Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVI. Cost of Capital and
Long−Term Financial
Policy- Cost of Capital © The McGraw−Hill^543
Companies, 2002
Flotation Costs and NPV
To illustrate how flotation costs can be included in an NPV analysis, suppose the Triple-
day Printing Company is currently at its target debt-equity ratio of 100 percent. It is con-
sidering building a new $500,000 printing plant in Kansas. This new plant is expected
to generate aftertax cash flows of $73,150 per year forever. The tax rate is 34 percent.
There are two financing options:
- A $500,000 new issue of common stock. The issuance costs of the new common
stock would be about 10 percent of the amount raised. The required return on the
company’s new equity is 20 percent. - A $500,000 issue of 30-year bonds. The issuance costs of the new debt would be
2 percent of the proceeds. The company can raise new debt at 10 percent.
In Their Own Words...
Samuel Weaver on Cost of Capital and
Hurdle Rates at Hershey Foods CorporationAt Hershey,
we reevaluate
our cost of
capital annually
or as market
conditions
warrant. The
calculation of the
cost of capital
essentially involves three different issues, each with a
few alternatives:
- Capital structure weighting
Historical book value
Target capital structure
Market-based weights - Cost of debt
Historical (coupon) interest rates
Market-based interest rates - Cost of equity
Dividend growth model
Capital asset pricing model, or CAPM
At Hershey, we calculate our cost of capital officially
based upon the projected “target” capital structure at
the end of our three-year intermediate planning
horizon. This allows management to see the immediate
impact of strategic decisions related to the planned
composition of Hershey’s capital pool. The cost of debt
is calculated as the anticipated weighted average
aftertax cost of debt in that final plan year based upon
the coupon rates attached to that debt. The cost of
equity is computed via the dividend growth model.
We recently conducted a survey of the 11 food
processing companies that we consider our industry
group competitors. The results of this survey indicated
that the cost of capital for most of these companies was
in the 10 to 12 percent range. Furthermore, without
exception, all 11 of these companies employed the
CAPM when calculating their cost of equity. Our
experience has been that the dividend growth model
works better for Hershey. We do pay dividends, and we
do experience steady, stable growth in our dividends.
This growth is also projected within our strategic plan.
Consequently, the dividend growth model is technically
applicable and appealing to management since it
reflects their best estimate of the future long-term
growth rate.
In addition to the calculation already described, the
other possible combinations and permutations are
calculated as barometers. Unofficially, the cost of capital
is calculated using market weights, current marginal
interest rates, and the CAPM cost of equity. For the most
part, and due to rounding the cost of capital to the
nearest whole percentage point, these alternative
calculations yield approximately the same results.
From the cost of capital, individual project hurdle
rates are developed using a subjectively determined risk
premium based on the characteristics of the project.
Projects are grouped into separate project categories,
such as cost savings, capacity expansion, product line
extension, and new products. For example, in general, a
new product is more risky than a cost savings project.
Consequently, each project category’s hurdle rate
reflects the level of risk and commensurate required
return as perceived by senior management. As a result,
capital project hurdle rates range from a slight premium
over the cost of capital to the highest hurdle rate of
approximately double the cost of capital.515Samuel Weaver, Ph.D., was formerly director, financial planning and analysis, for Hershey Chocolate North America. He is a certified management accountant. His position com-
bined the theoretical with the pragmatic and involved the analysis of many different facets of finance in addition to capital expenditure analysis.