Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VI. Cost of Capital and

Long−Term Financial

Policy

15. Cost of Capital © The McGraw−Hill^521
    Companies, 2002

CHAPTER

15

Cost of Capital

Eastman Chemicalis a leading international chemical company and maker of

plastic such as that used in soft drink containers. It was created on December

31, 1993, when its former parent company, Eastman Kodak, split off the division

as a separate company. Soon thereafter, Eastman Chemical adopted a new

motivational program for its employees. Everyone who works for the company,

from hourly workers up to the CEO, gets a bonus that depends on the amount

by which Eastman’s return on capital for the year exceeds its cost of capital. With

this approach, Eastman joins a growing number of firms that are tying

compensation packages to how good a job the firm does in providing an

adequate return for its investors. In this chapter, we learn how to compute a

firm’s cost of capital and find out what it means to the firm and its investors.

uppose you have just become the president of a large company and the first deci-

sion you face is whether to go ahead with a plan to renovate the company’s ware-

house distribution system. The plan will cost the company $50 million, and it is

expected to save $12 million per year after taxes over the next six years.

This is a familiar problem in capital budgeting. To address it, you would determine

the relevant cash flows, discount them, and, if the net present value is positive, take on

the project; if the NPV is negative, you would scrap it. So far, so good; but what should

you use as the discount rate?

From our discussion of risk and return, you know that the correct discount rate de-

pends on the riskiness of the project to renovate the warehouse distribution system. In

particular, the new project will have a positive NPV only if its return exceeds what the

financial markets offer on investments of similar risk. We called this minimum required

return the cost of capitalassociated with the project.^1

Thus, to make the right decision as president, you must examine what the capital

markets have to offer and use this information to arrive at an estimate of the project’s

cost of capital. Our primary purpose in this chapter is to describe how to go about doing

this. There are a variety of approaches to this task, and a number of conceptual and prac-

tical issues arise.

S

(^1) The term cost of moneyis also used.
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