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
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 dividend discount model 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