258 CHAPTER 6 The Cost of Capitali. What factors influence a company’s WACC?
j. Should the company use the composite WACC as the hurdle rate for each of its divisions?
k. What procedures are used to determine the risk-adjusted cost of capital for a particular di-
vision? What approaches are used to measure a division’s beta?- Cox is interested in establishing a new division, which will focus primarily on developing
new Internet-based projects. In trying to determine the cost of capital for this new division,
you discover that stand-alone firms involved in similar projects have on average the follow-
ing characteristics:
Their capital structure is 10 percent debt and 90 percent common equity.
Their cost of debt is typically 12 percent.
The beta is 1.7.
Given this information, what would your estimate be for the division’s cost of capital?
m. What are three types of project risk? How is each type of risk used?
n. Explain in words why new common stock that is raised externally has a higher percentage
cost than equity that is raised internally by reinvesting earnings.
o. (1) Cox estimates that if it issues new common stock, the flotation cost will be 15 percent.
Cox incorporates the flotation costs into the DCF approach. What is the estimated cost
of newly issued common stock, taking into account the flotation cost?
(2) Suppose Cox issues 30-year debt with a par value of $1,000 and a coupon rate of 10 per-
cent, paid annually. If flotation costs are 2 percent, what is the after-tax cost of debt for
the new bond issue?
p. What four common mistakes in estimating the WACC should Cox avoid?
Selected Additional References and Cases
For a comprehensive treatment of the cost of capital, see
Ehrhardt, Michael C., The Search for Value: Measuring the
Company’s Cost of Capital (Boston: Harvard Business
School Press, 1994).The following articles provide some valuable insights into the
CAPM approach to estimating the cost of equity:
Amihud, Yakov, and Haim Mendelson, “Liquidity and Cost
of Capital: Implications for Corporate Management,”
Journal of Applied Corporate Finance, Fall 1989, 65–73.
Boudreaux, Kenneth J., and Hugh W. Long; John R. Ezzell
and R. Burr Porter; Moshe Ben Horim; and Alan C.
Shapiro, “The Weighted Average Cost of Capital: A Dis-
cussion,” Financial Management, Summer 1979, 7–23.
Bowman, Robert G., “The Theoretical Relationship be-
tween Systematic Risk and Financial (Accounting) Vari-
ables,” Journal of Finance, June 1979, 617–630.
Brigham, Eugene F., Dilip K. Shome, and Steve R. Vinson,
“The Risk Premium Approach to Measuring a Utility’s
Cost of Equity,” Financial Management, Spring 1985,
33–45.
Chen, Andrew, “Recent Developments in the Cost of Debt
Capital,” Journal of Finance, June 1978, 863–883.
Chen, Carl R., “Time-Series Analysis of Beta Stationarity
and Its Determinants: A Case of Public Utilities,” Finan-
cial Management, Autumn 1982, 64–70.
Cooley, Philip L., “A Review of the Use of Beta in Regula-
tory Proceedings,” Financial Management, Winter 1981,
75–81.
Harris, Robert S., and Felecia C. Marston, “Estimating
Shareholder Risk Premia Using Analysts’ Growth Fore-
casts,” Financial Management, Summer 1992, 63–70.
Nantell, Timothy J., and C. Robert Carlson, “The Cost of
Capital as a Weighted Average,” Journal of Finance, De-
cember 1975, 1343–1355.
Siegal, Jeremy J., “The Application of DCF Methodology
for Determining the Cost of Equity Capital,” Financial
Management, Spring 1985, 46–53.
Taggart, Robert A., Jr., “Consistent Valuation and Cost of
Capital Expressions with Corporate and Personal Taxes,”
Financial Management, Autumn 1991, 8–20.
Timme, Stephen G., and Peter C. Eisemann, “On the Use
of Consensus Forecasts of Growth in the Constant
Growth Model: The Case of Electric Utilities,” Financial
Management, Winter 1989, 23–35.
The following cases in the Cases in Financial Management se-
ries cover concepts related to the cost of capital:
Case 4A, “West Coast Semiconductor;” Case 4B, “Ace Re-
pair;” Case 4C, “Premier Paint & Body;” Case 6, “Ran-
dolph Corporation;” and Case 57, “Auto Hut.”