Chapter 10 The Cost of Capital 325RiskL RiskA RiskHRisk7.09.010.013.0WACC0Rate of Return
(%)11.0Project LDivision L’s WACCComposite WACCDivision H’s WACCProject HDivisional Cost of Capital
F I G U R E 1 0! 210-10 SOME OTHER PROBLEMS WITH COST
OF CAPITAL ESTIMATES
A number of issues related to the cost of capital have not been mentioned or were
glossed over in this chapter. These topics are covered in advanced! nance courses,
but they deserve mention now to alert you to potential dangers and to provide a
preview of some matters covered in advanced courses.
- Depreciation-generated funds.^21 The largest single source of capital for many
! rms is depreciation, yet we have not discussed how the cost of this capital is
determined. In brief, depreciation cash " ows can either be reinvested or
returned to investors (stockholders and creditors). The cost of depreciation-
generated funds is thus an opportunity cost; and it is approximately equal to
the WACC from retained earnings, preferred stock, and debt. Therefore, we
can ignore it in our estimate of the WACC. - Privately owned! rms. Our discussion of the cost of equity focused on pub-
licly owned corporations, and we have concentrated on the rate of return
required by public stockholders. However, there is a serious question about
how to measure the cost of equity for a! rm whose stock is not traded. Tax
issues are also especially important in these cases. As a general rule, the
same principles of cost of capital estimation apply to both privately held
(^21) See Table 3-3, the statement of cash # ows, for an illustration of the cash # ows provided from depreciation. Refer
to advanced $ nance textbooks for a discussion on the treatment of depreciation-generated funds.