## Example 156

Based on conversations with its investment banker, Spatt believes its flotation costs will run 10 percent of the amount issued. This means that Spatt's proceeds from the equity sale will be only 90 percent of the amount sold. When flotation costs are considered, what is the cost of the expansion?

As we discuss in more detail in Chapter 16, Spatt needs to sell enough equity to raise \$100 million after covering the flotation costs. In other words:

Amount raised = \$100 million/.90 = \$111.11 million

Spatt's flotation costs are thus \$11.11 million, and the true cost of the expansion is \$111.11 million once we include flotation costs.

Things are only slightly more complicated if the firm uses both debt and equity. For example, suppose Spatt's target capital structure is 60 percent equity, 40 percent debt. The flotation costs associated with equity are still 10 percent, but the flotation costs for debt are less, say, 5 percent.

Earlier, when we had different capital costs for debt and equity, we calculated a weighted average cost of capital using the target capital structure weights. Here, we will do much the same thing. We can calculate a weighted average flotation cost, fA, by multiplying the equity flotation cost, fE, by the percentage of equity (E/V) and the debt flotation cost, fD, by the percentage of debt (D/V) and then adding the two together:

The weighted average flotation cost is thus 8 percent. What this tells us is that for every dollar in outside financing needed for new projects, the firm must actually raise \$1/(1 -.08) = \$1.087. In our example, the project cost is \$100 million when we ignore flotation costs. If we include them, then the true cost is \$100 million/(1 - fA) = \$100 million/.92 = \$108.7 million.

In taking issue costs into account, the firm must be careful not to use the wrong weights. The firm should use the target weights, even if it can finance the entire cost of the project with either debt or equity. The fact that a firm can finance a specific project with debt or equity is not directly relevant. If a firm has a target debt-equity ratio of 1, for example, but chooses to finance a particular project with all debt, it will have to raise additional equity later on to maintain its target debt-equity ratio. To take this into account, the firm should always use the target weights in calculating the flotation cost.

### Calculating the Weighted Average Flotation Cost

The Weinstein Corporation has a target capital structure that is 80 percent equity, 20 percent debt. The flotation costs for equity issues are 20 percent of the amount raised; the flotation costs for debt issues are 6 percent. If Weinstein needs \$65 million for a new manufacturing facility, what is the true cost once flotation costs are considered? We first calculate the weighted average flotation cost, fA:

fA = (E/V) X fE + (D/V) X fD = 80% X .20 + 20% X .06 = 17.2%

The weighted average flotation cost is thus 17.2 percent. The project cost is \$65 million when we ignore flotation costs. If we include them, then the true cost is \$65 million/(1 - A = \$65 million/.828 = \$78.5 million, again illustrating that flotation costs can be a considerable expense.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VI. Cost of Capital and Long-Term Financial Policy

15. Cost of Capital

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VI. Cost of Capital and Long-Term Financial Policy

15. Cost of Capital

Samuel Weaver on Cost of Capital and Hurdle Rates at Hershey Foods Corporation

At Hershey, we reevaluate our cost of capital annually or as market conditions warrant. The

_ calculation of the cost of capital essentially involves three different issues, each with a few alternatives:

• Capital structure weighting Historical book value Target capital structure Market-based weights

Historical (coupon) interest rates Market-based interest rates

• Cost of equity Dividend growth model

Capital asset pricing model, or CAPM

At Hershey, we calculate our cost of capital officially based upon the projected "target" capital structure at the end of our three-year intermediate planning horizon. This allows management to see the immediate impact of strategic decisions related to the planned composition of Hershey's capital pool. The cost of debt is calculated as the anticipated weighted average aftertax cost of debt in that final plan year based upon the coupon rates attached to that debt. The cost of equity is computed via the dividend growth model.

We recently conducted a survey of the 11 food processing companies that we consider our industry group competitors. The results of this survey indicated that the cost of capital for most of these companies was in the 10 to 12 percent range. Furthermore, without exception, all 11 of these companies employed the CAPM when calculating their cost of equity. Our experience has been that the dividend growth model works better for Hershey. We do pay dividends, and we do experience steady, stable growth in our dividends. This growth is also projected within our strategic plan. Consequently, the dividend growth model is technically applicable and appealing to management since it reflects their best estimate of the future long-term growth rate.

In addition to the calculation already described, the other possible combinations and permutations are calculated as barometers. Unofficially, the cost of capital is calculated using market weights, current marginal interest rates, and the CAPM cost of equity. For the most part, and due to rounding the cost of capital to the nearest whole percentage point, these alternative calculations yield approximately the same results.

From the cost of capital, individual project hurdle rates are developed using a subjectively determined risk premium based on the characteristics of the project. Projects are grouped into separate project categories, such as cost savings, capacity expansion, product line extension, and new products. For example, in general, a new product is more risky than a cost savings project. Consequently, each project category's hurdle rate reflects the level of risk and commensurate required return as perceived by senior management. As a result, capital project hurdle rates range from a slight premium over the cost of capital to the highest hurdle rate of approximately double the cost of capital.

Samuel Weaver, Ph.D., was formerly director, financial planning and analysis, for Hershey Chocolate North America. He is a certified management accountant. His position combined the theoretical with the pragmatic and involved the analysis of many different facets of finance in addition to capital expenditure analysis.

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