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 data.
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 by 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 than one issue outstanding;