238 CHAPTER 6 The Cost of Capital
overall average of these three methods is (14.6% 14.5% 14.4%)/3 14.5%.
These results are unusually consistent, so it would make little difference which one we
used. However, if the methods produced widely varied estimates, then a financial ana-
lyst would have to use his or her judgment as to the relative merits of each estimate
and then choose the estimate that seemed most reasonable under the circumstances.
Recent surveys found that the CAPM approach is by far the most widely used
method. Although most firms use more than one method, almost 74 percent of re-
spondents in one survey, and 85 percent in the other, used the CAPM.^11 This is in
sharp contrast to a 1982 survey, which found that only 30 percent of respondents used
the CAPM.^12 Approximately 16 percent now use the DCF approach, down from 31
percent in 1982. The bond-yield-plus-risk-premium is used primarily by companies
that are not publicly traded.
People experienced in estimating the cost of equity recognize that both careful
analysis and sound judgment are required. It would be nice to pretend that judgment
is unnecessary and to specify an easy, precise way of determining the exact cost of eq-
uity capital. Unfortunately, this is not possible—finance is in large part a matter of
judgment, and we simply must face that fact.Which approach is used most often by businesses today?Composite, or Weighted Average, Cost of Capital, WACC
As we shall see in Chapter 13, each firm has an optimal capital structure, defined as that
mix of debt, preferred, and common equity that causes its stock price to be maximized.
Therefore, a value-maximizing firm will establish a target (optimal) capital structure and
then raise new capital in a manner that will keep the actual capital structure on target
over time. In this chapter, we assume that the firm has identified its optimal capital struc-
ture, that it uses this optimum as the target, and that it finances so as to remain constantly
on target. How the target is established will be examined in Chapter 13.
The target proportions of debt, preferred stock, and common equity, along with the
component costs of capital, are used to calculate the firm’s WACC. To illustrate, sup-
pose NCC has a target capital structure calling for 30 percent debt, 10 percent pre-
ferred stock, and 60 percent common equity. Its before-tax cost of debt, rd, is 11 per-
cent; its after-tax cost of debt is rd(1 T) 11%(0.6) 6.6%; its cost of preferred
stock, rps, is 10.3 percent; its cost of common equity, rs, is 14.5 percent; its marginal tax
rate is 40 percent; and all of its new equity will come from retained earnings. We can
calculate NCC’s weighted average cost of capital, WACC, as follows:(^11) See John R. Graham and Campbell Harvey, “The Theory and Practice of Corporate Finance: Evidence
from the Field,” Journal of Financial Economics,Vol. 60, no. 1, 2001, and the paper cited in Footnote 7. In-
terestingly, a growing number of firms (about 34 percent) also are using CAPM-type models with more
than one factor. Of these firms, over 40 percent include factors for interest-rate risk, foreign exchange risk,
and business cycle risk (proxied by gross domestic product). More than 20 percent of these firms include a
factor for inflation, size, and exposure to particular commodity prices. Less than 20 percent of these firms
make adjustments due to distress factors, book-to-market ratios, or momentum factors.
(^12) See Lawrence J. Gitman and Vincent Mecurio, “Cost of Capital Techniques Used by Major U.S. Firms:
Survey Analysis of Fortune’s 1000, Financial Management, Vol. 14, 1982, 21–29.