Summary And Conclusions

This chapter has discussed cost of capital. The most important concept is the weighted average cost of capital, or WACC, which we interpreted as the required rate of return on the overall firm. It is also the discount rate appropriate for cash flows that are similar in risk to those of the overall firm. We described how the WACC can be calculated, and we illustrated how it can be used in certain types of analyses.

We also pointed out situations in which it is inappropriate to use the WACC as the discount rate. To handle such cases, we described some alternative approaches to developing discount rates, such as the pure play approach. We also discussed how the flotation costs associated with raising new capital can be included in an NPV analysis.

Ross et al.: Fundamentals I VI. Cost of Capital and I 15. Cost of Capital I I © The McGraw-Hill of Corporate Finance, Sixth Long-Term Financial Companies, 2002

Edition, Alternate Edition Policy

CHAPTER 15 Cost of Capital 517

Chapter Review and Self-Test Problems

15.1 Calculating the Cost of Equity Suppose stock in Watta Corporation has a beta of .80. The market risk premium is 6 percent, and the risk-free rate is 6 percent. Watta's last dividend was $1.20 per share, and the dividend is expected to grow at 8 percent indefinitely. The stock currently sells for $45 per share. What is Watta's cost of equity capital?

15.2 Calculating the WACC In addition to the information given in the previous problem, suppose Watta has a target debt-equity ratio of 50 percent. Its cost of debt is 9 percent, before taxes. If the tax rate is 35 percent, what is the WACC?

15.3 Flotation Costs Suppose in the previous problem Watta is seeking $30 million for a new project. The necessary funds will have to be raised externally. Watta's flotation costs for selling debt and equity are 2 percent and 16 percent, respectively. If flotation costs are considered, what is the true cost of the new project?

Answers to Chapter Review and Self-Test Problems

15.1 We start off with the SML approach. Based on the information given, the expected return on Watta's common stock is:

We now use the dividend growth model. The projected dividend is D0 X (1 + g) = $1.20 X 1.08 = $1.296, so the expected return using this approach is:

Because these two estimates, 10.80 percent and 10.88 percent, are fairly close, we will average them. Watta's cost of equity is approximately 10.84 percent.

15.2 Because the target debt-equity ratio is .50, Watta uses $.50 in debt for every $1 in equity. In other words, Watta's target capital structure is 1/3 debt and 2/3 equity. The WACC is thus:

15.3 Because Watta uses both debt and equity to finance its operations, we first need the weighted average flotation cost. As in the previous problem, the percentage of equity financing is 2/3, so the weighted average cost is:

fA = (E/V) X fe + (D/V) X fD = 2/3 X 16% + 1/3 X 2% = 11.33%

If Watta needs $30 million after flotation costs, then the true cost of the project is $30 million/(1 - fA) = $30 million/.8867 = $33.83 million.

CHAPTER 15 Cost of Capital 517

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

VI. Cost of Capital and Long-Term Financial Policy

15. Cost of Capital

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