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^541
    Companies, 2002

FLOTATION COSTS AND THE WEIGHTED

AVERAGE COST OF CAPITAL

So far, we have not included issue, or flotation, costs in our discussion of the weighted
average cost of capital. If a company accepts a new project, it may be required to issue,
or float, new bonds and stocks. This means that the firm will incur some costs, which we
call flotation costs.The nature and magnitude of flotation costs are discussed in some
detail in Chapter 16.
Sometimes it is suggested that the firm’s WACC should be adjusted upwards to re-
flect flotation costs. This is really not the best approach, because, once again, the re-
quired return on an investment depends on the risk of the investment, not the source of
the funds. This is not to say that flotation costs should be ignored. Because these costs
arise as a consequence of the decision to undertake a project, they are relevant cash
flows. We therefore briefly discuss how to include them in a project analysis.

The Basic Approach

We start with a simple case. The Spatt Company, an all-equity firm, has a cost of equity
of 20 percent. Because this firm is 100 percent equity, its WACC and its cost of equity
are the same. Spatt is contemplating a large-scale $100 million expansion of its existing
operations. The expansion would be funded by selling new stock.

CHAPTER 15 Cost of Capital 513

FIGURE 15.2

Expected

return (%)

20

SML

Beta

WACC = 14

10

Rf = 7

Low risk

(–4%)

Moderate risk

(0%)

A

High risk

(6%)

= 8%

With the subjective approach, the firm places projects into one of several risk classes. The

discount rate used to value the project is then determined by adding (for high risk) or

subtracting (for low risk) an adjustment factor to or from the firm's WACC. This results in

fewer incorrect decisions than if the firm simply used the WACC to make the decisions.

The Security Market Line (SML) and the Subjective Approach

15.6