226 CHAPTER 6 The Cost of Capital
Although NCC and other firms try to stay close to their target capital structures,
they frequently deviate in the short run for several reasons. First, market conditions
may be more favorable in one market than another at a particular time. For example,
if the stock market is extremely strong, a company may decide to issue common stock.
The second, and probably more important, reason for deviations relates to flotation
costs, which are the costs that a firm must incur to issue securities. Flotation costs are
addressed in detail later in the chapter, but note that these costs are to a large extent
fixed, so they become prohibitively high if small amounts of capital are raised. Thus,
it is inefficient and expensive to issue relatively small amounts of debt, preferred
stock, and common stock. Therefore, a company might issue common stock one year,
debt in the next couple of years, and preferred the following year, thus fluctuating
around its target capital structure rather than staying right on it all the time.
This situation can cause managers to make a serious error in selecting projects, a
process called capital budgeting. To illustrate, assume that NCC is currently at its tar-
get capital structure, and it is now considering how to raise capital to finance next
year’s projects. NCC could raise a combination of debt and equity, but to minimize
flotation costs it will raise either debt or equity, but not both. Suppose NCC borrows
heavily at 8 percent during 2003 to finance long-term projects that yield 10 percent.
In 2004, it has new long-term projects available that yield 13 percent, well above the
return on the 2003 projects. However, to return to its target capital structure, it must
issue equity, which costs 15.3 percent. Therefore, the company might incorrectly re-
ject these 13 percent projects because they would have to be financed with funds cost-
ing 15.3percent.
However, this entire line of reasoning would be incorrect. Why should a company
accept 10 percent long-term projects one year and then reject 13 percent long-term
projects the next? Note also that if NCC had reversed the order of its financing, rais-
ing equity in 2003 and debt in 2004, it would have reversed its decisions, rejecting all
projects in 2003 and accepting them all in 2004. Does it make sense to accept or reject
projects just because of the more or less arbitrary sequence in which capital is raised?
The answer is no. To avoid such errors, managers should view companies as ongoing concerns,
and calculate their costs of capital as weighted averages of the various types of funds they use,
regardless of the specific source of financing employed in a particular year.
The following sections discuss each of the component costs in more detail, and
then we show how to combine them to calculate the weighted average cost of capital.What are the three major capital components?
What is a component cost?
What is a target capital structure?
Why should the cost of capital used in capital budgeting be calculated as a
weighted average of the various types of funds the firm generally uses rather
than the cost of the specific financing used to fund a particular project?Cost of Debt, rd(1 T)
The first step in estimating the cost of debt is to determine the rate of return
debtholders require, or rd. Although estimating rdis conceptually straightforward,
some problems arise in practice. Companies use both fixed and floating rate debt,
straight and convertible debt, and debt with and without sinking funds, and each form
has a somewhat different cost.
It is unlikely that the financial manager will know at the start of a planning period
the exact types and amounts of debt that will be used during the period: The type or