Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VI. Cost of Capital and

Long−Term Financial

Policy

(^536) 15. Cost of Capital © The McGraw−Hill
Companies, 2002
508 PART SIX Cost of Capital and Long-Term Financial Policy

TABLE 15.1

Summary of Capital

Cost Calculations

I. The cost of equity,RE

A. Dividend growth model approach (from Chapter 8):

RED 1 /P 0 g

where D 1 is the expected dividend in one period, gis the dividend growth rate,

and P 0 is the current stock price.

B. SML approach (from Chapter 13):

RERf (^) E(RM
Rf)
where Rfis the risk-free rate, RMis the expected return on the overall market,
and (^) Eis the systematic risk of the equity.
II. The cost of debt,RD
A. For a firm with publicly held debt, the cost of debt can be measured as the
yield to maturity on the outstanding debt. The coupon rate is irrelevant. Yield
to maturity is covered in Chapter 7.
B. If the firm has no publicly traded debt, then the cost of debt can be measured
as the yield to maturity on similarly rated bonds (bond ratings are discussed in
Chapter 7).
III. The weighted average cost of capital, WACC
A. The firm’s WACC is the overall required return on the firm as a whole. It is the
appropriate discount rate to use for cash flows similar in risk to those of the
overall firm.
B. The WACC is calculated as:
WACC (E/V) RE(D/V) RD(1
TC)
where TCis the corporate tax rate, Eis the market value of the firm’s equity, D
is the marketvalue of the firm’s debt, and VED.Note that E/Vis the
percentage of the firm’s financing (in market value terms) that is equity, and
D/Vis the percentage that is debt.
Using the WACC
A firm is considering a project that will result in initial aftertax cash savings of $5 million at the
end of the first year. These savings will grow at the rate of 5 percent per year. The firm has a
debt-equity ratio of .5, a cost of equity of 29.2 percent, and a cost of debt of 10 percent. The
cost-saving proposal is closely related to the firm’s core business, so it is viewed as having
the same risk as the overall firm. Should the firm take on the project?
Assuming a 34 percent tax rate, the firm should take on this project if it costs less than $30
million. To see this, first note that the PV is:
PV 
This is an example of a growing perpetuity as discussed in Chapter 6. The WACC is:
WACC (E/V) RE(D/V) RD(1
TC)
2/3 29.2% 1/3 10% (1
.34)
21.67%
The PV is thus:
PV $30 million
The NPV will be positive only if the cost is less than $30 million.
$5 million
.2167
.05
$5 million
WACC
.05
EXAMPLE 15.5