COST OF CAPITAL
Answers to Concepts Review and Critical Thinking Questions
It is the minimum rate of return the firm must earn overall on its existing assets. If it earns more than this,
value is created.
Book values for debt are likely to be much closer to market values than are equity book values.
No. The cost of capital depends on the risk of the project, not the source of the money.
Interest expense is tax-deductible. There is no difference between pretax and aftertax equity costs.
The primary advantage of the DCF model is its simplicity. The method is disadvantaged in that (1) the model
is applicable only to firms that actually pay dividends; many do not; (2) even if a firm does pay dividends, the
DCF model requires a constant dividend growth rate forever; (3) the estimated cost of equity from this method
is very sensitive to changes in g, which is a very uncertain parameter; and (4) the model does not explicitly
consider risk, although risk is implicitly considered to the extent that the market has impounded the relevant
risk of the stock into its market price. While the share price and most recent dividend can be observed in the
market, the dividend growth rate must be estimated. Two common methods of estimating g are to use analysts’
earnings and payout forecasts or to determine some appropriate average historical g from the firm’s available
Two primary advantages of the SML approach are that the model explicitly incorporates the relevant risk of
the stock and the method is more widely applicable than is the DCF model, since the SML doesn’t make any
assumptions about the firm’s dividends. The primary disadvantages of the SML method are (1) three
parameters (the risk-free rate, the expected return on the market, and beta) must be estimated, and (2) the
method essentially uses historical information to estimate these parameters. The risk-free rate is usually
estimated to be the yield on very short maturity T-bills and is, hence, observable; the market risk premium is
usually estimated from historical risk premiums and, hence, is not observable. The stock beta, which is
unobservable, is usually estimated either by determining some average historical beta from the firm and the
market’s return data, or using beta estimates provided by analysts and investment firms.
The appropriate aftertax cost of debt to the company is the interest rate it would have to pay if it were to issue
new debt today. Hence, if the YTM on outstanding bonds of the company is observed, the company has an
accurate estimate of its cost of debt. If the debt is privately-placed, the firm could still estimate its cost of debt
by (1) looking at the cost of debt for similar firms in similar risk classes, (2) looking at the average debt cost
for firms with the same credit rating (assuming the firm’s private debt is rated), or (3) consulting analysts and
investment bankers. Even if the debt is publicly traded, an additional complication is when the firm has more