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PART SIX
11 Calculating the Cost

of Capital
viewpoints
Business Application
Stream Devices, Inc., is about to launch a new project to create and market a combination streaming music-video projector.
Stream Devices currently uses a particular mixture of debt, common stock, and preferred shares in its capital structure, but the
firm is thinking of using the launch of the new project as an opportunity to change that capital structure.
The new project will be funded with 40 percent debt, 10 percent preferred stock, and 50 percent common stock. Stream
Devices currently has 10 million shares of common stock outstanding, selling at $18.75 per share, and expects to pay an
annual dividend of $1.35 one year from now, after which future dividends are expected to grow at a constant 6 percent rate.
Stream’s current debt consists of 20-year, 10 percent annual coupon bonds with a face value of $150 million and a market
value of $165 million, and the company’s capital mix also includes 100,000 shares of 10 percent preferred stock selling at par.
If Stream Devices faces a marginal tax rate of 21 percent, and estimates that it can take full advantage of the interest tax
shields on debt, what weighted average cost of capital should it use as it evaluates this project? (See the solution at the end
of the chapter.)
Personal Application
MacKenzie is currently finishing up her bachelor’s degree and is considering going back to grad school for a master’s degree.
She currently has $17,125 in student loans carrying an 8 percent interest rate from her bachelor’s degree and estimates that
she will need to take out an additional $29,000 in student loans (at the same interest rate) to make it through the master’s
program she’d like to attend. The IRS allows taxpayers with student loans to deduct the interest on those loans, but only up
to a maximum amount of $2,500 per year. Assuming that Mackenzie will face a marginal personal tax rate of 22 percent when
she graduates, what will be the average after-tax interest rate that she will be paying on the student loans immediately after
she graduates with her master’s? (See the solution at the end of the chapter.)
How else can Mackenzie finance her

graduate degree? What will happen to
her after-tax interest rate?
372
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Photodisc/Getty Images
I
n the previous two chapters, we as the cost of capital for evaluating the average rate of return that the
discussed investors’ required decisions about investing the firm’s firm must earn from existing opera-
return given a particular risk capital. Since firms seldom use equal tions when we don’t expect the firm’s
profile. In this chapter, we examine amounts of debt and equity capital capital structure to change, we can
the question from the firm’s point of sources, we will need to calculate this calculate the WACC using the firm’s
view: How much must the firm pay as a weighted average, with weights current capital structure and existing
to finance its operations and expan- based on the proportion of debt and component costs; however, if we’re
sions using debt and equity sources? equity capital used. trying to determine the average rate
Firms use a combination of debt and As we’ll see, we can measure such of return that we would need to earn
equity sources to fund their opera- a weighted-average cost of capital from a new project in order for it to
tions, projects, and any expansions (WACC) in a variety of situations and add value to the firm, we would want
they may undertake. In Chapter 14, for a number of purposes. For exam- to use the project’s proposed capital
we’ll explore the factors that manag- ple, if we’re interested in determining structure and its component costs.
ers consider as they choose the opti-
mal capital structure mix. For now,
we’ll assume that management has Learning Goals
chosen the optimal mix for us, and
that it’s our job to implement it. LG11-1 Understand the relation- LG11-5 Identify which elements of
ship of cost of capital to the WACC are used to calculate a
investor’s required return. project-specific WACC.
LG11-1 As we’ve seen in previous
LG11-2 Use the weighted-average LG11-6 Evaluate trade-offs between
chapters, investors face different cost of capital (WACC) a firmwide WACC and a
kinds of risks associated with debt, formula to calculate a proj- divisional cost of capital
preferred stock, and equity. As a ect’s cost of capital. approach.
result, their required rates of return LG11-3 Explain how the firm LG11-7 Distinguish subjective and
chooses among estimating objective approaches to divi-
for each debt or equity source differ
costs of equity, preferred sional cost of capital.
as well. So, as the firm uses a combi- stock, and debt. LG11-8 Demonstrate how to adjust
nation of different financing sources, LG11-4 Calculate the weights used the WACC to reflect flotation
we must calculate the investors’ aver- for WACC projections. costs.
age required rate of return to use
373
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weighted-average cost One important point about the component costs to be used in the firm’s computation
of capital (WACC) of the average required rate of return is that dividends paid to either common or preferred
The weighted-average stockholders are not tax deductible, but interest paid to debt holders is tax deductible, up
after-tax cost of the capital to a certain point.
used by a firm, with weights
set equal to the relative We will go into more detail later in this chapter concerning when and how much debt
percentage of each type of interest is tax deductible, but, for now, the important point is this: since at least a portion
capital used. of the firm’s payments to its debt holders is tax deductible, those payments are, in effect,
being at least partially subsidized by the government: If the firm hadn’t paid out that inter-
component costs
est rate to the debt holders, it would have had to have paid out taxes to the government on
The individual costs of each the money it used to pay the interest. And, to the extent that that subsidy on debt means that
type of capital—bonds, pre-
ferred stock, and common it’s a relatively cheap source of capital, firms should, and will, take advantage of it.
stock.
LG11-2 ∙
11.1 The WACC Formula
Until recently, calculating the average cost per dollar of capital raised, referred to as the
weighted average cost of capital (WACC), was a fairly simple proposition. However, the
Tax Cut and Jobs Act (TCJA) of 2017, discussed previously, had significant direct and
indirect effects on the calculation of the WACC, which make the calculation a little more
complicated than it was before.
First, the reduction of corporate tax rates to a flat 21 percent rate means that the after-
tax cost of debt, even though still subsidized through the deductibility of interest for
most firms, is not as subsidized as it previously was. That is, debt is still cheap relative to
equity and preferred stock, but it’s not as relatively cheap as it used to be.
In addition, the TCJA also placed constraints on when firms can deduct those interest
payments. Previously, any interest paid on a firm’s debt was generally completely deduct-
ible. However, starting with tax years beginning after December 31, 2017, businesses with
revenues of more that $25 million are only allowed to deduct for tax purposes interest
expenses totaling up to 30 percent of “adjustable taxable income.” For tax years ending
in 2018–2021, adjustable taxable income is defined as income with allowable deductions
for depreciation, amortization, and depletion added back in (i.e., EBITDA); for tax years
ending in 2022 and later, adjustable taxable income will be set equal to EBIT.
Any business interest expense that is disallowed under this limitation in a particular
tax year can still be carried forward as an expense in subsequent tax years, but “pushing
back” the tax deductibility of such interest payments is obviously going to reduce the
present value of those tax deductions and, potentially, change exactly how much debt the
firm decides to use.
Together, these new rules present us with three possible scenarios concerning how
debt interest will be treated:
1. The unconstrained scenario: For most firms, including those with revenues less
than $25 million per year, and the vast majority of healthy, publicly traded firms,
we think that interest on all their debt will be fully tax deductible.
2. The fully constrained scenario: For firms that have so much debt that at least 30
percent of their EBITDA or EBIT (as appropriate) is already claimed by existing
debt issues for the foreseeable future, the likelihood of being able to take advan-
tage of the interest tax shield on a new debt issue for such firms is either so low or
so far away in the future that it might as well not even exist.
3. The uncertain scenario: For firms that more or less fall in the middle of the other
two scenarios, being unable to immediately take full advantage of the tax inter-
est shields during the period when the interest payments are made, but also being
expected to be able to use those interest tax shields at some near-term time in the
future, means that the impact of the interest tax shields will fall somewhere in the
middle between the first two scenarios.
374 part six Capital Budgeting
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Of these three scenarios, the third, uncertain, one is the one most difficult to model,
as questions concerning exactly how long the delays between each interest payment and
the firm being able to use the tax shield are, what the expected future EBITDA or EBIT
levels are, and so forth, make finding a closed-form solution for the impact of the cumula-
tive tax shields on the WACC beyond the focus of this discussion.
Accordingly, we will leave the discussion of the third scenario to more advanced
texts, and will instead focus on analyzing the first two situations. The WACC for the
unconstrained scenario, where firms can make full and immediate use of the interest tax
shields as soon as the interest payments are made, is shown below in equation 11-1, while
the formula for the full constrained scenario, for firms that cannot make use of any of the
interest tax shields, is shown below in equation 11-2:
WAC C Unconstrained = Percentage of equity × Cost of equity

+ Percentage of preferred stock × Cost of preferred stock
     
    + Percentage of debt × After-tax cost of debt
     
     (11-1)
E P D
= _______________
      × i E + _______________
       × i P + _______________
       × i D × (1 − T C)
E + P + D E + P + D E + P + D
WAC C Constrained = Percentage of equity × Cost of equity

+ Percentage of preferred stock × Cost of preferred stock
    + Percentage of debt × After-tax cost of debt
     
     
       (11-2)
E P D
=  _______     × i E +  _______
    × i P +  _______
    × i D
E + P + D E + P + D E + P + D
where
E = Market value of equity used in financing the relevant project or firm.
P = Market value of preferred stock used.
D = Market value of debt used.
_________
  E     = Percentage of financing that is equity.
E+P+D
_________
  P     = Percentage of financing that is preferred stock.
    
      E + P +   
      D
   
    
  
    
      
     
_________
  D     = Percentage of financing that is debt.
E+P+D
iE = Cost of equity.
iP = Cost of preferred stock.
iD = Before-tax cost of debt.
TC = The marginal corporate tax rate.
Notice that we use weights based on market values rather than book values because
market values reflect investors’ assessment of what they would be willing to pay for
the various types of securities, while book values would reflect what was paid for such
securities at varying times in the past. Since we’re interested in coming up with the
cost of capital for new investments in the firm or its projects, using market values here
makes more sense.
Calculating the Component Cost of Equity LG11-3

We could calculate iE using the capital asset pricing model, as discussed in Chapter 10:
i E = R f + β(R M − R f) (11-3)
chapter 11 Calculating the Cost of Capital 375
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S PREADSHEET T IP
WACC in Excel
In this text, we normally try to stay away from using Excel “templates” (i.e., worksheets
that already have most of the calculations coded in, and where you have to simply type
in the inputs) and instead prefer to show you how to build the worksheet you need
“from the ground up,” building on the built-in Excel functions. However, this chapter will
be a rare exception to that rule: With the exception of the calculation of iD, most of our
calculations will be custom formulas, and, in fact, the same custom formulas throughout
most of the material, so we will make heavy use of templates such as the one shown
below (in addition to any supporting calculations necessary to calculate the component
costs of equity, preferred stock, and debt).
Notice that, once we have the costs and the weights of the components, calculating
WACC involves merely taking a weighted average.
Microsoft Excel
Or we can assume that the equity in question is a constant-growth stock such as the
ones we modeled in Chapter 8. Under this assumption, we can solve the constant-growth
model for iE:
D 
i E =  ___1  + g (11-4)
P 0
Which way is better? Well, theoretically, both should give us the same answer, but
depending on the situation, some pragmatic reasons may dictate your choice.
1. In situations where you do not have sufficient historic observations to estimate β
(i.e., when the stock is fairly new), or when you suspect that the past level of the
stock’s systematic (or market) risk might not be a good indicator of the future risk,
you do not want to use the CAPM. Using calculated historic systematic risk when it
is not a good estimate of βE, estimated future systematic risk, will not work too well.
2. In situations where you can expect constant dividend growth, the constant-growth
model is appropriate. But although you can try to adjust the model for stocks with-
out constant dividend growth, doing so may introduce potentially sizable errors, so
it is not the best choice for stocks that increase their dividends irregularly.
cor01589_ch11_372-405.indd 376 10/09/21 03:10 PM

Overall, we should expect that the CAPM approach to estimating iE will apply more
accurately in most cases. However, if you do encounter a situation in which the constant-
growth model applies, then you can certainly use it. If we are really fortunate and happen
to have enough information to use both approaches, then we should probably use both,
taking an average of the resulting estimates of iE.1
LG11-2
EXAMPLE 11-1
Cost of Equity For interactive versions

of this example, log in
ADK Industries’ common shares sell for $32.75 per share. ADK expects to set its next to Connect or go to
mhhe.com/Cornett6e.
annual dividend at $1.54 per share. If ADK expects future dividends to grow by 6 percent
per year, indefinitely, the current risk-free rate is 3 percent, the expected return on the mar-
ket is 9 percent, and the stock has a beta of 1.3, what should be the firm’s cost of equity?
SOLUTION: The cost of equity using the CAPM will be
i E = R f + β(R M − R f)
   
   
=  0.03 + 1.3[0.09 − 0.03
  ]
= 0.1080, or 10.80%
The cost of equity using the constant-growth model will be

D 
i E = ___
  1   + g
P 0
      ______
$1.54  
=      
+ 0.06
$32.75
= 0.1070, or 10.70%
10.70% + 10.80%
Our best estimate of ADKs equity would therefore be _______________
        
= 10.75% .
2
The spreadsheet solution is:
Microsoft Excel
As shown, calculating the cost of equity when we have enough information to use both
CAPM and the constant-growth approach simply involves calculating both, then taking the
average of the two.
Similar to Problem 11-1
1
Think of taking such an average as being intuitively the same as diversifying our “portfolio” of data across
the two different estimation techniques, thereby reducing the average amount of estimation error. Taking this
average is intuitively the same as diversifying your portfolio of data across two different estimation tech-
niques. These options allow you to reduce your average amount of estimation error.
cor01589_ch11_372-405.indd 377 10/09/21 03:10 PM

Calculating the Component Cost of Preferred Stock

As we discussed in Chapter 8, preferred stock represents a special case of the constant-
growth model, wherein g equals zero. So we can estimate preferred stocks’ component
cost using a simplified version of equation 11-4:
D 
i P = ___
  1   (11-5)
P 0
EXAMPLE 11-2 LG11-3
For interactive versions

Cost of Preferred Stock
to Connect or go to Suppose that ADK also has one million shares of 7 percent preferred stock outstanding, trad-
mhhe.com/Cornett6e.
ing at $72 per share. What is ADK’s component cost for preferred equity?
SOLUTION: The cost of the preferred stock will equal
D 
i P = ___
  1  
P 0
    ____
$7  
=      
$72
= 0.0972, or 9.72%
Microsoft Excel
There is no built-in function in Excel for calculating the

MATH COACH cost of preferred equity, but since the rate of return on
preferred equity will be equal to the dividend divided by
Preferred Stock Dividends the price, this is easy to calculate in Excel.
The assumed par value of preferred stock is $100. So, a 7 percent Similar to Problem 11-4
preferred stock pays $7 a year in dividends.
Calculating the Component Cost of Debt

Because of the potential tax deductibility of debt interest for the firm, computing the
component cost of debt actually has two parts. We must first estimate the before-tax cost
of debt, iD, and then apply the correct version of the WACC, either equation 11-1 or equa-
tion 11-2, as appropriate, to convert iD to the appropriate after-tax rate of return.
To estimate iD, we need to solve for the yield to maturity (YTM) on the firm’s existing
debt
⎧ ⎡ ⎤ ⎫
⎢ ⎥
1
⎪ 1 − ___________
    N   ⎪
⎨ (
1
 +  i  
)
 
FV ⎬
 
Solve ⎪PV = PMT ×    __________________
     D
   +  ___________
 N ⎪    for i D (11-6)
⎩ ⎣ i D ⎦ (1 + i D)  ⎭
Solve for the interest rate that makes the price equal to the sum of the present values of
the coupons and the face value of the bond, as discussed in Chapter 7.
cor01589_ch11_372-405.indd 378 10/09/21 03:10 PM

Intuitively, by using the price on the firm’s existing debt in equation 11-6, we are
calculating the rate of return expected by investors currently buying the firm’s existing
bonds. As discussed later when we cover how to calculate project-specific WACCs, the
fact that all of the firms’ bonds get their interest paid out of all the firm’s cash flows
before any of the firm’s shareholders get anything implies that this expected rate of return
on existing firm debt should also be a good proxy for the rate of return that potential
investors would demand on any new debt issued by the firm, as well.
Finally, if we think of the YTM as the rate that bond investors expect to get for invest-
ing in the bond, then we need to adjust it for any possible tax deductibility of debt interest
to convert this to a measure of how much it actually costs the firm to pay that YTM.
As per our discussion above, our decision as to which version of the WACC formula
to use, the one in equation 11-1 or the one in equation 11-2, will boil down to a determi-
nation of whether the firm can or cannot take immediate advantage of the interest tax
shields when the debt payments are made: If they can, we will use equation 11-1, which
will set the after-tax cost of debt equal to iD × (1 − TC ); if they cannot, we will use equa-
tion 11-2, treating the after-tax cost of debt as being equal to the before-tax cost of debt.
For example, if a firm pays a 10 percent coupon on $1 million in debt while it is subject
to a 21 percent tax rate, then each coupon payment will be equal to 0.10 × $1,000,000 =
$100,000, but that $100,000 in interest, being potentially tax deductible, may reduce the
firm’s tax bill.
If the firm can take advantage of the tax shields, each $100,000 interest payment will be
immediately deductible, allowing the firm to lower each year’s tax by 0.21 × $100,000 =
$21,000. So, paying $100,000 in interest saves the firm $21,000 in taxes, making the
effective after-tax cost of debt equal to $100,000 − $21,000 = $79,000 and the effective
after-tax interest rate equal to 10% × (1 − 0.21) = 7.9%.
However, if the same firm was not able to take advantage of the interest tax shields,
then the effective after-tax cost of debt would be equal to the before-tax cost, 10 percent.
LG11-3
EXAMPLE 11-3
Cost of Debt with No Restriction on Interest Deductions For interactive versions

ADK has 30,000 20-year, 8 percent annual coupon bonds outstanding; expects annual rev- to Connect or go to
mhhe.com/Cornett6e.
enues of approximately $18 million per year for the life of the bonds; and anticipates EBIT
to be at least $8 million per year. If the bonds currently sell for 97.5 percent of par and the
firm pays an average tax rate of 21 percent and can take full advantage of the interest tax
shields, what will be the before-tax and after-tax component costs for debt it expects rev-
enues of $5 million per year?
SOLUTION: The before-tax cost of debt will be the solution to

CALCULATOR HINTS
⎧ ⎡ ⎤ ⎫
⎢ ⎥
1
⎪ 1 − ____________
   20   ⎪
⎨ (
1
 +  i 
)
 
$1,000 ⎬ N = 20
  975 = $80 ×      
olve ⎪$
S ___________________
  D
    +  
____________   ⎪
   for i D
⎩ ⎣ i D ⎦ (1 + i D)  ⎭
20 PV = −975
PMT = 80
FV = 1000
which will equal 8.26 percent. Multiplying this by one minus the tax rate will yield the after-
CPT I = 8.26
tax cost of debt: 0.0826 × (1 − 0.21) = 0.0653, or 6.53 percent.
Microsoft Excel
cor01589_ch11_372-405.indd 379 10/09/21 03:10 PM

The best way to calculate the before-tax cost of debt in Excel is to use the RATE(nper,p
mt,pv,[fv],[type],[guess]) function, which takes the present value (price), payment amounts,
future value (face value), and number of coupon payments and uses it to calculate the rate
per coupon period that makes the TVM equation work out. The [type] is the default value,
as payments occur at the end of the periods, and you can enter a [guess] for the inter-
est rate if you wish to tell it where to start its search for the actual rate, but it’s usually not
necessary.
The one thing you do have to be careful about, though, is that, assuming that rates will
be entered and read as nominal annual rates, you need to make sure that you adjust all
of the relevant arguments for the number of payments per year. As shown in cell B8, this
involves multiplying the maturity in years by the number of payments per year (cell B6),
dividing the annual payment by the number of payments per year, and multiplying the result
of the RATE() function by the number of payments per year, as well, to get your answer on a
nominal annual basis if required.
Lastly, we take the before-tax cost of debt (cell B8) and multiply it by one minus the tax
rate to get the after-tax cost of debt (cell B9).
Similar to Problem 11-2
EXAMPLE 11-4 LG11-3

Cost of Debt
to Connect or go to Continuing the previous example, suppose that ADK expects its debt ratio to be so high that
mhhe.com/Cornett6e.
it will not be able to take advantage of the interest tax shelter on this bond issue for the fore-
seeable future. What, then, would be the appropriate after-tax interest rate to be used for the
debt component of ADK’s WACC?
SOLUTION: The after-tax interest rate would simply be equal to the before-tax interest
rate of 8.26 percent.
LG11-4 Calculating the Weights

Calculating the weights to be used in the WACC formula is mathematically very simple:
We just calculate the percentages of the funding that come from equity, preferred stock,
and debt, respectively.
Sounds easy, right? Well, the tricky part to this lies in determining what we mean by
“the funding”: If we are calculating WACC for a firm, then “the funding” encompasses
all the capital in the firm, and E, P, and D will be determined by computing the total
market value of the firm’s common stock, preferred stock, and debt, respectively. How-
ever, if we are computing WACC for a project, then “the funding” will only include the
financing for that project, and E, P, and D will be equal to the amount of each used in the
financing of that project.2
If you think about this for a second, you will realize that this means that projects can
wind up having different WACCs than their firm. That is not just OK, it is also exactly
right because, as we will see in a later chapter, the firm is like a diversified portfolio of
different projects, all with different risks and returns. And one of the things that can con-
tribute to the risk of a project is the choice of how much common stock, preferred stock,
and debt are used to finance it.
2
We’ll discuss more about calculating WACC for a project later in the chapter.
cor01589_ch11_372-405.indd 380 10/09/21 03:10 PM

LG11-4
EXAMPLE 11-5
Capital Structure Weights and WACC For interactive versions
Let us continue the previous examples but roll back to assuming that ADK can take full to Connect or go to
mhhe.com/Cornett6e.
advantage of the interest tax shields. Suppose that ADK has issued 3 million shares of com-
mon stock, 1 million shares of preferred stock, and the previously mentioned 30,000 bonds
outstanding. What will ADK’s WACC be, considering ADK as a firm?
SOLUTION: Using the securities’ prices given in previous examples, ADK’s equity,

preferred stock, and debt will have the following total market values:
• Equity: 3m × $32.75 = $98.25m
• Preferred stock: 1m × $72 = $72m
• Debt: 30,000 × $975 = $29.25m
The total combined market value for all three capital sources is $199.5 million. The appli-
cable weights for each capital source will therefore be
E $98.25m
For common equity: _______
      = ________
    
= 0.4925, or 49.25%
E + P + D $199.5m
P
_______ $72m
For preferred stock: 
               =  ________
         = 0.3609, or 36.09%
E + P + D $199.5m
D $29.25m
For debt:  _______ = ________
          = 0.1466, or 14.66%
E + P + D $199.5m
Tying this all together with the answers from the previous examples, ADK will have a
WACC of
E P D
WACC = _______________
       × i E + _______________
       × i P + _______________
       × i D × (1 − T C)
E + P + D E + P + D E + P + D
       
        
= (0.4925 × 0.1075) + (0.3609 × 0.0972) + (0.1466 × 0.0653)
= 0.0976, or 9.76%
Microsoft Excel
cor01589_ch11_372-405.indd 381 10/09/21 03:10 PM

This is where the template that we showed you before comes in. We enter the costs of
equity, preferred stock, and debt, as well as the tax rate, then we enter enough information
about each source of capital to calculate the total market value of each source: namely,
how many shares/bonds are outstanding, and what their respective prices are. This allows
us to calculate the total market value of all outstanding common shares, preferred stock,
and debt, as shown in cells B14 through B16. The sum of the three is then the total market
capitalization of the firm, which we use as the divisor underneath each type of asset’s mar-
ket value to get the weights in cells B18 through B20. Finally, we multiply these weights
times the relevant costs of each type (remembering to multiply the before-tax cost of debt
by one minus the tax rate to get the after-tax cost of debt) and then add all the results up to
get the WACC, shown in cell B22.
Similar to Problems 11-5 to 11-7, 11-11, Self-Test Problem 1
TIME OUT
11-1 Explain why we multiply the component cost of debt by a factor containing the
marginal tax rate, TD, but don’t do so for the component costs of equity or
preferred stock.
11-2 How would we compute iD if a company had multiple bond issues outstanding?
LG11-5
∙
11.2 Firm WACC versus Project WACC
So far, we have been defining the WACC as a weighted-average cost across the firm’s
different financing sources. If we think of the firm as a portfolio of different projects
and products, we see that the WACC will be a weighted-average cost of capital across
the items in that portfolio, too. This way it represents the cost of capital for the “typical”
project that the firm is currently undertaking. However, firms grow by taking on new
projects. So now the question is: Can managers use our firmwide WACC, calculated pre-
viously, to evaluate the firm’s newly proposed projects?
The answer is: It depends. If a new project is similar enough to existing projects,
then yes, managers can use the firm’s WACC as the new project’s cost of capital. But
say that your firm is contemplating undertaking a significantly different project—one
far different from any project that the firm is already engaged in. What then? Then we
cannot expect the firm’s overall WACC to appropriately measure the new project’s cost
of capital.
Let your intuition work on this for a second: If the new project is riskier than the firm’s
existing projects, then it should be “charged” a higher cost of capital; if it’s safer, then the
firm should assign the new project a lower cost of capital. That seems only fair, right?
Consider a U.S. firm—let’s call it GassUp—that currently owns a chain of gas sta-
tions. Firm management is considering a new project: opening up a series of gourmet
coffee shops inside its existing gas stations. Given the demand for upscale coffee in the
United States, as well as the historically volatile oil markets, it’s probably difficult to
say exactly whether the coffee shops will be more or less risky than gas stations. We
can probably say, though, that the two enterprises will face different risks. For example,
one could argue that at least a certain amount of gas is a necessity, while gourmet coffee
is more of a luxury good, so it makes sense that the two “parts” of the new, expanded
cor01589_ch11_372-405.indd 382 10/09/21 03:10 PM

product line for GassUp will perform differently in boom or bust periods. Likewise, what
if the coffee shops are located within the busiest and most stable gas stations—say the
ones that lie along freeways? Then the firm faces remodeling existing buildings, rather
than starting from scratch, and can pick and choose to put gourmet coffee facilities in the
gas stations that have the volume to support them, which likely means that the risks of
adding the facilities for gourmet coffee to those stations will be lower than building new
facilities from scratch.
So, this means that GassUp probably should not use the same WACC for the new line
of gourmet coffee expansions to its gas stations as it does for the gas stations themselves;
that is, the WACC for the new expansion projects should not be equal to the WACC of the
firm as it currently exists.
However, does this mean that all the components of WACC for each new gourmet
coffee expansion should be different for every store? Well, not exactly. As we’ll discuss,
some inputs to WACC should be project-specific, but others should be consistent with the
firmwide values used in calculating a firmwide WACC.
Project Cost Numbers to Take from the Firm

It is tempting to argue that all component inputs for a project-specific WACC should be
based on the specific project attributes, but if we created all project-specific numbers,
what fundamental issue related to bonds and preferred stock would we be ignoring?
That both bonds and preferred stocks create claims on the firm, not on any particu-
lar group of projects within that firm. Furthermore, debt claims are superior to those
of common stockholders. So if the new project does significantly increase the firm’s
overall risk, the increased risk will be borne disproportionately by common stockhold-
ers. Debt holders and preferred stockholders will likely face minimal impact on the
risk and return that their investments give them, no matter what new project the firm
undertakes—even if those claimants own bonds or preferred shares that the firm issued
to fund the new project.
For example, suppose GassUp decides to build entirely separate facilities for its cof-
fee shops, which it will name “Bottoms Up.” Furthermore, suppose GassUp partially
finances its expansion into coffee shops with debt, and that the project turns out to be
more like “Bottoms Down”—far less successful than the firm had hoped. Though this
would be an unfortunate turn of events for GassUp’s common shareholders, the firm’s
creditors and preferred shareholders would likely still collect their usual interest and divi-
dend payments from GassUp’s gross revenues from gas station operations.
Creditors understand that their repayment probably comes from continuing operations
and take current cash flows into account when a firm comes seeking funds. For example,
if a small firm approaches a bank for a loan to finance an expansion, the bank will nor-
mally spend more time analyzing current cash flows to determine the probability that it
will recoup its loan than it will analyzing the potential new cash flows from the proposed
expansion.
Note that this situation holds true only as long as the new projects represent fairly small
investments compared to ongoing operations. As new projects become large relative to
ongoing cash-flow-producing activities, creditors will have to examine the likelihood of
being repaid from the new projects much more closely. New projects, however great their
potential, inherently carry more risk than do established current operations. Changes in the
proportion of new projects relative to ongoing operations will thus translate into increased
risk for the creditor, who will ask for a higher rate of return to offset the risk.
Since most firms tend to grow incrementally, we will assume (unless otherwise indi-
cated) that we’re examining situations in which the number of new projects is small rela-
tive to ongoing operations. We can therefore also assume that using the firm’s existing,
pre-project component costs of debt and preferred stock to calculate WACC is appropriate.
cor01589_ch11_372-405.indd 383 10/09/21 03:10 PM

Project Cost Numbers to Find Elsewhere: The Pure-Play

Approach
Since we have decided not to adjust the firmwide costs of debt or preferred stock for the
risk of a project, where should we account for the new project risk brought to the firm
overall? As with several other questions associated with risk and profit-sharing that we’ll
discuss in Chapter 16, the answer lies with equity.
The firm’s risk changes when it takes on a project that is noticeably different from its
existing lines of business. Debt holders and preferred stockholders will not bear much of
this change in risk; rather, when it takes on a new project, the firm instead creates risk
for its common stockholders that is disproportionately large compared to the amount of
stockholder capital used to finance the project.
In response to such a change in the firm’s risk profile, stockholders adjust their
required rate of return to adjust for the new risk level. Absent any alteration to the firm’s
capital structure,3 changes in the firm’s risk profile are due to differences in the firm’s
business risk business risks based on the mix of the new and existing product lines. The stock’s beta
The risk of a project arising reflects those differences in each product line.
from the line of business Obviously, no proposed new project will have a history of previous returns. Without
it is in; the variability of a such data, neither analysts nor investors can calculate a project-specific beta. So what
firm’s or division’s cash
flows. data can we use? To the extent that we can find other firms engaged in the proposed
new line of business, we can use their betas as proxies to estimate the project’s risk. Ide-
ally, the other firms would be engaged only in the proposed new line of business; such
monothemed firms are usually referred to as pure plays, with this term also in turn being
applied to this approach to estimating a project’s beta.
proxy beta An average of n such proxy betas will give us a fairly accurate estimate of what the
The beta (a measure of new project’s beta will be.4
the riskiness) of a firm in a
similar line of business as a i E = r f + β Avg[E(r M) − r f]
proposed new project.
where
N
 Σ    β j
j=1
β Avg = ______
        (11-7)
n
S PREADSHEET T IP
Calculating Average in Excel
Technically speaking, a calculation of an average as shown above is an arithmetic aver-
age. Excel uses the AVERAGE(number1,[numer2], . . .) function to calculate this.
This average will be an estimate, in the strictest statistical sense of the word. You
might recall from your statistics classes that we will need to be careful to get as large a
sample as possible if we want to get as much statistical power for our estimate as possible.
Ideally, we would like to find at least three or four companies from which to draw proxy
betas, called pure-play proxies, to ensure that we have a large enough sample size to
3
In reality, new projects are often financed with different proportions of equity, debt, and preferred stock than
were used to fund the firm’s existing operations. As we will discuss in Chapter 16, such a change in capital
structure will result in a change in financial risk with increased leverage magnifying β.
4
As we will also discuss in Chapter 16, we will be able to take a straight average of the proxy firms’ betas
as the estimate of our beta only if the capital structures of all the proxies are identical to each other and to
that of our proposed new project. If not, we will need to adjust the proxies’ estimated betas for differences
in capital structures before averaging them. Then we will need to readjust the average beta for our project’s
capital structure before using the estimate.
cor01589_ch11_372-405.indd 384 10/09/21 03:10 PM

safely make meaningful inferences. In reality, however, two proxies (or even one) might
represent a suitable sample if their business line resembles the proposed new project
closely enough. In particular, we may want to use betas from industry front-runners, and
rely less on betas of any firms that the company really doesn’t want to emulate.
What shall we do if we cannot find any pure-play proxies? Well, in that case, we may
want to use firms that, while not solely in the same business as the proposed project’s
venture, have a sizable proportion of revenues from that line. We may then be able to
“back out” the impact of their other lines of business from their firm’s beta to leave us
with a good enough estimate of what the new project’s beta might be.
Be sure to use weights based on the project’s sources of capital, and not necessarily
the firm’s capital structure. If the new project is going to use more or less debt than the
firm’s existing projects do, then the risk and reward-sharing are going to vary across the
different types of capital (as discussed in Chapter 16), and we will want to recognize this
in our WACC computation.
Finally, we need to consider the appropriate corporate tax rate to use in calculating the
WACC for a project. Since all corporate tax rates are now 21 percent, the appropriate tax
rate to compute the project’s WACC will also be 21 percent.
To summarize, the component costs and weights to compute a project-specific WACC
should be as shown in equation 11-8 (for firms that can take full advantage of the interest
tax shields) or in equation 11-9 (for firms that cannot take advantage of the interest tax
shields), with the source of each part indicated by the appropriate subscript:
E Project
WAC C Unconstrained, Project = ____________________
  
      
× i E, Project
E Project + P Project + D Project
P Project
  + ____________________
    
      
      
× i P, Firm (11-8)
D Project
+ ___________________________
    × i D, Firm × (1 − T C)
  
E Project
____________________
WAC C Constrained, Project =   
      × i E, Project
P Project
____________________
  +   
    
          × i P, Firm  (11-9)
D Project
+ ____________________
  
      × i D, Firm
LG11-5
EXAMPLE 11-6
Calculation of Project WACC For interactive versions

to Connect or go to
Suppose that Evita’s Subs, a local shipyard, is considering opening up a chain of sandwich mhhe.com/Cornett6e.
shops. Evita’s capital structure currently consists of 2 million outstanding shares of common
stock, selling for $83 per share, and a $50 million bond issue, selling at 103 percent of par.
Evita’s stock has a beta of 0.72, the expected market risk premium is 7 percent, and the
current risk-free rate is 4.5 percent. The bonds pay a 9 percent annual coupon and mature
in 20 years. The current operations of the firm produce EBIT of $100 million per year, and
the new sandwich operations would add only an expected $12 million per year to that.
Also, suppose that Evita’s management has done some research on the sandwich shop
industry and discovered that such firms have an average beta of 1.23. If the new project
will be funded for $110 million consisting of 50 percent debt and 50 percent equity, and
Evita’s faces a marginal tax rate of 21 percent and can make full use of the tax shield on
new debt, what should be the WACC for this new project?
cor01589_ch11_372-405.indd 385 10/09/21 03:10 PM

SOLUTION: First, note that Evita’s currently doesn’t have any outstanding preferred stock
and doesn’t plan on using any to finance the new project, so that makes our job a little sim-
pler. Also note that, though we are given enough information to calculate the firm’s current
capital structure weights and component cost of equity, we will use the new project’s capi-
tal structure to calculate the weights instead, as it differs from the existing capital structure.
And we already know the capital structure weights for the new project (50 percent debt
and 50 percent equity), so we just need to calculate the appropriate component costs.
For equity, the appropriate cost will be based upon the average risk of sandwich shops:
i E = R f + β Project( R M − R f)
    
      = 0.045 + 1.23[0.07]
= 0.1311, or 13.11%
Since the new sandwich project appears to be small relative to the firm’s existing line
of business, we will assume that the new bondholders will expect to be repaid out of cash
flows to the existing shipyards, and the YTM on the new bonds issued to finance this proj-
ect will be the same as the YTM on the existing bonds:
⎧ ⎡ ⎤ ⎫
⎢ ⎥
1
⎪ 1 − ____________
   20   ⎪
⎨ $1,000 ⎬
(1 + i D)  ____________
  1,030 = $90 ×  ___________________
Solve ⎪$           +        for i D
⎣ ⎦ (1 + i D) 20⎭
⎪
⎩ i D
which gives us an iD of 8.68 percent.

Now, since we are told that the firm currently has EBIT of $100 million and that the
new project is expected to add $12 million, we expect total EBIT with the new project to
be $112 million. Since EBIT must be less than or equal to EBITDA, it doesn’t really matter
which year it is: If total interest expenditures are less than 30 percent of EBIT, they will also
be less than 30 percent of EBITDA.
Since the firm can be expected to price the new $55 million in debt with a coupon of
8.86 percent so it will sell at face value, and since it pays a coupon of 9 percent on the
currently outstanding $50 million in debt already in the capital structure, total interest pay-
ments with the new project funded should be equal to 8.68% × $55 million + 9% × $50
million = $9,373,000, which is only 8.37 percent of the $112 million expected yearly EBIT.
Therefore, the after-tax cost of debt will be equal to iD × (1 − TC) = 0.0886 × (1 − 0.21) =
.0700, or 7 percent.
Therefore, the WACC of the new project will be
( )
E Project D Project
ACC Project = ___________________________
W     × i E, Project + ___________________________
       
    × i D, Firm ×  1 − T C
E Project + P Project + D Project E Project + P Project + D Project
     
          
= 0.5 × 0.1311 + 0.5 × 0.868 × (1 − 0.21)
= 0.0998, or 9.98%
Microsoft Excel
cor01589_ch11_372-405.indd 386 10/09/21 03:10 PM

This calculation of WACC can be accomplished using the same template that we used in CALCULATOR HINTS
the last example (albeit without any preferred stock, which we indicate by setting both the
cost and weight of preferred stock to zero in the template). The only thing we have to take N = 20
PV = −1030
care with is to ensure that we use the beta and weights for the new project rather than the
PMT = 90
existing firm.
FV = 1000
Similar to Problems 11-8 to 11-11, Self-Test Problem 2 CPT I = 8.68
TIME OUT
11-3 For computing a project WACC, why do we take some component costs from the firm
but compute others that are specific for the project being considered?
11-4 It is usually much easier to find proxy firms that are engaged in multiple lines of busi-
ness than it is to find pure-play proxies. Explain how such firms can be used to estimate
the beta for a new project.
∙
11.3 Divisional WACC LG11-6
Do firms calculate risk-appropriate WACC for every new project they consider? While
this would be ideal, pragmatically it just is not always feasible. In large corporations, man-
agers evaluate dozens or even hundreds of proposed new projects each year. The costs in
terms of time and effort of estimating project-specific WACCs individually for each proj-
ect are simply prohibitive. Instead, large firms often take a middle-of-the-road approach
that can achieve many of the results of using project-specific WACC calculations with
much less time and resources. The key to this approach is to calculate divisional WACCs divisional WACC
for each product line of the company based on that line’s, but not each individual prod- An estimated WACC com-
uct’s, risk profile. puted using some sort
of proxy for the average
equity risk of the projects in
a particular division.
Pros and Cons of a Divisional WACC
As with most choices in life as well as finance, there are pros and cons to using the divi-
sional WACC approach. Let’s first consider the disadvantage of using a firm’s WACC to
evaluate new, risk-heterogeneous projects. To make things simple, let’s assume that we
are looking at a firm that uses only equity finance, so that WACC is simply equal to iE,
and let’s further assume that all the proposed new projects are in the same product line
as each other and as the firm’s existing projects, so that the divisional WACC would be
equal to the firm’s existing WACC.
Take a look at Figure 11.1. Similar to our discussion of the security market line in
Chapter 10, required rates of return for projects with varying degrees of risk would
lie along the sloped line shown in the figure. We could then evaluate projects with
various degrees of risk based on the relationship between their expected rate of return
and the required rate of return for that risk level. Turning to Figure 11.2, you can
see that using risk-appropriate WACCs, projects A and B would be accepted because
their expected rates of return would be higher than their respective required rates of
return. Projects C and D would be rejected since our simple scheme shows that these
projects are not expected to return enough to cover market-required returns, given the
projects’ riskiness.
cor01589_ch11_372-405.indd 387 10/09/21 03:10 PM

FIGURE 11.1
Risk-Appropriate WACCs
In an all-equity firm, WACC
is theoretically equal to iE
for each proposed project,
which will increase as the
risk (i.e., β) of the project
Risk-appropriate WACC
Return
increases.
Risk
FIGURE 11.2
Sample Projects versus
Risk-Sensitive WACC
Projects A and B have
expected returns greater
Project B
than their risk-appropriate
WACCs. Projects C and D
Return
have expected returns less

Project C
than their risk-appropriate
WACCs. Project A
Project D
Risk
FIGURE 11.3
Sample Project versus
Firmwide WACC
If we were to mistakenly
compare projects bearing
Project B
different risks to this single
firmwide WACC, we would Project C
Return
conclude that projects A and

D have expected rates of
return less than the firmwide Firm WACC
WACC and Projects B and Project A
C have expected returns Project D
greater than the firmwide
WACC.
Risk
However, using a firmwide WACC would result in a comparison of the project’s

expected rates of return to a single, flat, firmwide cost of capital, as Figure 11.3 shows.
Using a simple firmwide WACC to evaluate new projects would give an unfair advan-
tage to projects that present more risk than the firm’s average beta. Using a firmwide
WACC would also work against projects that involved less risk than the firm’s average
beta. Looking at the same sample projects as before, we see that Project A would now be
rejected, while Project C would be accepted.
cor01589_ch11_372-405.indd 388 10/09/21 03:10 PM

Using a firmwide WACC in this way, as an inappropriate benchmark for projects of

differing risk from the firm’s current operations, will result in quite a few incorrect deci-
sions. In fact, the use of a firmwide WACC to evaluate any projects with risk-return coor-
dinates lying in the two shaded triangles shown in Figure 11.4 will result in an incorrect
accept/reject decision.
Computing a few “risk aware” divisional WACCs instead of just one “risk insensitive”
firmwide WACC can greatly reduce the number of projects that get incorrectly accepted or
rejected this way. To do so, we divide the firm’s existing projects into divisions, where the
different divisions proxy for systematically different average project risk levels. Calculating
WACCs for each division separately, as Figure 11.5 shows, greatly reduces the problem of
basing decisions on inaccurate results from using firmwide WACC for all projects.
Using divisional WACCs like this will not eliminate problems of incorrect acceptance
and incorrect rejection, but it will greatly reduce their frequency. Instead of making
errors corresponding to the two large triangular areas indicated in Figure 11.4, we will
instead have six smaller areas of error shown in Figure 11.6. More acceptance/rejection
regions will result in fewer errors.
FIGURE 11.4 Incorrect Decisions Caused by Inappropriate Use of Firmwide WACC

The gold-shaded triangle on the lower left contains projects such as Project A, which is incorrectly rejected by a firm. It has risk less than
the average risk of the firm. Its expected rate of return is greater than its correctly calculated risk-appropriate WACC but less than an inap-
propriately calculated firmwide WACC. The pink-shaded triangle on the upper right contains projects such as Project C, which is incorrectly
accepted by a firm. It has risk greater than the average risk of the firm. Its expected rate of return is less than a correctly calculated risk-
appropriate WACC but greater than an inappropriately calculated firmwide WACC.
Project B
Incorrect
acceptance
Return
Risk-appropriate WACC Project C
Firm WACC
Project A
Incorrect
rejection Project D
Risk
FIGURE 11.5
Divisional WACCs
Instead of calculating a
single firmwide WACC based
on the average risk of all
projects in the firm, assume
that the firm calculates divi-
“High risk” WACC sion-specific WACCs based
Return
on the average risk of the

“Medium risk” WACC projects in each respective
division.
“Low risk” WACC
Risk
cor01589_ch11_372-405.indd 389 10/09/21 03:10 PM

FIGURE 11.6
Divisional WACC Errors
Total incorrect acceptances/
rejections turn out to be less
when divisional WACCs are Incorrect
acceptance
used.
Return
Incorrect
rejection
Risk
FIGURE 11.7
Example Decisions
Using Divisional WACCs
Projects A and B here are
correctly accepted, while Project B Incorrect
projects C and D are cor- acceptance
rectly rejected. Risk-appropriate WACC
Return
Project C
Project A
Incorrect Project D
rejection
Risk
For example, let’s consider our four sample projects from before. Suppose that, instead
of assigning the proposed new projects to the same firmwide division we had previously
assumed, the firm divides its operations into “low-risk,” “mid-risk,” and “high-risk”
product lines and decides that, based on their associated products and risk profiles, Proj-
ect A should be assigned to the “low-risk” division, Project D to the “mid-risk” division,
and Projects B and C to the “high-risk” division. If we were to now evaluate them using
divisional WACCs as shown in Figure 11.7, we would correctly accept both projects A
and B and correctly reject projects C and D.
LG11-7 Subjective versus Objective Approaches

We can form divisional WACCs subjectively by simply considering the project’s risk
relative to the firm’s existing lines of business and then, if the project is riskier (safer)
than the firm average, adjust the firm WACC upward (downward) to account for our
subjective opinion of project riskiness. The biggest disadvantage to this approach is that
the adjustments are pretty much picked out of thin air and created just for the project at
hand. For example, consider the sample subjective divisional WACCs in Table 11.1. Both
the project assignments to the divisions and then the WACC adjustments for the very low
risk, low risk, high risk, and very high risk are fairly arbitrary.
An objective approach would be to compute the average beta per division, use these
figures in the CAPM formula to calculate iE for each division, and then, in turn, use
divisional estimates of iE to construct divisional WACCs. Though the objective approach
would usually be more precise, resulting in fewer incorrect accept/reject decisions, the
subjective approach is more frequently used because it is easier to implement.
cor01589_ch11_372-405.indd 390 10/09/21 03:10 PM

TABLE 11.1 Subjective Divisional WACCs

Risk Level Discount Rate
Very low risk Firm WACC − 5%
Low risk Firm WACC − 2%
Same risk as firm Firm WACC
High risk Firm WACC + 3%
Very high risk Firm WACC + 7%
LG11-7
EXAMPLE 11-7
Divisional Costs of Capital For interactive versions

Assume that BF, Inc., an all-equity firm, has a firmwide WACC of 10 percent and that the firm to Connect or go to
mhhe.com/Cornett6e.
is broken into three divisions: Textiles, Accessories, and Miscellaneous. The average Tex-
tiles project has a beta of 0.7, the average Accessories project has a beta of 1.3, and the
average Miscellaneous project has a beta of 1.1.
The firm is currently considering the projects shown in the table below. The current
approach is to use the firm’s WACC to evaluate all projects, but management sees the
wisdom in adopting a subjective divisional cost of capital approach. Firm management is
thus considering a divisional cost of capital scheme in which it will use the firm’s WACC for
Miscellaneous projects, the firm’s WACC minus 1 percent for Textiles projects, and the firm’s
WACC plus 3 percent for Accessories projects. The current expected return to the market
is 12 percent, and the current risk-free rate is 5.75 percent.
For this group of projects, how much better would its accept/reject decisions be if it
used this approach rather than if it continued to use the firm’s WACC to evaluate all proj-
ects? Would switching to an objective divisional cost of capital approach, where the WACC
for each division is based on that division’s average beta, improve its accept/reject criteria
any further?
Project Division Expected iE Beta

A βAccessories 17.00% 1.3
B βAccessories 15.00 1.2
C βMiscellaneous 13.00 1.3
D βMiscellaneous 11.00 0.7
E βTextiles 9.00 0.8
F βTextiles 7.00 0.5
SOLUTION: Determine the required rates of return for each project assuming that the
firm uses the firmwide WACC and adds the subjective adjustments to construct divisional
WACCs. The objective computation of divisional WACCs using each division’s average
beta and the iE computed using each project’s specific beta is indicated in the follow-
ing table. In each case, project acceptances appear in blue print, and project rejections
appear in red print.
Expected Firm Subjective Objective Specific

Project Division Beta
iE WACC iE iE iE
A βAccessories 17.00% 1.3 10.00% 13.00% 13.88% 13.88%
B βAccessories 15.00 1.2 10.00 13.00 13.88 13.25
C βMiscellaneous 13.00 1.3 10.00 10.00 12.63 13.88
D βMiscellaneous 11.00 0.7 10.00 10.00 12.63 10.13
E βTextiles 9.00 0.8 10.00 9.00 10.13 10.75
F βTextiles 7.00 0.5 10.00 9.00 10.13 8.88
cor01589_ch11_372-405.indd 391 10/09/21 03:10 PM

Using the “Specific iE” yields the “correct” accept/reject decision; that is, these accept/
reject decisions would be generated exactly the same if the firm had the time and resources
to compute the iE on a project-by-project basis. In this particular situation, using the firm
WACC as a benchmark for all the projects would result in projects E and F being rejected
since they both will return expected rates less than the firm’s 10 percent required rate
of return. By comparison to the results using the Specific iE, both of these rejections are
appropriate. We would prefer that the accept/reject criteria took account of risk; that is, both
projects would be rejected because their expected returns (9 percent and 7 percent, respec-
tively) are less than the required returns (10.75 and 8.88 percent, respectively) based on their
specific levels of project risk rather than assuming that both projects carry the same risk as
the firm’s overall risk. However, using the firm’s WACC incorrectly accepts project C.
Using the subjectively adjusted approach to calculating iE results in required rates of return
of 13 percent for Accessories projects, 10 percent for Miscellaneous projects, and 9 per-
cent for Textiles projects. The associated accept/reject decisions actually incorrectly accept
projects C and E, making the subjectively adjusted WACC approach worse (in this specific
example) than simply using the firmwide WACC.
Finally, using the objective approach to constructing divisional costs of capital, along with
the three divisions’ average betas given above, results in required rates of return for the three
divisions of
i E = R f + β(R M − 11.3 R f)
i E, Accessories = 0.0575 + 1.3[0.12 − 0.0575] = 0.1388, or 13.88%
       
            
i E, Miscellaneous = 0.0575 + 1.1[0.12 − 0.0575] = 0.1263, or 12.63%
i E, Textiles = 0.0575 + 0.7[0.12 − 0.0575] = 0.1013, or 10.13%
As these solutions show, using these divisional costs of capital figures as required rates of
return for each project results in correct rejections of projects E and F, but also results in an
incorrect rejection of project D and an incorrect acceptance of project C relative to computing
iE on a project-by-project basis.
Overall, using either the objective or subjective approaches to calculating divisional costs
of capital will not be as precise as using project-specific WACCs: We will wind up incorrectly
accepting and/or rejecting some projects. Making incorrect decisions on some of our project
choices may be worth it if the projects in question aren’t large enough for project-specific cal-
culations to be cost-effective.
Microsoft Excel
cor01589_ch11_372-405.indd 392 10/09/21 03:10 PM

In reality, it is probably pretty unlikely that a firm would need to calculate firm WACC,
subjective divisional costs of capital, objective divisional costs of capital, and firm-specific
divisional costs of capital. However, this is exactly the type of situation with highly repetitive
reuses of inputs for which Excel really shines.
In the given spreadsheet, we’ve used conditional formatting to show accept/reject deci-
sions, setting a computed value to green if the expected return from a project would be
greater than the cost of capital (and therefore accepted) using a particular approach, and to
red if it would be less than the cost of capital (and therefore rejected).
For the firm WACCs in cells E3 through E8, we merely entered 10 percent manually.
For the subjective costs of capital in cells F3 through F8, we added the project’s divi-
sion’s subjective adjustment from cells B14 through B16, as appropriate, to the firm WACC.
For the objective costs of capital in cells F11 through F16, we used the CAPM formula
but referenced the appropriate divisional beta in cells B10 through B12.
Finally, for the calculation of the project-specific costs of capital in cells F19 through
F24, we again used the CAPM, but this time referenced each project’s specific beta in cells
D3 through D8.
Similar to Problems 11-14, 11-15
TIME OUT
11-5 Divisions of a corporation are not usually formed based explicitly on differences in risk
between the projects in different divisions. Rather, they are normally formed along
product-type or geographic differences. Explain how this division scheme may still
result in divisions that do differ among themselves by average risk. Also explain why
calculating divisional WACCs in such a situation will still improve decision making over
simply using a firmwide WACC for project acceptance or rejection.
11-6 Explain why, in Example 11-7, using objectively computed divisional WACCs still
resulted in an incorrect accept/reject decision for project D.
∙
11.4 Flotation Costs LG11-8
We know that firms use varied sources of funding. Until now, our calculations have been
assuming that we were using retained earnings to fund projects. What if a firm funds a
project by issuing externally generated new capital—additional stock, bonds, and so on?
Then the firm has to pay the costs of printing the new stock or bond certificates, commis-
sions to the underwriters helping the firm to sell the stocks and bonds, government reg-
istration fees, and other associated costs. So to figure project WACCs, we must integrate
flotation costs
these flotation costs into our component costs as well.
We can approach the commission costs in two basic ways. We can either increase the Fees paid by firms to
investment banks for issu-
project’s WACC to incorporate the flotation costs’ impact as a percentage of WACC, ing new securities.
or we can leave the WACC alone and adjust the project’s initial investment upward to
reflect the “true” cost of the project. Both approaches have advantages and disadvan-
separation principle
tages. The first approach tends to understate the component cost of new equity, and the
Theory maintaining that the
latter approach violates the separation principle of capital budgeting, which states that
sources and uses of capital
the calculations of cash flows should remain independent of financing. We will discuss should be decided upon
the separation principle and the second approach in the next chapter. independently.
cor01589_ch11_372-405.indd 393 10/09/21 03:10 PM

Adjusting the WACC

The first approach to adjusting for flotation costs is to adjust the issue price of new secu-
rities by subtracting flotation cost, F, to reflect the net security price. Then use this net
price to calculate the component cost of capital. For equity, this approach is most com-
monly applied to the constant-growth model:
D 
i E = _____
  1     + g (11-10)
P 0 − F
If we instead want to apply this approach to the cost of equity obtained from the
CAPM formula, we would adjust it upward by an equivalent amount.
EXAMPLE 11-8 LG11-8

Flotation-Adjusted Cost of Equity
to Connect or go to Suppose that, as in Example 11-1, ADK Industries’ common shares are selling for $32.75 per share,
mhhe.com/Cornett6e.
and the company expects to set its next annual dividend at $1.54 per share. All future dividends
are expected to grow by 6 percent per year indefinitely. In addition, let us suppose that ADK faces
a flotation cost of 20 percent on new equity issues. Calculate the flotation-adjusted cost of equity.
SOLUTION: Twenty percent of $32.75 will be $6.55, so the flotation-adjusted cost of equity will be
D 
i E = _____
  1     + g
P 0 − F
   
    $1.54  
= ____________
       + 0.06
$32.75 − $6.55
= 0.1188, or 11.88%
Notice that the result is 1.18 percent above the non-flotation-adjusted cost of equity,
10.70 percent, computed using the constant-growth model in Example 11-1. If we instead
wanted to use the CAPM estimate, we would take the non-flotation-adjusted CAPM estimate
from the same example, 10.80 percent, and add the same differential of 1.18 percent to it to
get the flotation-adjusted value:
i E = 0.1080 + 0.0118 = 0.1198, or 11.98%
The adjustments for the component costs of preferred stock and debt will be similar:
D 
i P = _____
  1     (11-11)
⎢ ⎥
P 0 − F
⎧ ⎡ 1 ⎤ ⎫
⎪ 1 − ___________
FV ⎪
    N  
(1 + i D)  ___________
Solve ⎨ P   V − F = PMT ×  __________________
         +      ⎬     for i D (11-12)
⎪ i D (1 + i D) N⎪
⎩ ⎣ ⎦ ⎭
Microsoft Excel
To calculate the flotation-adjusted cost of equity, we first calculate the dollar flotation cost
per share, shown in cell B7. This is then used to calculate the rate of return on a perpetuity, but
it substitutes the amount the firm actually raises from selling each share (selling price minus
flotation cost, or cell B2 minus cell B7) in cell B9.
Similar to Problems 11-23, 11-24
cor01589_ch11_372-405.indd 394 10/09/21 03:10 PM

TIME OUT
11-7 Why should we expect the flotation costs for debt to be significantly lower than those
for equity?
11-8 Explain how we should go about computing the WACC for a project that uses both
retained earnings and a new equity issue.
viewpoints REVISITED
Business Application Solution
Stream Devices, Inc., faces current component costs of capital equal to
D  D 
i E = ___
  1   + g i P = ___
  1  
P 0 P 0
    
    $1.35  
 
 
 
$10
=  ______    
+ 0.06 =  _____   
$18.75 $100
= 0.1320, or 13.20% = 0.1000, or 10.00% CALCULATOR HINTS
⎧ ⎡ ⎤ ⎫
⎢ ⎥
1 N = 20
⎪ 1 − ____________
    20   ⎪
⎨ $1,000 ⎬
(1 + i D)  ____________ PV = −1,100
S   1,100 = $100 ×      
olve ⎪$ ___________________
     +     ⎪
   for i D
⎣ ⎦ (1 + i D) 20⎭
PMT = 100
⎩ i D FV = 1000
CPT I = 8.91%
gives iD = 0.0891, or 8.91%
Using the target capital structure weights, Stream’s WACC equals
WACC = 0.5 × 0.1320 + 0.1 × 0.10 + 0.4 × 0.0891 × [1 − 0.21]
       
   
= 0.1042, or 10.42%
S PREADSHEET T IP
Business Applications Solution in Excel
This problem uses a straightforward application of the template that we’ve used several
times before, while noting that we do have preferred shares in this problem, unlike pre-
vious examples:
Microsoft Excel
cor01589_ch11_372-405.indd 395 10/09/21 03:10 PM

Personal Application Solution

MacKenzie can expect a total of $17,125 + $29,000 = $46,125 in student loans when she graduates from her
master’s program. At an 8 percent rate of interest, the yearly interest charges will be $3,690 immediately after she
graduates (though they will go down once she starts paying off some of the principal). Since the yearly interest will
be more than the allowable $2,500 deduction, we can express her after-tax interest rate as the following weighted
average:
D Nondeductible
WACC = ____________________
        
× i D
D Nondeductible + D Deductible
D Deductible
+ ________________________
        × i D × (1 − T P)
D Nondeductible + D Deductible
    
    
    
       
$3,690 − $2,500 $2,500
=  _________________
         × 0.08 +  _   × 0.08 × (1 − 0.22)
$3,690 $3,690
= 0.3225 × 0.08 + 0.6775 × 0.08 × 0.78
= 0.0681, or 6.81%
summary of learning goals

This chapter covers how to incorporate previous chapters’ pricing formulas into weighted-average costs of capital
calculations. We also discussed situations in which a firmwide WACC is appropriate for valuing a project, and when
we need to calculate a project-specific WACC. We also discussed the trade-offs inherent in using divisional WACCs.
Finally, we saw that incorporating flotation costs will increase the WACC above the value it would have if the firm
was able to raise all funds internally.
LG11-1 Understand the relationship of cost of equity, preferred stock, and debt, reworked to solve for
capital to the investor’s required return. When firms the appropriate interest rate.
use multiple sources of capital, they need to calculate the
LG11-4 Calculate the weights used for WACC
appropriate discount rate for valuing their firm’s cash
flows as a weighted average of the capital component projections. Appropriate weights used in calculating
costs. a WACC should reflect the relative sizes of the total
market capitalizations for each kind of security that
LG11-2 Use the weighted-average cost of capital the firm issues—debt, preferred stock, and pure equity.
(WACC) formula to calculate a project’s cost of Use market values rather than book values to calculate
capital. The WACC formula uses the after-tax costs a WACC because market values reflect investors’
of capital to compute the firm’s weighted-average cost assessment of what they would be willing to pay for the
of debt financing. Since interest on a firm’s pure debt various types of securities.
is paid out of before-tax income, the yield paid on
bonds does not really come entirely out of the firm’s LG11-5 Identify which elements of WACC are used
pockets. If the firm had not paid out the interest owed to to calculate a project-specific WACC. Any debt or
debt holders, then those funds would have been taxed. preferred stock that a firm issues, regardless of whether
So, effectively, if the firm can take full advantage of the securities will finance new projects or fund existing
interest tax shields on the debt, the firm only pays out operations, are rightfully obligations of the entire
(1 − TC) times the yield on debt to the debt holders; the firm. Thus, any debt and preferred stock components
government “pays” the remainder, TC, times the yield. of capital should use firmwide, not project-specific,
WACC figures. Therefore, we can expect common
LG11-3 Explain how the firm chooses among stockholders to bear the brunt of the risk of new projects.
estimating costs of equity, preferred stock, and Accordingly, the component cost of equity should reflect
debt. We estimate the component costs of capital using the project risk as measured by a proxy beta.
pricing formulas we have seen in previous chapters for
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cor01589_ch11_372-405.indd 396 10/09/21 03:10 PM

LG11-6 Evaluate trade-offs between a be adjusted (sometimes arbitrarily so that risky division
firmwide WACC and a divisional cost of capital WACCs will be higher than firm WACCs). Similarly,
approach. Since firms evaluate projects continually, subjective approaches adjust downward divisional
managers need a shortcut to avoid calculating project- WACCs for relatively safe divisions. An objective
specific WACCs for every project that they consider. approach to computing a divisional WACC uses the
They may use either a firmwide WACC or a divisional average beta of projects in each division to calculate the
WACC instead, but using the shortcuts involves a trade- WACC.
off between speed and precision. Using firmwide or
LG11-8 Demonstrate how to adjust the WACC to
divisional WACCS means that the firm can calculate
fewer WACCs than it has projects, but doing so will reflect flotation costs. Flotation costs increase costs
also introduce error into the accept/reject decisions. if the firm must rely upon externally raised funds for
Decision errors rise further when managers use a single, a project. We adjust the WACC for flotation costs by
firmwide WACC for all projects, or when they evaluate subtracting the flotation costs from the prices of new
projects with significantly different risk than the firm’s securities at issue. Then we use the lower adjusted prices
or division’s average risk. to calculate the respective component costs. Since we
reduce the price of the securities but not the size of the
LG11-7 Distinguish subjective and objective expected future cash flows due to capital providers, this
approaches to divisional cost of capital. The subjective approach raises each capital source’s effective cost.
approach requires only that WACCs for “risky” divisions
chapter equations
E P D
11-1 WACC Unconstrained = _______________
       × i E + _______________
       × i P + _______________
       × i D × (1 − T C)
E + P + D E + P + D E + P + D
E P D
11-2 WAC C Constrained = _______
      × i E + _______
      × i P + _______
      × i D
E + P + D E + P + D E + P + D
11-3 i E = R f + β(R M − R f)
D 
11-4 i E = ___
  1  + g
P 0
___
D 1
11-5 i p =     
P 0
⎧ ⎡ ⎤ ⎫
⎢ ⎥
1
⎪ 1 − ___________
    N   ⎪
⎨ FV ⎬
( 1 + i D)  ___________
  V = PMT ×    
1 1-6 Solve ⎪P   
__________________
    +  
     ⎪    for i D
⎩ ⎣ i D ⎦ (1 + i D) N⎭
11-7 i E = r f + β Avg[E( r M) − r f]
where
   N  
 Σ    β j
j=1
β Avg = ______
       
n
E Project
____________________
11-8 WACC Unconstrained, Project =          
× i E, Project
P Project
    
     ____________________
  +       × i P, Firm
D Project
+___________________________
  
    × i D, Firm  × (1 − T C)
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E Project
____________________
11-9 WAC C Constrained, Project =          
× i E, Project
P Project
    + ____________________
       
      
× i P, Firm 
D Project
+ ____________________
 
       
× i D, Firm
D 
11-10 i E = _____
  1     + g
P 0 − F
D 
11-11 i P = _____
  1    
P 0 − F
⎧ ⎡ ⎤ ⎫
⎢ ⎥
1
⎪ 1 − ___________
    N   ⎪
⎨ FV ⎬
( 1 + i D)  ___________
  V − F = PMT ×    
1 1-12 Solve ⎪P   
__________________
    +  
     ⎪    for i D
⎩ ⎣ i D ⎦ (1 + i D) N⎭
chapter spreadsheet functions

Sum a range or set of sumbers: SUM(number1,[number2], . . .)
Calculate average/arithmetic mean of a set of numbers:

AVERAGE(number1,[number2], . . .)
Calculate periodic rate in a TVM problem: RATE(nper,pmt,pv,[fv],[type],[guess])
key terms
business risk The risk of a project arising from the line flotation costs Fees paid by firms to investment banks
of business it is in; the variability of a firm’s or division’s for issuing new securities. p. 393
cash flows. p. 384 proxy beta The beta (a measure of the riskiness) of a
component costs The individual costs of each type of firm in a similar line of business as a proposed new proj-
capital—bonds, preferred stock, and common stock. p. 373 ect. p. 384
divisional WACC An estimated WACC computed using separation principle Theory maintaining that the
some sort of proxy for the average equity risk of the proj- sources and uses of capital should be decided upon inde-
ects in a particular division. p. 387 pendently. p. 384
financial risk The risk of a project to equity holders stem- weighted-average cost of capital (WACC) The
ming from the use of debt in the financial structure of the weighted-average after-tax cost of the capital used by a
firm; refers to the issue of how a firm decides to distribute firm, with weights set equal to the relative percentage of
the business risk between debt and equity holders. p. 384 each type of capital used. p. 373
self-test problems with solutions

LG11-3, 11-4 1 Computing Firmwide WACC Sound & Vision Studios (SVS) has 5 million
common shares outstanding, which sell for $24 per share. SVS management is expected to
set the next annual dividend at $2.25 per share, and investors and analysts expect all future
dividends to grow by 8 percent per year, indefinitely. The current risk-free rate is 5.50
percent, the expected return on the market is 11 percent, and the stock has a beta of 2.2.
SVS also has 1 million shares of 5 percent preferred stock outstanding, with these shares
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selling for $44 per share, and 150,000, 15-year, 9 percent annual coupon bonds outstanding,
currently selling for 112 percent of par. If SVS is in the 21 percent tax bracket and expects
to be able to take full advantage of any interest tax shields, what is the firm’s WACC?
Solution:
The component cost of equity, iE, computed using the CAPM, will be equal to
0.055 + 2.2(0.11 − 0.055) = 0.1760
The component cost of equity computed using the constant-growth model will be equal to
$2.25
______
   
  
+ 0.08 = 0.1738
$24.00
Absent any guidance concerning which estimate is most appropriate, our best approach
is to take the average of the two as iE:
0.1760 + 0.1738
_____________
i E =   
      
= 0.1749
2
The component cost of preferred stock, iP, will be equal to
$5
____
     = 0.1136
$44
The before-tax component cost of debt, iD, will be the solution to
  1  15  
1 − _
[ ]
( 1 + i D)  
____________ $1,000
$1,120 = $90 ×         + ____________
        
⇒ i D = 0.0763
i D (1 + i D) 15
The market values of equity, preferred stock, and debt will be:
E = 5m × $24.00 = $120m
P  =  1m × $44.00 = $44m
   
    
D = 150,000 × $1,120 = $168m
And we can use these proportions to calculate the weights:
E
_______ $120m
  = ___________________
             
= 0.3614
E + P + D $120m + $44m + $168m
P
_______ $44m
 
     = ___________________
             
= 0.1325
E + P + D $120m + $44m + $168m
E
_______ $168m
  = ___________________
             
= 0.5060
E + P + D $120m + $44m + $168m
Using the weights, the component costs, and the tax rate, we can calculate the WACC as:
WACC = 0.3614 × 0.1749 + 0.1325 × 0.1136 + 0.5060 × 0.0763 × (1 − 0.21)
      
     
= 0.1088, or 10.88%
2 Calculating Project WACC Ranks Engineering, a civil engineering firm that has LG11-5
historically gotten most of its revenues from the planning and construction of public
works projects, is considering starting a new division that will submit architectural
designs for private engineering projects, such as designing shopping malls. Adding the
new division is expected to increase the firm’s EBIT from $8 million to $10 million.
While the civil engineering industry has a fairly low beta of 0.65, the private design
market is a bit riskier, and Ranks has commissioned a study that shows that the average
beta in that industry is approximately 1.3. Rank’s capital structure currently consists
of 1 million outstanding shares of common stock, selling for $37 per share, and a
$15 million bond issue, selling at 98 percent of par. The expected market risk premium
is 8 percent, and the current risk-free rate is 5.7 percent. The bonds pay an 8 percent
annual coupon and mature in 10 years, and Ranks expects to be able to take full
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advantage of the interest tax shields on debt. If the new division will be funded with 70
percent equity and 30 percent debt, what should be the WACC for this new division?
Solution:
The weights to be used in the calculation of the division’s WACC will be the 70
percent equity/30 percent debt specified in the problem and will not be based upon the
company’s existing capital structure.
The component cost of equity, iE, will use the beta of the new line of business:
0.057 + 1.3(0.08) = 0.1610
The component cost of debt, iD, will be the solution to:
  1  10  
1 − _
[ ]
( 1 + i D)  
____________ $1,000
$980 = $80 ×         +  ____________
      
⇒ i D = 0.0830
i D (1 + i D) 10
The rise in EBIT from $8 million to $10 million will be taxed at the 21 percent
corporate tax rate, so the appropriate computation of the division’s WACC will be equal to:
WACC = 0.70 × 0.1610 + 0.30 × 0.0830 × (1 − 0.21)
     
   
= 0.1324, or 13.24%
LG11-6 34 Firmwide WACC Decisions An all-equity firm is considering the projects shown
in the following table. The T-bill rate is 6 percent and the market risk premium is
9 percent. If the firm uses its current WACC of 16.8 percent to evaluate these projects,
which project(s), if any, will be incorrectly rejected?
Project Expected Return Beta

A 8.0% 0.2
B 19.0 1.4
C 13.0 0.8
D 17.0 1.3
Solution:
If the firm uses the current WACC of 16.8 percent to evaluate all projects, projects A
and C will be rejected. To determine if these rejections are correct or incorrect, we have
to calculate what the projects’ risk-specific WACCs should be:
WAC C A = i E,A = 0.06 + 0.2 × 0.09 = 0.078, or 7.8%
     
   
WAC C C = i E,C = 0.06 + 0.8 × 0.09 = 0.132, or 13.2%
Based on these numbers, project C should be rejected, as its risk-appropriate WACC
of 13.2 percent is higher than its expected return of 13 percent. This result indicates that
the project is not expected to earn a high enough level of return to compensate for its
expected risk. Project A’s risk-appropriate rate of return at 7.8 percent is less than its
expected 8 percent return, so it should be accepted. Project A’s rejection when using the
firmwide WACC is incorrect.
LG11-8 4 Include Impact of Flotation Costs Redo Self-Test Problem 1 for a proposed new
project in the same line of business as the firm’s current operations, but assuming that
new equity will have a flotation cost of 15 percent, preferred stock will have a flotation
cost of 10 percent, and debt will have a flotation cost of 3 percent.
Solution:
The component cost of equity, iE, using flotation costs and the constant-growth model, will be
$2.25
____________________
 
       
+ 0.08 = 0.1903
$24.00 − (0.15 × $24.00)
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Because this is 19.03% − 17.38% = 1.65% higher than the calculated number when
we ignored flotation costs, we could also adjust the iE we had previously calculated
using the CAPM of 17.60% by adding 1.65% to it, also: 17.60% + 1.65% = 19.25%,
similar to the approach we took in Example 11-8. Taking an average of the two
measures of iE computed incorporating flotation costs will give us the number we
should use in the calculation of the WACC:
0.1903 + 0.1925
_____________
  
      
= 0.1914
2
The component cost of preferred stock, iP, will equal
$5
 ______________
      = 0.1263
$44 − (0.1 × $44)
The component cost of debt, iD, will be the solution to:
  1  15  
1 − _
$ 1,120(1 − 0.03) = $90 ×  [____________ ]
(1 + i D)  $1,000
     
   + ____________
      
⇒ i D = 0.0799
i D ( 1 + i D) 15
No change in the capital structure weights or in the tax rate will occur, so the WACC
for the new project will be:
WACC = 0.3614 × 0.1914 + 0.1325 × 0.1263 + 0.5060 × 0.0799 × (1 − 0.21)
         
= 0.1178, or 11.78%
questions
1. How would you handle calculating the cost of capi- anticipated that the new line of business would
tal if a firm were planning to issue two different constitute over 80 percent of your firm’s operations
classes of common stock? (LG11-1) within three years. If the expansion was going to
2. Expressing WACC in terms of iE,iP, and iD, what is be financed partially with debt, would it still make
the theoretical minimum for the WACC? (LG11-2) sense to use the firm’s existing cost of debt, or
should you compute a new rate of return for debt
3. Under what situations would you want to use the
based on the new line of business? (LG11-5)
CAPM approach for estimating the component cost
of equity? The constant-growth model? (LG11-3) 7. Explain why the divisional cost of capital approach
may cause problems if new projects are assigned to
4. Could you calculate the component cost of equity
the wrong division. (LG11-6)
for a stock with nonconstant expected growth rates
in dividends if you didn’t have the information 8. When will the subjective approach to forming divi-
necessary to compute the component cost using the sional WACCs be better than using the firmwide
CAPM? Why or why not? (LG11-3) WACC to evaluate all projects? (LG11-7)
5. Why do we use market-based weights instead of 9. Suppose a new project was going to be financed
book-value-based weights when computing the partially with retained earnings. What flotation costs
WACC? (LG11-4) should you use for retained earnings? (LG11-8)
6. Suppose your firm wanted to expand into a new
line of business quickly, and that management
problems
11-1 Cost of Equity Diddy Corp. stock has a beta of 1.2, the current risk-free rate is basic
5 percent, and the expected return on the market is 13.5 percent. What is Diddy’s problems
cost of equity? (LG11-3)
401
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11-2 Spreadsheet Problem: Cost of Debt Oberon, Inc., has a $20 million (face
value) 10-year bond issue selling for 97 percent of par that pays an annual cou-
pon of 8.25 percent. What would be Oberon’s before-tax component cost of
debt? (LG11-3)
11-3 Tax Rate Suppose that LilyMac Photography expects EBIT to be approximately
$200,000 per year for the foreseeable future, and that it has 1,000 10-year, 9 per-
cent annual coupon bonds outstanding. What would the appropriate tax rate be
for use in the calculation of the debt component of LilyMac’s WACC? (LG11-3)
11-4 Cost of Preferred Stock ILK has preferred stock selling for 97 percent of par
that pays an 8 percent annual coupon. What would be ILK’s component cost of
preferred stock? (LG11-3)
11-5 Spreadsheet Problem: Weight of Equity FarCry Industries, a maker of tele-
communications equipment, has 2 million shares of common stock outstanding,
1 million shares of preferred stock outstanding, and 10,000 bonds. If the common
shares are selling for $27 per share, the preferred shares are selling for $14.50 per
share, and the bonds are selling for 98 percent of par, what would be the weight
used for equity in the computation of FarCry’s WACC? (LG11-4)
11-6 Spreadsheet Problem: Weight of Debt FarCry Industries, a maker of telecom-
munications equipment, has 2 million shares of common stock outstanding, 1
million shares of preferred stock outstanding, and 10,000 bonds. If the common
shares are selling for $27 per share, the preferred shares are selling for $14.50
per share, and the bonds are selling for 98 percent of par, what weight should you
use for debt in the computation of FarCry’s WACC? (LG11-4)
11-7 Spreadsheet Problem: Weight of Preferred Stock FarCry Industries, a maker
of telecommunications equipment, has 2 million shares of common stock out-
standing, 1 million shares of preferred stock outstanding, and 10,000 bonds. If
the common shares sell for $27 per share, the preferred shares sell for $14.50 per
share, and the bonds sell for 98 percent of par, what weight should you use for
preferred stock in the computation of FarCry’s WACC? (LG11-4)
intermediate 11-8 WACC Suppose that TapDance, Inc.’s, capital structure features 65 percent
problems equity and 35 percent debt, and that its before-tax cost of debt is 8 percent, while
its cost of equity is 13 percent. If the appropriate weighted average tax rate is 21
percent and TapDance estimates it cannot make any use of the interest tax shield
in the foreseeable future, what will be TapDance’s WACC? (LG11-2)
11-9 WACC Suppose that MNINK Industries’ capital structure features 63 percent
equity, 7 percent preferred stock, and 30 percent debt. If the before-tax compo-
nent costs of equity, preferred stock, and debt are 11.60 percent, 9.5 percent, and
9 percent, respectively, what is MNINK’s WACC if the firm faces an average tax
rate of 21 percent and can make full use of the interest tax shield? (LG11-2)
11-10 Spreadsheet Problem: WACC Johnny Cake Ltd. has 10 million shares of stock
outstanding selling at $23 per share and an issue of $50 million in 9 percent
annual coupon bonds with a maturity of 17 years, selling at 93.5 percent of par.
If Johnny Cake’s weighted-average tax rate is 21 percent, it cannot make use of
interest tax shields for the foreseeable future, its next dividend is expected to be
$3 per share, and all future dividends are expected to grow at 6 percent per year,
indefinitely, what is its WACC? (LG11-3)
11-11 Spreadsheet Problem: WACC Weights BetterPie Industries has 3 million
shares of common stock outstanding, 2 million shares of preferred stock out-
standing, and 10,000 bonds. If the common shares are selling for $47 per share,
the preferred shares are selling for $24.50 per share, and the bonds are selling for
402
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99 percent of par, what would be the weights used in the calculation of Better-
Pie’s WACC? (LG11-4)
11-12 Spreadsheet Problem: Flotation Cost Suppose that Brown-Murphies’ com-
mon shares sell for $19.50 per share, that the firm is expected to set their next
annual dividend at $0.57 per share, and that all future dividends are expected to
grow by 4 percent per year, indefinitely. If Brown-Murphies faces a flotation cost
of 13 percent on new equity issues, what will be the flotation-adjusted cost of
equity? (LG11-8)
11-13 Flotation Cost A firm is considering a project that will generate perpetual after- advanced
tax cash flows of $15,000 per year beginning next year. The project has the same problems
risk as the firm’s overall operations and must be financed externally. Equity flo-
tation costs 14 percent and debt issues cost 4 percent on an after-tax basis. The
firm’s D/E ratio is 0.8. What is the most the firm can pay for the project and still
earn its required return? (LG11-2)
11-14 Spreadsheet Problem: Firmwide versus Project-Specific WACCs An all-
equity firm is considering the projects shown below. The T-bill rate is 4 percent
and the market risk premium is 7 percent. If the firm uses its current WACC of
12 percent to evaluate these projects, which project(s), if any, will be incorrectly
rejected? (LG11-6)
Project Expected Return Beta

A 8.0% 0.5
B 19.0 1.2
C 13.0 1.4
D 17.0 1.6
11-15 Spreadsheet Problem: Divisional WACCs Suppose your firm has decided to
use a divisional WACC approach to analyze projects. The firm currently has four
divisions, A through D, with average betas for each division of 0.6, 1.0, 1.3, and
1.6, respectively. If all current and future projects will be financed with half debt
and half equity, and if the current cost of equity (based on an average firm beta of
1.0 and a current risk-free rate of 7 percent) is 13 percent and the after-tax yield
on the company’s bonds is 8 percent, what will the WACCs be for each division?
(LG11-7)
integrated mini-case WACC for a New Project

LilyMac Studios, a national chain of photography studios, is considering opening up a
chain of coffee shop/art galleries. While the existing operations of the firm have a beta
of 1.17, the new chain is expected to have a beta of 0.8.
LilyMac currently has 500,000 shares of common stock outstanding, which are
selling for $63.72 per share, and a $10 million bond issue, selling at 104 percent of
par. The expected market risk premium is 6 percent, and the current risk-free rate is 5.5
percent. The bonds pay an 8 percent semiannual coupon and mature in 20 years, and
LilyMac anticipates that they can make full use of the interest tax shields.
The current operations of the firm produce EBIT of $18 million per year, and the
chain’s operations are expected to add $25 million per year to that. The new chain will
be funded with 65 percent equity and 35 percent debt, and estimated flotation costs are
expected to be 12 percent and 5 percent, respectively.
What should be the WACC for the new chain of coffee shops?
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ANSWERS TO TIME OUT
11-1 Debt interest is paid out of before-tax earnings, implying that paying $1 in interest
really costs the firm only $1 × (1 − TC) if the firm can take full advantage of the interest
tax shield; common and preferred stock dividends are paid out of after-tax net income,
and so they do not have a tax-shelter effect.
11-2 We would compute the weighted-average cost of debt using the percentage of total
market value of each issue as its weight.
11-3 The costs of debt and preferred stock are firmwide obligations, not project-specific
ones, because debt holders and owners of preferred shares can legally expect to be
paid back out of the firm’s revenues even if the specific project being funded is not
successful.
11-4 We can often “back out” a pure-play beta by adjusting such a firm’s beta to offset the
impact of the other lines of business. For example, suppose that we are trying to find a
proxy beta for a project involving the production of dishwashers. If we can find a poten-
tial proxy company with a beta of 0.75 that makes both dishwashers and air condition-
ers (and that earns approximately half its revenue from each line of business), and we
can elsewhere estimate the average beta of an air-conditioning manufacturer to be, say,
0.8, then we extrapolate that the beta for the dishwasher division of that company must
be the solution to 0.75 = (0.5 × 0.8) + (0.5 × βDishwashers), or βDishwashers = 0.7.
11-5 Divisions based on either product type or geographic location will also usually proxy
for differences in project risk. For example, many large auto manufacturers use divi-
sional breakdowns based on both product types and geography (e.g., “Ford of North
America” or “Dodge Truck Division”). Though these divisions are not explicitly targeted
at separating projects by risk, selling a new Ford Focus in Europe is obviously going to
have different risks than selling the same car in North America due to the differences
in competitive environment, consumer tastes, and so on.
11-6 Project D’s beta is lower than average for its division, so the objectively computed
divisional WACC for its division will still overstate the project’s required rate of return
versus a project-specific WACC. Holding the project up to too high of a benchmark will
cause it to be incorrectly rejected.
11-7 Debt is easier for the underwriter to sell for several reasons. Debt is safer and there-
fore more attractive to many groups of potential buyers. It also tends to be sold in
larger denominations primarily to large financial institutions, such as mutual funds and
pension funds, which requires the underwriter to contact a smaller group of potential
buyers than if assisting in a stock issue.
11-8 We would take a weighted average of the flotation cost for new equity and that of
retained earnings (which would be equal to zero), where the weights would be equal
to the proportion of each type of equity financing used.
Design elements: Arrows: maxuser/Getty Images; Stopwatch: _human/Getty Images; Whistle: Devonyu/
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11 Calculating the Cost

How else can Mackenzie finance her

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374 part six Capital Budgeting

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WAC ​C​ Unconstrained​ = Percentage of equity × Cost of equity

WAC ​C​ Constrained​ = Percentage of equity × Cost of equity

Calculating the Component Cost of Equity LG11-3

chapter 11 Calculating the Cost of Capital 375

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Cost of Equity For interactive versions

SOLUTION: The cost of equity using the CAPM will be

The cost of equity using the constant-growth model will be

Similar to Problem 11-1

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Calculating the Component Cost of Preferred Stock

EXAMPLE 11-2 LG11-3

For interactive versions

SOLUTION: The cost of the preferred stock will equal

There is no built-in function in Excel for calculating the

Calculating the Component Cost of Debt

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Cost of Debt with No Restriction on Interest Deductions For interactive versions

SOLUTION: The before-tax cost of debt will be the solution to

chapter 11 Calculating the Cost of Capital 379

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Similar to Problem 11-2

EXAMPLE 11-4 LG11-3

For interactive versions

LG11-4 Calculating the Weights

380 part six Capital Budgeting

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SOLUTION: Using the securities’ prices given in previous examples, ADK’s equity,

The spreadsheet solution is:

chapter 11 Calculating the Cost of Capital 381

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Similar to Problems 11-5 to 11-7, 11-11, Self-Test Problem 1

382 part six Capital Budgeting

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Project Cost Numbers to Take from the Firm

chapter 11 Calculating the Cost of Capital 383

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Project Cost Numbers to Find Elsewhere: The Pure-Play

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Calculation of Project WACC For interactive versions

chapter 11 Calculating the Cost of Capital 385

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which gives us an iD of 8.68 percent.

The spreadsheet solution is:

386 part six Capital Budgeting

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chapter 11 Calculating the Cost of Capital 387

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have expected returns less

conclude that projects A and

However, using a firmwide WACC would result in a comparison of the project’s

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WAC C Unconstrained = Percentage of equity × Cost of equity

WAC C Constrained = Percentage of equity × Cost of equity

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