Introduction to Corporate Finance

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^523
    Companies, 2002

It is a common error to forget this crucial point and fall into the trap of thinking that the
cost of capital for an investment depends primarily on how and where the capital is
raised.

Financial Policy and Cost of Capital

We know that the particular mixture of debt and equity a firm chooses to employ—its
capital structure—is a managerial variable. In this chapter, we will take the firm’s fi-
nancial policy as given. In particular, we will assume that the firm has a fixed debt-eq-
uity ratio that it maintains. This ratio reflects the firm’s target capital structure. How a
firm might choose that ratio is the subject of our next chapter.
From the preceding discussion, we know that a firm’s overall cost of capital will re-
flect the required return on the firm’s assets as a whole. Given that a firm uses both debt
and equity capital, this overall cost of capital will be a mixture of the returns needed to
compensate its creditors and those needed to compensate its stockholders. In other
words, a firm’s cost of capital will reflect both its cost of debt capital and its cost of eq-
uity capital. We discuss these costs separately in the sections that follow.

THE COST OF EQUITY

We begin with the most difficult question on the subject of cost of capital: What is the
firm’s overall cost of equity? The reason this is a difficult question is that there is no
way of directly observing the return that the firm’s equity investors require on their in-
vestment. Instead, we must somehow estimate it. This section discusses two approaches
to determining the cost of equity: the dividend growth model approach and the security
market line, SML, approach.

The Dividend Growth Model Approach

The easiest way to estimate the cost of equity capital is to use the dividend growth model
we developed in Chapter 8. Recall that, under the assumption that the firm’s dividend
will grow at a constant rate g, the price per share of the stock, P 0 , can be written as:

P 0  

where D 0 is the dividend just paid and D 1 is the next period’s projected dividend. Notice
that we have used the symbol RE(the Estands for equity) for the required return on the
stock.
As we discussed in Chapter 8, we can rearrange this to solve for REas follows:
RED 1 /P 0 g [15.1]

Because REis the return that the shareholders require on the stock, it can be interpreted
as the firm’s cost of equity capital.

D 1

RE
g

D 0 (1 g)

RE
g

CONCEPT QUESTIONS

15.1a What is the primary determinant of the cost of capital for an investment?

15.1bWhat is the relationship between the required return on an investment and the

cost of capital associated with that investment?

CHAPTER 15 Cost of Capital 495

15.2

cost of equity

The return that equity

investors require on their

investment in the firm.