Adjusting the Cost of Capital for Risk 241
the change in the weights. In Chapter 13 we will discuss this in more depth, and we
will demonstrate that a firm’s optimal capital structure is the one that minimizes its
cost of capital.
Dividend Policy As we shall see in Chapter 14, the percentage of earnings paid out
in dividends may affect a stock’s required rate of return, rs. Also, if a firm’s payout ra-
tio is so high that it must issue new stock to fund its capital budget, this will force it to
incur flotation costs, and this too will affect its cost of capital. This second point is dis-
cussed in detail later in this chapter and also in Chapter 14.
Investment Policy When we estimate the cost of capital, we use as the starting
point the required rates of return on the firm’s outstanding stock and bonds. Those
rates reflect the risk of the firm’s existing assets. Therefore, we have implicitly been as-
suming that new capital will be invested in assets and with the same degree of risk as
existing assets. This assumption is generally correct, as most firms do invest in assets
similar to those they currently use. However, it would be incorrect if a firm dramati-
cally changed its investment policy. For example, if a firm invests in an entirely new
line of business, its marginal cost of capital should reflect the riskiness of that new
business. To illustrate, Time Warner’s merger with AOL undoubtedly increased its
risk and cost of capital.
What three factors that affect the cost of capital are generally beyond the firm’s
control?
What three policies under the firm’s control are likely to affect its cost of
capital?
Explain how a change in interest rates in the economy would affect each compo-
nent of the weighted average cost of capital.
Adjusting the Cost of Capital for Risk
As we have calculated it, the cost of capital reflects the average risk and overall capital
structure of the entire firm. But what if a firm has divisions in several business lines
that differ in risk? Or what if a company is considering a project that is much riskier
Global Variations in the Cost of Capital
For U.S. firms to be competitive with foreign companies,
they must have a cost of capital no greater than that faced by
their international competitors. In the past, many experts ar-
gued that U.S. firms were at a disadvantage. In particular,
Japanese firms enjoyed a very low cost of capital, which low-
ered their total costs and thus made it hard for U.S. firms to
compete. Recent events, however, have considerably nar-
rowed cost of capital differences between U.S. and Japanese
firms. In particular, the U.S. stock market has outperformed
the Japanese market in the last decade, which has made it
easier and cheaper for U.S. firms to raise equity capital.
As capital markets become increasingly integrated, cross-
country differences in the cost of capital are disappearing.
Today, most large corporations raise capital throughout the
world, hence we are moving toward one global capital mar-
ket rather than distinct capital markets in each country. Al-
though government policies and market conditions can af-
fect the cost of capital within a given country, this primarily
affects smaller firms that do not have access to global capital
markets, and even these differences are becoming less im-
portant as time goes by. What matters most is the risk of the
individual firm, not the market in which it raises capital.
238 The Cost of Capital
