Eastman Chemical is a leading international chemical company and maker of plastic such as that used in soft drink containers. It was created on December 31, 1993, when its former parent company, Eastman Kodak, split off the division as a separate company. Soon thereafter, Eastman Chemical adopted a new motivational program for its employees. Everyone who works for the company, from hourly workers up to the CEO, gets a bonus that depends on the amount by which Eastman's return on capital for the year exceeds its cost of capital. With this approach, Eastman joins a growing number of firms that are tying compensation packages to how good a job the firm does in providing an adequate return for its investors. In this chapter, we learn how to compute a firm's cost of capital and find out what it means to the firm and its investors.

Suppose you have just become the president of a large company and the first decision you face is whether to go ahead with a plan to renovate the company's warehouse distribution system. The plan will cost the company $50 million, and it is expected to save $12 million per year after taxes over the next six years. This is a familiar problem in capital budgeting. To address it, you would determine the relevant cash flows, discount them, and, if the net present value is positive, take on the project; if the NPV is negative, you would scrap it. So far, so good; but what should you use as the discount rate?

From our discussion of risk and return, you know that the correct discount rate depends on the riskiness of the project to renovate the warehouse distribution system. In particular, the new project will have a positive NPV only if its return exceeds what the financial markets offer on investments of similar risk. We called this minimum required return the cost of capital associated with the project.1

Thus, to make the right decision as president, you must examine what the capital markets have to offer and use this information to arrive at an estimate of the project's cost of capital. Our primary purpose in this chapter is to describe how to go about doing this. There are a variety of approaches to this task, and a number of conceptual and practical issues arise.

'The term cost of money is also used.

Ross et al.: Fundamentals VI. Cost of Capital and of Corporate Finance, Sixth Long-Term Financial Edition, Alternate Edition Policy

15. Cost of Capital

© The McGraw-Hill Companies, 2002

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