In the last four chapters, we explained how risk in! uences prices and required rates
of return on bonds and stocks. A " rm’s primary objective is to maximize its share-
holders’ value. The principal way value is increased is by investing in projects that
earn more than their cost of capital. In the next two chapters, we will see that a proj-
ect’s future cash! ows can be forecasted and that those cash! ows can be discounted
to " nd their present value. Then if the PV of the future cash! ows exceeds the proj-
ect’s cost, the " rm’s value will increase if the project is accepted. However, we need a
discount rate to " nd the PV of the future cash! ows, and that discount rate is the
" rm’s cost of capital. Finding the cost of the capital required to take on new projects
is the primary focus of this chapter.^2
Most formulas used in this chapter were developed earlier, when we examined
the required rates of return on bonds and stocks. Indeed, the rates of return that inves-
tors require on bonds and stocks represent the costs of those securities to the fi rm. As we
shall see, companies estimate the required returns on their securities, calculate a
weighted average of the costs of their di# erent types of capital, and use this average
cost for capital budgeting purposes.
When you " nish this chapter, you should be able to:
- Explain why the weighted average cost of capital (WACC) is used in capital
budgeting.- Estimate the costs of di# erent capital components—debt, preferred stock,
retained earnings, and common stock.- Combine the di# erent component costs to determine the " rm’s WACC.
These concepts are necessary to understand the firm’s capital budgeting process.
10-1 AN OVERVIEW OF THE WEIGHTED AVERAGE COST
OF CAPITAL !WACC"
Table 10-1 shows Allied Food Products’ balance sheet as presented in Chapter 3,
with two additions: (1) the actual capital supplied by investors (banks, bondhold-
ers, and stockholders) and (2) the capital structure that Allied plans to use in the
future. Allied’s overall cost of capital is an average of the costs of the various types
of capital it uses. Allied’s debt costs 10%, it currently uses no preferred stock but
Similarly, each of GE’s divisions has its own level of risk
(hence, its own cost of capital). GE’s overall cost of capital is
an average of its divisions’ costs. For example, GE’s NBC
subsidiary probably has a different cost of capital than its
aircraft engine division; and even within divisions, some
projects are riskier than others. Moreover, overseas projects
may have different risks and thus different costs of capital
than similar domestic projects.
As we will see in this chapter, the cost of capital is an
essential element in the capital budgeting process. This
process is the primary determinant of the firm’s long-run
stock price.P U T T I N G T H I N G S I N P E R S P E C T I V E
Chapter 10 The Cost of Capital 307(^2) If projects di! er in risk, risk-adjusted costs of capital should be used, not one single corporate cost of capital. We
discuss this point later in the chapter.