252 CHAPTER 6 The Cost of Capital
Companies generally hire an investment banker to assist them when they is-
sue common stock, preferred stock, or bonds. In return for a fee, the invest-
ment banker helps the company with the terms, price, and sale of the issue.
The banker’s fees are often referred to asflotation costs.The total cost of
capital should include not only the required return paid to investors but also
the flotation fees paid to the investment banker for marketing the issue.
When calculating the cost of new common stock, the DCF approach can be
adapted to account for flotation costs. For a constant growth stock, this cost can be
expressed as: reD 1 /[P 0 (1 F)] g. Note that flotation costs cause reto be greater
than rs.
Flotation cost adjustments can also be made for debt. The bond’s issue price is
reduced for flotation expenses and then used to solve for the after-tax yield to
maturity.
The three equity cost estimating techniques discussed in this chapter have serious
limitations when applied to small firms, thus increasing the need for the small-
business manager to use judgment.The cost of capital as developed in this chapter is used in the following chapters to de-
termine the value of a corporation and to evaluate capital budgeting projects. In addi-
tion, we will extend the concepts developed here in Chapter 13, where we consider the
effect of the capital structure on the cost of capital.Questions
Define each of the following terms:
a.Weighted average cost of capital, WACC; after-tax cost of debt, rd(1 T)
b.Cost of preferred stock, rps; cost of common equity or cost of common stock, rs
c.Target capital structure
d.Flotation cost, F; cost of new external common equity, re
In what sense is the WACC an average cost? A marginal cost?
How would each of the following affect a firm’s cost of debt, rd(1T); its cost of eq-
uity, rs; and its weighted average cost of capital, WACC? Indicate by a plus (), a minus
(), or a zero (0) if the factor would raise, lower, or have an indeterminate effect on the
item in question. Assume other things are held constant. Be prepared to justify your an-
swer, but recognize that several of the parts probably have no single correct answer; these
questions are designed to stimulate thought and discussion.Effect on
rd(1 T) rs WACC
a.The corporate tax rate is lowered.
b.The Federal Reserve tightens credit.
c.The firm uses more debt.
d.The firm doubles the amount of capital
it raises during the year.
e.The firm expands into a risky new area.
f.Investors become more risk averse.Distinguish between beta (or market) risk, within-firm (or corporate) risk, and stand-alone
risk for a potential project. Of the three measures, which is theoretically the most relevant,
and why?6–46–36–26–1