RISK, COST OF CAPITAL, AND CAPITAL
Answers to Concepts Review and Critical Thinking Questions
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.
You are assuming that the new project’s risk is the same as the risk of the firm as a whole, and that
the firm is financed entirely with equity.
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 arises when the firm has more than one issue
outstanding; these issues rarely have the same yield because no two issues are ever completely
This only considers the dividend yield component of the required return on equity.
This is the current yield only, not the promised yield to maturity. In addition, it is based on the
book value of the liability, and it ignores taxes.
Equity is inherently riskier than debt (except, perhaps, in the unusual case where a firm’s assets
have a negative beta). For this reason, the cost of equity exceeds the cost of debt. If taxes are
considered in this case, it can be seen that at reasonable tax rates, the cost of equity does exceed
the cost of debt.