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CHAPTER 9 The Cost of Capital Define “hurdle rate” and show how it relates to the firm’s Weighted Average Cost of Capital (WACC). Calculate the WACC using both book- and market-value weights. Calculate component costs of capital with flotation costs and taxes. | 9 The Cost of Capital After studying this chapter you should be able to 1. Define hurdle rate and show how it relates to the firm s Weighted Average Cost of Capital WACC . 2. Calculate the WACC using both book- and market-value weights. 3. Calculate component costs of capital with flotation costs and taxes. 4. Explain how and why a firm s WACC changes as total capital requirements change. 5. Use Excel to calculate the break-points in a firm s marginal WACC curve and graph this curve in Excel. Knowledge of a firm s cost of capital is vital if managers are to make appropriate decisions regarding the use of the firm s funds. Without this knowledge poor investments may be made that actually reduce shareholder wealth. In this chapter we will examine what the cost of capital is and how to calculate it. 255 256 The Cost of Capital The Appropriate Hurdle Rate A firm s required rate of return on investments is often referred to as its hurdle rate because all projects must earn a rate of return high enough to clear this rate. Otherwise a project will not cover its cost of financing thereby reducing shareholder wealth. But what is the appropriate rate to use Let s look at an example. The managers of the Rocky Mountain Motors RMM are considering the purchase of a new tract of land which will be held for one year. The purchase price of the land is 10 000. RMM s capital structure is currently made up of 40 debt 10 preferred stock and 50 common equity. Because this capital structure is considered to be optimal any new financing will be raised in the same proportions. RMM must raise the new funds as indicated in Table 9-1. Table 9-1 Funding for RMM s Land Purchase Source of Funds Amount Dollar Cost After-Tax Cost Debt 4 000 280 7 Preferred Stock 1 000 100 10 Common Stock 5 000 600 12 Total 10 000 980 9.8 Before making the decision RMM s managers must determine what required rate of return will simultaneously satisfy all of their capital providers. What minimum rate of return will
