ESho/ S10+ 24 an- S10+ 2( here1F re H H
D 0 * 1 + g. M g $0 * 1 '.
B 4 1 14 * 1 1 0( . M (10A B (0 * 1 0 1 1( .
B 4 1 40

H B 42 1 (0 M (10A H 1(13 ( A1 @1 :hat is Cole,an9s overall? or /eighte - average? cost of capital *: CC.D 8gnore flotation costs1 ns/er: ESho/ S10+ 22 here1F Cole,an9s : CC is 1111A1 +T
Chapter 10: The Cost of Capital Integra te d Case 223

Capital Structur e :eights 0 13 0 11 0 12 1 10

Co,ponent Costs H $ro-uct 2A 1 1)A 4 0 14 14 ) 14 : CC H 11 11 A

: CC H / - r - *1 L T. M / p r p M / cr s H 013*1 0 A . * 0 1 2 . M 011*4 A . M 012*1 4 A . H 11)A M 014A M )14A H 1111A1 S1 :hat factors influence Cole,an9s co,posite : CCD There are factors that the fir, cannot that the= can control that influence

ns/er: ESho/ S10+ 23 here1F control : CC1 an- those

'actors the fir, cannot control: 8nterest rates Ta7 rates 'actors the fir, can control: Capital structur e polic= Divi-en- polic= 8nvest, e n t polic= L1 Shoul- the co,pan= use the co,posite : CC as the hur-le rate for each of its projectsD %7plain1 ns/er: ESho/ S10+ 2) here1F ris6 of an average "o1 The co,posite : CC reflects the project un-er ta6 e n b= the fir,1 Jar6e t con-itions

Therefore? the : CC onl= represents the Qhur-le rate R for a t=pical project /ith average ris61 -ifferen t ris6s1 reflect the project9s ris61
224 Integra te d Case Chapter 10: The Cost of Capital

Differen t projects have

The project9s : CC shoul- be a-juste- to