End-of-chapter questions. 12-1. The cost of capital is the rate that must be earned on investments in order to satisfy the required rate of return of the firm's investors

12-1. The cost of capital is the rate that must be earned on investments in order to satisfy the required rate of return of the firm's investors. This rate is a function of the investors' required rate of return, the corporation's tax rate, and the flotation costs incurred in issuing new securities. Therefore, the cost of capital determines the rate of return that must be achieved on the company's investments, so as to earn the target return of the firm's investors. Stated differently, the cost of capital is the rate of return that will leave the price of the common stock unchanged.

12-2. Two objectives may be given for determining a company's weighted average cost of capital:

(1) The weighted average cost of capital is used as the minimum acceptable rate of return for capital investments. The value of the firm should be maximized by accepting all projects where the net present value is positive when discounted at the firm's weighted average cost of capital.

(2) The weighted average cost of capital is also used in evaluating a firm’s historical performance. That is, to create shareholder value a firm must not only earn a profit in the traditional accounting sense, but it must earn a return on its invested capital that is acceptable to the investors who provide the firm’s financing. This “acceptable return” is the firm’s weighted average cost of capital.

12-3. All types of capital, including debt, preferred stock, and common stock, should be incorporated into the cost of capital computation, with the relative importance of a particular source being based upon the percentage of financing to be provided.

12-4. The effect of taxes on the firm's cost of capital is observed in computing the cost of debt. Since interest is a tax deductible expense, the use of debt indirectly decreases the firm's taxes. Therefore, since we have computed the internal rate of return on an after-tax basis, we also compute the cost of debt on an after-tax basis. In completing a security offering, investment bankers and other involved individuals receive a commission for their services. As a result, the amount of capital net of these flotation costs is less than the funds invested by the individual purchasing the security. Consequently, the firm must earn more than the investors' required rate of return to compensate for this leakage of capital.

12-5. a. Equity capital can be raised by either retaining profits within the firm or by issuing new common stock. Either route represents funds invested by the common stockholder. The first avenue simply indicates that the common stockholder permits management to retain capital that could be remitted to these investors.

b. Even though a new stock issue does not result from retaining internal common equity, these funds should not be reinvested unless management can reasonably expect to satisfy the investors' required rate of return. In essence, even though no explicit out-of-pocket cost results from retaining the capital, the cost in measuring a firm's cost of capital is actually the opportunity cost associated with these funds for the investor.

c. The two popular methods for computing the cost of equity capital include (1) the dividend-growth model, and (2) the capital asset pricing model. The first approach finds the rate of return that equates the present value of future dividends, assuming a constant growth rate, with the current market price of the security. The CAPM finds the appropriate required rate of return, given the firm's systematic risk.

12-6 In general, the relative costs of various sources of capital reflect the riskness of the source to the investor. For example, for a given firm, we would expect debt securities to be less risky than preferred stock which is less risky than common stock. Consequently, debt would demand a lower required return than the firm’s preferred stock, which is lower than the required rate of return for common stock.

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