Chapter 10

The Cost of Capital

Learning Objectives
After reading this chapter, students should be able to:
Explain what is meant by a frms weighted average cost of capital.
Defne and calculate the component costs of debt and preferred stoc. Explain why the
cost of debt is tax ad!usted and the cost of preferred is not.
Explain why retained earnings are not free and use three approaches to estimate the
component cost of retained earnings.
"rie#y explain the two alternative approaches that can be used to account for #otation
costs.
"rie#y explain why the cost of new common e$uity is higher than the cost of retained
earnings, calculate the cost of new common e$uity, and calculate the retained earnings
breapoint%which is the point where new common e$uity would have to be issued.
&alculate the frms composite, or weighted average, cost of capital.
'dentify some of the factors that a(ect the )A&&%dividing them into factors the frm
cannot control and those they can.
"rie#y explain how frms should evaluate pro!ects with di(erent riss, and the problems
encountered when divisions within the same frm all use the frms composite )A&& when
considering capital budgeting pro!ects.
*ist some problems with cost of capital estimates.
Chapter 10: The Cost of Capital Learning Objectives 243
Lecture Suggestions
&hapter +, uses the rate of return concepts covered in previous chapters, along with the
concept of the weighted average cost of capital -)A&&., to develop a corporate cost of
capital for use in capital budgeting.
)e begin by describing the logic of the )A&&, and why it should be used in capital
budgeting. )e next explain how to estimate the cost of each component of capital, and how
to put the components together to determine the )A&&. )e go on to discuss factors that
a(ect the )A&& and how to ad!ust the cost of capital for ris. )e conclude the chapter with a
discussion on some problems with cost of capital estimates.
)hat we cover, and the way we cover it, can be seen by scanning the slides and
'ntegrated &ase solution for &hapter +,, which appears at the end of this chapter solution. /or
other suggestions about the lecture, please see the 0*ecture 1uggestions2 in &hapter 3, where
we describe how we conduct our classes.
D!S O" C#$T%&: 3 O' () D!S *(0+,inute perio-s.
244 Lecture Suggestions Chapter 10: The Cost of Capital
ns/ers to %n-+Of+Chapter 0uestions
10+1 4robable E(ect on
rd-+ 5 6. rs )A&&
a1 6he corporate tax rate is lowered. 7 , 7
b1 6he /ederal 8eserve tightens credit. 7 7 7
c1 6he frm uses more debt9 that is, it increases
its debt:assets ratio. 7 7 ,
-1 6he dividend payout ratio is increased. , , ,
e1 6he frm doubles the amount of capital it raises
during the year. , or 7 , or 7 ,
or 7
f1 6he frm expands into a risy new area. 7 7 7
g1 6he frm merges with another frm whose earnings
are counter;cyclical both to those of the frst frm and
to the stoc maret. 5 5 5
h1 6he stoc maret falls drastically, and the frms stoc
falls along with the rest. , 7 7
i1 'nvestors become more ris averse. 7 7 7
j1 6he frm is an electric utility with a large investment in
nuclear plants. 1everal states propose a ban on
nuclear power generation. 7 7 7
10+2 An increase in the ris;free rate will increase the cost of debt. 8emember from &hapter
<, r = r8/ 7 D84 7 *4 7 >84. 6hus, if r8/ increases so does r -the cost of debt..
1imilarly, if the ris;free rate increases so does the cost of e$uity. /rom the &A4>
e$uation, rs = r8/ 7 -r> 5 r8/.b. &onse$uently, if r8/ increases rs will increase too.
10+3 Each frm has an optimal capital structure, defned as that mix of debt, preferred, and
common e$uity that causes its stoc price to be maximi?ed. A value;maximi?ing frm
will determine its optimal capital structure, use it as a target, and then raise new
capital in a manner designed to eep the actual capital structure on target over time.
6he target proportions of debt, preferred stoc, and common e$uity, along with the
costs of those components, are used to calculate the frms weighted average cost of
capital, )A&&.
6he weights could be based either on the accounting values shown on the frms
balance sheet -boo values. or on the maret values of the di(erent securities.
6heoretically, the weights should be based on maret values, but if a frms boo value
weights are reasonably close to its maret value weights, boo value weights can be
Chapter 10: The Cost of Capital Answers and Solutions 24(
used as a proxy for maret value weights. &onse$uently, target maret value weights
should be used in the )A&& e$uation.
10+4 'n general, failing to ad!ust for di(erences in ris would lead the frm to accept too
many risy pro!ects and re!ect too many safe ones. @ver time, the frm would become
more risy, its )A&& would increase, and its shareholder value would su(er.
6he cost of capital for average;ris pro!ects would be the frms cost of capital,
+,A. A somewhat higher cost would be used for more risy pro!ects, and a lower cost
would be used for less risy ones. /or example, we might use +3A for more risy
pro!ects and BA for less risy pro!ects. 6hese choices are arbitrary.
10+( 6he cost of retained earnings is lower than the cost of new common e$uity9 therefore,
if new common stoc had to be issued then the frms )A&& would increase.
6he calculated )A&& does depend on the si?e of the capital budget. A frm
calculates its retained earnings breapoint -and any other capital breapoints for
additional debt and preferred.. 6his 8:E breapoint represents the amount of capital
raised beyond which new common stoc must be issued. 6hus, a capital budget
smaller than this breapoint would use the lower cost retained earnings and thus a
lower )A&&. A capital budget greater than this breapoint would use the higher cost
of new e$uity and thus a higher )A&&.
Dividend policy has a signifcant impact on the )A&&. 6he 8:E breapoint is
calculated as the addition to retained earnings divided by the e$uity fraction. 6he
higher the frms dividend payout, the smaller the addition to retained earnings and
the lower the 8:E breapoint. -6hat is, the frms )A&& will increase at a smaller
capital budget..
242 Answers and Solutions Chapter 10: The Cost of Capital
Solutions to %n-+Of+Chapter $roble,s
10+1 rd-+ 5 6. = ,.+3-,.<C. = D.E,A.
10+2 4p = FGD.C,9 Dp = FH.E,9 rp = I
rp =
p
p
4
D
=
C, . GD F
E, . H F
= EA.
10+3 G,A Debt9 <,A &ommon e$uity9 rd = BA9 6 = G,A9 )A&& = B.B<A9 rs = I
)A&&= -wd.-rd.-+ 5 6. 7 -wc.-rs.
,.,BB<= -,.G.-,.,B.-+ 5 ,.G. 7 -,.<.rs
,.,BB<= ,.,3+< 7 ,.<rs
,.,DE = ,.<rs
rs = +HA.
10+4 4, = FH,9 D+ = FH.,,9 g = CA9 rs = I
a1 rs =
,
+
4
D
7 g =
,, . H, F
,, . H F
7 ,.,C = +CA.
b1 / = +,A9 re = I
re =
. / + - 4
D
,
+

7 g =
. +, . , + - H, F
,, . H F

7 ,.,C
=
,, . 3D F
,, . H F
7 ,.,C = +<.++A.
10+( 4ro!ects A, ", &, D, and E would be accepted since each pro!ects return is greater than
the frms )A&&.
10+2 a1 rs =
,
+
4
D
7 g =
3H F
+G . 3 F
7 DA = B.HA 7 DA = +<.HA.
b1 rs = r8/ 7 -r> 5 r8/.b
= BA 7 -+HA 5 BA.+.< = BA 7 -GA.+.< = BA 7 <.GA = +C.GA.
c1 rs = "ond rate 7 8is premium = +3A 7 GA = +<A.
-1 1ince you have e$ual confdence in the inputs used for the three approaches, an
average of the three methodologies probably would be warranted.
Chapter 10: The Cost of Capital Answers and Solutions 243
rs =
H
A +< A G . +C A H . +< + +
= +C.BA.
10+3 a1 rs =
,
+
4
D
7 g
=
H< F
+E . H F
7 ,.,<
= +G.EHA.
b1 / = -FH<.,, 5 FH3.G,.:FH<.,, = FH.<,:FH<.,, = +,A.
c1 re = D+:J4,-+ 5 /.K 7 g = FH.+E:FH3.G, 7 <A = B.E+A 7 <A = +C.E+A.
10+) Debt = G,A, &ommon e$uity = <,A.
4, = F33.C,, D, = F3.,,, D+ = F3.,,-+.,D. = F3.+G, g = DA.
rs =
,
+
4
D
7 g =
C, . 33 F
+G . 3 F
7 DA = +<.C+A.
)A&&= -,.G.-,.+3.-+ 5 ,.G. 7 -,.<.-,.+<C+.
= ,.,3EE 7 ,.,BB+ = +3.DBA.
10+4 &apital 1ources Amount &apital 1tructure )eight
*ong;term debt F+,+C3 G,.,A
&ommon E$uity +,D3E <, .,
F3,EE, +,, .,A
)A&&= wdrd-+ 5 6. 7 wcrs = ,.G-,.+H.-,.<. 7 ,.<-,.+<.
= ,.,H+3 7 ,.,B<, = +3.D3A.
10+10 'f the investment re$uires FC.B million, that means that it re$uires FH.CG million -<,A.
of common e$uity and F3.H< million -G,A. of debt. 'n this scenario, the frm would
exhaust its F3 million of retained earnings and be forced to raise new stoc at a cost
of +CA. Leeding F3.H< million in debt, the frm could get by raising debt at only +,A.
6herefore, its weighted average cost of capital is: )A&& = ,.G-+,A.-+ 5 ,.G. 7
,.<-+CA. = ++.GA.
10+11 rs = D+:4, 7 g = F3-+.,D.:F3G.DC 7 DA
= E.<CA 7 DA = +C.<CA.
)A&& = wd-rd.-+ 5 6. 7 wc-rs.9 wc = + 5 wd.
+H.BCA = wd-++A.-+ 5 ,.HC. 7 -+ 5 wd.-+C.<CA.
,.+HBC= ,.,D+Cwd 7 ,.+C<C 5 ,.+C<Cwd
;,.,+D = ;,.,ECwd
wd = ,.3, = 3,A.
24) Answers and Solutions Chapter 10: The Cost of Capital
10+12 a1 rd = +,A, rd-+ 5 6. = +,A-,.<. = <A.
D:A = GCA9 D, = F39 g = GA9 4, = F3,9 6 = G,A.
4ro!ect A: 8ate of return = +HA.
4ro!ect ": 8ate of return = +,A.
rs = F3-+.,G.:F3, 7 GA = +G.G,A.
b1 )A&& = ,.GC-<A. 7 ,.CC-+G.G,A. = +,.<3A.
c1 1ince the frms )A&& is +,.<3A and each of the pro!ects is e$ually risy and as
risy as the frms other assets, >E& should accept 4ro!ect A. 'ts rate of return is
greater than the frms )A&&. 4ro!ect " should not be accepted, since its rate of
return is less than >E&s )A&&.
10+13 'f the frmMs dividend yield is CA and its stoc price is FG<.DC, the next expected
annual dividend can be calculated.
Dividend yield= D+:4,
CA = D+:FG<.DC
D+ = F3.HHDC.
Lext, the frmMs cost of new common stoc can be determined from the D&/ approach
for the cost of e$uity.
re = D+:J4,-+ 5 /.K 7 g
= F3.HHDC:JFG<.DC-+ 5 ,.,C.K 7 ,.+3
= +D.3<A.
10+14 rp =
+C . B3 F
. ++ . , - +,, F
=
+C . B3 F
++ F
= ++.BGA.
10+1( a1 Examining the D&/ approach to the cost of retained earnings, the expected growth
rate can be determined from the cost of common e$uity, price, and expected
dividend. Nowever, frst, this problem re$uires that the formula for )A&& be used
to determine the cost of common e$uity.
)A&&= wd-rd.-+ 5 6. 7 wc-rs.
+H.,A = ,.G-+,A.-+ 5 ,.G. 7 ,.<-rs.
+,.<A = ,.<rs
rs = ,.+D<<D or +D.<DA.
/rom the cost of common e$uity, the expected growth rate can now be
determined.
rs = D+:4, 7 g
,.+D<<D = FH:FHC 7 g
g = ,.,B,BC3 or B.+,A.
Chapter 10: The Cost of Capital Answers and Solutions 244
b1 /rom the formula for the long;run growth rate:
g = -+ 5 Div. payout ratio. 8@E = -+ 5 Div. payout ratio. -L':E$uity.
,.,B,BC3 = -+ 5 Div. payout ratio. -F+,+,, million:F<,,,, million.
,.,B,BC3 = -+ 5 Div. payout ratio. ,.+EHHHHH
,.GB<+,G = -+ 5 Div. payout ratio.
Div. payout ratio = ,.C,HEB< or C,.HBA.
10+12 a1 )ith a fnancial calculator, input L = C, 4O = ;G.G3, 4>6 = ,, /O = <.C,, and then
solve for ':P8 = g = E.,3A EA.
b1 D+ = D,-+ 7 g. = F3.<,-+.,E. = F3.E+.
c1 rs = D+:4, 7 g = F3.E+:FH<.,, 7 EA = +C.E+A.
10+13 a1 rs =
,
+
4
D
7 g
,.,B=
,, . <, F
<, . H F
7 g
,.,B= ,.,< 7 g
g = HA.
b1 &urrent E41 FC.G,,
*ess: Dividends per share H .<,,
8etained earnings per share F+.E,,
8ate of return , .,B,
'ncrease in E41 F,.+<3
4lus: &urrent E41 C .G,,
Lext years E41 FC .C<3
Alternatively, E41+ = E41,-+ 7 g. = FC.G,-+.,H. = FC.C<3.
10+1) a1 rd-+ 5 6. = ,.+,-+ 5 ,.H. = DA.
rp = FC:FGB = +,.3A.
rs = FH.C,:FH< 7 <A = +C.D3A.
b1 )A&&:
After;tax )eighted
&omponent )eight &ost = &ost
Debt J,.+,-+ 5 6.K ,.+C D.,,A +.,CA
4referred stoc ,.+, +,.3, +.,3
&ommon stoc ,.DC +C.D3 ++ .DB
)A&&= +H .E<A
c1 4ro!ects + and 3 will be accepted since their rates of return exceed the )A&&.
2(0 Answers and Solutions Chapter 10: The Cost of Capital
Chapter 10: The Cost of Capital Answers and Solutions 2(1
10+14 a1 'f all pro!ect decisions are independent, the frm should accept all pro!ects whose
returns exceed their ris;ad!usted costs of capital. 6he appropriate costs of capital
are summari?ed below:
8e$uired 8ate of &ost of
4ro!ect 'nvestment 8eturn &apital
A FG million +G.,A +3A
" C million +.C +3
& H million B.C E
D 3 million B., +,
E < million +3.C +3
/ C million +3.C +,
Q < million D., E
N H million ++.C E
6herefore, Riege should accept pro!ects A, &, E, /, and N.
b1 )ith only F+H million to invest in its capital budget, Riege must choose the best
combination of 4ro!ects A, &, E, /, and N. &ollectively, the pro!ects would account
for an investment of F3+ million, so naturally not all these pro!ects may be
accepted. *ooing at the excess return created by the pro!ects -rate of return
minus the cost of capital., we see that the excess returns for 4ro!ects A, &, E, /,
and N are 3A, +.CA, ,.CA, 3.CA, and H.CA. 6he frm should accept the pro!ects
which provide the greatest excess returns. "y that rationale, the frst pro!ect to be
eliminated from consideration is 4ro!ect E. 6his brings the total investment
re$uired down to F+C million, therefore one more pro!ect must be eliminated. 6he
next lowest excess return is 4ro!ect &. 6herefore, RiegeMs optimal capital budget
consists of 4ro!ects A, /, and N, and it amounts to F+3 million.
c1 1ince 4ro!ects A, /, and N are already accepted pro!ects, we must ad!ust the costs
of capital for the other two value producing pro!ects -& and E..
8e$uired 8ate of &ost of
4ro!ect 'nvestment 8eturn &apital
& FH million B.CA EA 7 +A = BA
E < million +3.C +3A 7 +A =+HA
'f new capital must be issued, 4ro!ect E ceases to be an acceptable pro!ect. @n the
other hand, 4ro!ect &Ms expected rate of return still exceeds the ris;ad!usted cost
of capital even after raising additional capital. Nence, RiegeMs new capital budget
should consist of 4ro!ects A, &, /, and N and re$uires F+C million of capital, so FH
million of additional capital must be raised.
10+20 a1 After;tax cost of new debt: rd-+ 5 6. = ,.,B-+ 5 ,.G. = C.GA.
&ost of common e$uity: &alculate g as follows:
)ith a fnancial calculator, input L = B, 4O = ;H.B,, 4>6 = ,, /O = D.E,, and then
solve for ':P8 = g = E.,+A EA.
rs =
,
+
4
D
7 g =
,, . <C F
. E, . D .-F CC . , -
7 ,.,E =
,, . <C F
3B . G F
7 ,.,E = ,.+G< = +G.<A.
2(2 Answers and Solutions Chapter 10: The Cost of Capital
b1 )A&& calculation:
After;tax )eighted
&omponent )eight &ost = &ost
Debt J,.,B-+ 5 6.K ,.G, C.GA 3.+<A
&ommon e$uity -8E. ,.<, +G.< E .D<
)A&&= +, .B3A
Chapter 10: The Cost of Capital Answers and Solutions 2(3
Co,prehensive5Sprea-sheet $roble,
Note to Instructors:
The solution to this proble, is not provi-e- to stu-ents at the bac6 of their te7t1
8nstructors can access the Excel 9le on the te7tboo6:s ;eb site or the 8nstructor:s
&esource CD1
10+21 a1
b1
c1
2(4 ComprehensiveSpreadsheet !roblem Chapter 10: The Cost of Capital
-1
1yeMs )A&& will be ++.33A so long as it fnances with debt, preferred stoc, and
common e$uity raised as retained earnings. 'f it expands so rapidly that it uses up
all of its retained earnings and must issue new common stoc with a cost of
+H.EHA -average of D&/ and &A4> estimates., then its )A&& will increase to
++.C+A.
Chapter 10: The Cost of Capital ComprehensiveSpreadsheet !roblem 2((
Lote that we used the capital structure
based on long;term capital as calculated
above.
Lote that we used the average of
the 3 methods used to calculate
rs.
Lote that we used the average of
the 3 methods used to calculate
rs.
8ntegrate- Case
10+22
Cole,an Technologies 8nc1
Cost o" Capital
Cole,an Technologies is consi-ering a ,ajor e7pansion progra, that
has been propose- b< the co,pan<:s infor,ation technolog< group1
=efore procee-ing /ith the e7pansion> the co,pan< ,ust esti,ate
its cost of capital1 ssu,e that <ou are an assistant to ?err< Leh,an>
the 9nancial vice presi-ent1 !our 9rst tas6 is to esti,ate Cole,an:s
cost of capital1 Leh,an has provi-e- <ou /ith the follo/ing -ata>
/hich he believes ,a< be relevant to <our tas6:
11 The 9r,:s ta7 rate is 40@1
21 The current price of Cole,an:s 12@ coupon> se,iannual
pa<,ent> noncallable bon-s /ith 1( <ears re,aining to ,aturit<
is A1>1(31321 Cole,an -oes not use short+ter, interest+bearing
-ebt on a per,anent basis1 "e/ bon-s /oul- be privatel<
place- /ith no Botation cost1
31 The current price of the 9r,:s 10@> A100 par value> Cuarterl<
-ivi-en-> perpetual preferre- stoc6 is A1111101
41 Cole,an:s co,,on stoc6 is currentl< selling for A(0 per share1
8ts last -ivi-en- *D
0
. /as A4114> an- -ivi-en-s are e7pecte- to
gro/ at a constant rate of (@ in the foreseeable future1
Cole,an:s beta is 112> the <iel- on T+bon-s is 3@> an- the ,ar6et
ris6 pre,iu, is esti,ate- to be 2@1 'or the bon-+<iel-+plus+ris6+
pre,iu, approach> the 9r, uses a ris6 pre,iu, of 4@1
(1 Cole,an:s target capital structure is 30@ -ebt> 10@ preferre-
stoc6> an- 20@ co,,on eCuit<1
2(2 Integrated Case Chapter 10: The Cost of Capital
To structure the tas6 so,e/hat> Leh,an has as6e- <ou to ans/er
the follo/ing Cuestions1
1 *1. ;hat sources of capital shoul- be inclu-e- /hen <ou
esti,ate Cole,an:s ;CCD
ns/er: ESho/ S10+1 through S10+3 here1F The ;CC is use-
pri,aril< for ,a6ing long+ter, capital invest,ent -ecisions>
i1e1> for capital bu-geting1 Thus> the ;CC shoul- inclu-e
the t<pes of capital use- to pa< for long+ter, assets> an-
this is t<picall< long+ter, -ebt> preferre- stoc6 *if use-.>
an- co,,on stoc61 Short+ter, sources of capital consist of
*1. spontaneous> noninterest+bearing liabilities such as
accounts pa<able an- accrue- liabilities an- *2. short+ter,
interest+bearing -ebt> such as notes pa<able1 8f the 9r,
uses short+ter, interest+bearing -ebt to acCuire 97e-
assets rather than just to 9nance /or6ing capital nee-s>
then the ;CC shoul- inclu-e a short+ter, -ebt co,ponent1
"oninterest+bearing -ebt is generall< not inclu-e- in the
cost of capital esti,ate because these fun-s are nette- out
/hen -eter,ining invest,ent nee-s> that is> net operating
rather than gross operating /or6ing capital is inclu-e- in
capital e7pen-itures1
1 *2. Shoul- the co,ponent costs be 9gure- on a before+ta7 or
an after+ta7 basisD
ns/er: ESho/ S10+4 here1F Stoc6hol-ers are concerne- pri,aril<
/ith those corporate cash Bo/s that are available for their
use> na,el<> those cash Bo/s available to pa< -ivi-en-s or
for reinvest,ent1 Since -ivi-en-s are pai- fro, an-
Chapter 10: The Cost of Capital Integrated Case 2(3
reinvest,ent is ,a-e /ith after+ta7 -ollars> all cash Bo/
an- rate of return calculations shoul- be -one on an after+
ta7 basis1
1 *3. Shoul- the costs be historical *e,be--e-. costs or ne/
*,arginal. costsD
ns/er: ESho/ S10+( an- S10+2 here1F 8n 9nancial ,anage,ent> the
cost of capital is use- pri,aril< to ,a6e -ecisions that
involve raising ne/ capital1 Thus> the relevant co,ponent
costs are to-a<:s ,arginal costs rather than historical
costs1
=1 ;hat is the ,ar6et interest rate on Cole,an:s -ebt an- its
co,ponent cost of -ebtD
ns/er: ESho/ S10+3 through S10+4 here1F Cole,an:s 12@ bon-
/ith 1( <ears to ,aturit< is currentl< selling for A1>1(31321
Thus> its <iel- to ,aturit< is 10@:
0 1 2 3 24 30
G G G G G G
+1>1(3132 20 20 20 20 20
1>000
%nter " H 30> $I H +11(3132> $JT H 20> an- 'I H 1000> an-
then press the 85!& button to 9n- r
-
52 H 85!& H (10@1 Since
this is a se,iannual rate> ,ultipl< b< 2 to 9n- the annual
rate> r
-
H 10@> the pre+ta7 cost of -ebt1
Since interest is ta7 -e-uctible> Kncle Sa,> in eLect>
pa<s part of the cost> an- Cole,an:s relevant co,ponent
cost of -ebt is the after+ta7 cost:
r
-
*1 M T. H 1010@*1 M 0140. H 1010@*0120. H 210@1
2() Integrated Case Chapter 10: The Cost of Capital
Optional 0uestion
Shoul- <ou use the no,inal cost of -ebt or the eLective annual costD
ns/er: Our 10@ pre+ta7 esti,ate is the no,inal cost of -ebt1 Since
the 9r,:s -ebt has se,iannual coupons> its eLective
annual rate is 1012(@:
*110(.
2
M 110 H 11102( M 110 H 01102( H 1012(@1
#o/ever> no,inal rates are generall< use-1 The reason is
that the cost of capital is use- in capital bu-geting> an-
capital bu-geting cash Bo/s are generall< assu,e- to
occur at <ear+en-1 Therefore> using no,inal rates ,a6es
the treat,ent of the capital bu-geting -iscount rate an-
cash Bo/s consistent1
C1 *1. ;hat is the 9r,:s cost of preferre- stoc6D
ns/er: ESho/ S10+10 an- S10+11 here1F Since the preferre- issue is
perpetual> its cost is esti,ate- as follo/s:
r
p
H
p
p
$
D
H
10 1 111 A
. 100 *A 1 1 0
H
10 1 111 A
10 A
H 01040 H 410@1
"ote *1. that since preferre- -ivi-en-s are not ta7
-e-uctible to the issuer> there is no nee- for a ta7
a-just,ent> an- *2. that /e coul- have esti,ate- the
eLective annual cost of the preferre-> but as in the case of
-ebt> the no,inal cost is generall< use-1
C1 *2. Cole,an:s preferre- stoc6 is ris6ier to investors than its
-ebt> <et the preferre-:s <iel- to investors is lo/er than the
Chapter 10: The Cost of Capital Integrated Case 2(4
<iel- to ,aturit< on the -ebt1 Does this suggest that <ou
have ,a-e a ,ista6eD *#int: Thin6 about ta7es1.
ns/er: ESho/ S10+12 an- S10+13 here1F Corporate investors o/n
,ost preferre- stoc6> because 30@ of preferre- -ivi-en-s
receive- b< corporations are nonta7able1 Therefore>
preferre- often has a lo/er before+ta7 <iel- than the
before+ta7 <iel- on -ebt issue- b< the sa,e co,pan<1
"ote> though> that the after+ta7 <iel- to a corporate
investor an- the after+ta7 cost to the issuer are higher on
preferre- stoc6 than on -ebt1
D1 *1. ;h< is there a cost associate- /ith retaine- earningsD
ns/er: ESho/ S10+14 through S10+12 here1F Cole,an:s earnings
can either be retaine- an- reinveste- in the business or
pai- out as -ivi-en-s1 8f earnings are retaine-> Cole,an:s
sharehol-ers forgo the opportunit< to receive cash an- to
reinvest it in stoc6s> bon-s> real estate> an- the li6e1 Thus>
Cole,an shoul- earn on its retaine- earnings at least as
,uch as its stoc6hol-ers the,selves coul- earn on
alternative invest,ents of eCuivalent ris61 'urther> the
co,pan<:s stoc6hol-ers coul- invest in Cole,an:s o/n
co,,on stoc6> /here the< coul- e7pect to earn r
s
1 ;e
conclu-e that retaine- earnings have an opportunit< cost
that is eCual to r
s
> the rate of return investors e7pect on the
9r,:s co,,on stoc61
D1 *2. ;hat is Cole,an:s esti,ate- cost of co,,on eCuit< using
the C$J approachD
220 Integrated Case Chapter 10: The Cost of Capital
ns/er: ESho/ S10+13 here1F The C$J esti,ate for Cole,an:s cost
of co,,on eCuit< is 1412@:
r
s
H r
&'
N *r
J
M r
&'
.b
H 310@ N *210@.112 H 310@ N 312@ H 1412@1
%1 ;hat is the esti,ate- cost of co,,on eCuit< using the DC'
approachD
ns/er: ESho/ S10+1) through S10+20 here1F Since Cole,an is a
constant gro/th stoc6> the constant gro/th ,o-el can be
use-:
s
r
H
s
r O
H
g $
D
0
1
+
H
0( 1 0
(0 A
. 0( 1 1 * 14 1 4 A
$
. g 1 * D
0
0
+ +
+
H
(0 A
40 1 4 A
N 010( H 010)) N 010( H )1)@ N (10@ H
131)@1
'1 ;hat is the bon-+<iel-+plus+ris6+pre,iu, esti,ate for
Cole,an:s cost of co,,on eCuit<D
ns/er: ESho/ S10+21 here1F The bon-+<iel-+plus+ris6+pre,iu,
esti,ate is 14@:
r
s
H =on- <iel- N &is6 pre,iu, H 1010@ N 410@ H 1410@1
"ote that the ris6 pre,iu, reCuire- in this ,etho- is
-iPcult to esti,ate> so this approach onl< provi-es a
ballpar6 esti,ate of r
s
1 8t is useful> though> as a chec6 on
the DC' an- C$J esti,ates> /hich can> un-er certain
circu,stances> pro-uce unreasonable esti,ates1
Q1 ;hat is <our 9nal esti,ate for r
s
D
Chapter 10: The Cost of Capital Integrated Case 221
ns/er: ESho/ S10+22 here1F The follo/ing table su,,ariRes the r
s
esti,ates:
Jetho- %sti,ate
C$J 1412@
DC' 131)
r
-
N r
p
14 10
verage 14 10@
t this point> consi-erable ju-g,ent is reCuire-1 8f a
,etho- is -ee,e- to be inferior -ue to the SCualit<T of its
inputs> then it ,ight be given little /eight or even
-isregar-e-1 8n our e7a,ple> though> the three ,etho-s
pro-uce- relativel< close results> so /e -eci-e- to use the
average> 14@> as our esti,ate for Cole,an:s cost of
co,,on eCuit<1
#1 %7plain in /or-s /h< ne/ co,,on stoc6 has a higher cost
than retaine- earnings1
ns/er: ESho/ S10+23 here1F The co,pan< is raising ,one< in or-er
to ,a6e an invest,ent1 The ,one< has a cost> an- this cost
is base- pri,aril< on the investors: reCuire- rate of return>
consi-ering ris6 an- alternative invest,ent opportunities1
So> the ne/ invest,ent ,ust provi-e a return at least
eCual to the investors: opportunit< cost1
8f the co,pan< raises capital b< selling stoc6> the
co,pan< -oesn:t receive all of the ,one< that investors
contribute1 'or e7a,ple> if investors put up A100>000> an- if
the< e7pect a 1(@ return on that A100>000> then A1(>000 of
pro9ts ,ust be generate-1 =ut if Botation costs are 20@
*A20>000.> then the co,pan< /ill receive onl< A)0>000 of the
A100>000 investors contribute1 That A)0>000 ,ust then
222 Integrated Case Chapter 10: The Cost of Capital
pro-uce a A1(>000 pro9t> or a A1(5A)0 H 1)13(@ rate of
return versus a 1(@ return on eCuit< raise- as retaine-
earnings1
81 *1. ;hat are t/o approaches that can be use- to a-just for
Botation costsD
ns/er: The 9rst approach is to inclu-e the Botation costs as part of
the project:s up+front cost1 This re-uces the project:s
esti,ate- return1 The secon- approach is to a-just the cost
of capital to inclu-e Botation costs1 This is ,ost co,,onl<
-one b< incorporating Botation costs in the DC' ,o-el1
81 *2. Cole,an esti,ates that if it issues ne/ co,,on stoc6> the
Botation cost /ill be 1(@1 Cole,an incorporates the
Botation costs into the DC' approach1 ;hat is the
esti,ate- cost of ne/l< issue- co,,on stoc6> consi-ering
the Botation costD
ns/er: ESho/ S10+24 an- S10+2( here1F
r
e
H
. ' 1 * $
. g 1 * D
0
0

+
N g
H
. 1( 1 0 1 * (0 A
. 0( 1 1 * 14 1 4 A

N (10@
H
(0 1 42 A
40 1 4 A
N (10@ H 1(13(@1
?1 ;hat is Cole,an:s overall> or /eighte- average> cost of
capital *;CC.D 8gnore Botation costs1
ns/er: ESho/ S10+22 here1F Cole,an:s ;CC is 1111@1
+T
Chapter 10: The Cost of Capital Integrated Case 223
Capital Structure Co,ponent
;eights Costs H $ro-uct
013 2@ 11)@
011 4 014
0 12 14 ) 14
110 ;CCH 11 11@
;CCH /
-
r
-
*1 M T. N /
p
r
p
N /
c
r
s
H 013*10@.*012. N 011*4@. N 012*14@.
H 11)@ N 014@ N )14@ H 1111@1
U1 ;hat factors inBuence Cole,an:s co,posite ;CCD
ns/er: ESho/ S10+23 here1F There are factors that the 9r, cannot
control an- those that the< can control that inBuence
;CC1
'actors the 9r, cannot control:
8nterest rates
Ta7 rates
'actors the 9r, can control:
Capital structure polic<
Divi-en- polic<
8nvest,ent polic<
L1 Shoul- the co,pan< use the co,posite ;CC as the hur-le
rate for each of its projectsD %7plain1
ns/er: ESho/ S10+2) here1F "o1 The co,posite ;CC reBects the
ris6 of an average project un-erta6en b< the 9r,1
Therefore> the ;CC onl< represents the Shur-le rateT for
a t<pical project /ith average ris61 DiLerent projects have
-iLerent ris6s1 The project:s ;CC shoul- be a-juste- to
reBect the project:s ris61
224 Integrated Case Chapter 10: The Cost of Capital
Jar6et con-itions