CP

246 CHAPTER 6 The Cost of Capital

The first step is to determine the divisional cost of capital, and then to group divi-

sional projects into subjective risk categories. Then, using the divisional WACC as a

starting point, risk-adjusted costs of capital are developed for each category. For ex-

ample, a firm might establish three risk classes—high, average, and low—then assign

average-risk projects the divisional cost of capital, higher-risk projects an above-

average cost, and lower-risk projects a below-average cost. Thus, if a division’s WACC

were 10 percent, its managers might use 10 percent to evaluate average-risk projects in

the division, 12 percent for high-risk projects, and 8 percent for low-risk projects.

While this approach is better than not risk adjusting at all, these risk adjustments are

necessarily subjective and somewhat arbitrary. Unfortunately, given the data, there is

no completely satisfactory way to specify exactly how much higher or lower we should

go in setting risk-adjusted costs of capital.

What are the three types of project risk?

Which type of risk is theoretically the most relevant? Why?

Describe a procedure firms can use to develop costs of capital for projects with

differing degrees of risk.

Adjusting the Cost of Capital for Flotation Costs

Most debt is privately placed, and most equity is raised internally as retained earnings.

In these cases, there are no flotation costs, hence the component costs of debt and eq-

uity should be estimated as discussed earlier. However, if companies issue debt or new

stock to the public, then flotation costs can become important. In the following sec-

tions, we explain how to estimate the component costs of publicly issued debt and

stock, and we show how these new component costs affect the marginal cost of capital.

Axis Goods Inc., a retailer of trendy sportswear, has a target capital structure of 45

percent debt, 2 percent preferred stock, and 53 percent common stock. Its common

stock sells for $23, the next expected dividend is $1.24, and the expected constant

growth rate is 8 percent. Based on the constant growth DCF model, Axis’ cost of com-

mon equity is rs13.4% when the equity is raised as retained earnings. Axis’ cost of

preferred stock is 10.3 percent, based on the method discussed in the chapter, which

incorporates flotation costs. In the following sections, we examine the effects of flota-

tion costs on the component costs of debt and common stock, and on the marginal

cost of capital.

Flotation Costs and the Component Cost of Debt

Axis can issue a 30-year, $1,000 par value bond with an interest rate of 10 percent,

paid annually. Here T  40%, so the after-tax component cost of debt is

rd(1.0 
0.4)10% 6.0%. However, if Axis must incur flotation costs, F, of 1 per-

cent of the value of the issue, then this formula must be used to find the after-tax cost

of debt:

(6-8)

Here M is the bond’s par value, F is the flotation percentage, N is the bond’s maturity,

T is the firm’s tax rate, INT is the dollars of interest per period, and rdis the

M(1
F) a

N

t 1

INT(1
T)

(1rd)t



M

(1rd)N

.

The Cost of Capital 243