Q1: WHAT SOURCES OF CAPITAL SHOULD BE INCLUDED WHEN YOU ESTIMATE COX'S

WEIGHTED AVERAGE COST OF CAPITAL (WACC)?

The WACC is used primarily for making long term capital investment decisions, i.e., for capital budgeting.
Thus the wacc should include the types of capital used to pay for long term assets, and this is typically
long term debt, preferred stock, and common stock, short term securities of capital consist of
spontaneous, noninterest bearing liabilities such as account payable and accruals and short term interest
bearing debt, such as notes payable. If the firm uses short term interest bearing debt to acquire fixed
assets rather than just to finance working capital needs, than the wacc should include short term debt
component. Non interest debt is generally not included in the cost of capital estimate because these
funds are acquired out when determining investing needs that is net rather than gross working capital is
included in capital expenditure.
2. SHOULD THE COMPONENT COSTS BE FIGURED ON A BEFORE-TAX OR AN AFTER-TAX
BASIS?
Stockholders are concerned primarily with those corporate cash flows that are available for their use,
namely those cash flows available to pay dividends or for reinvestment. Since dividends are paid from
and reinvestment is made with after tax dollars, all cash flow and rate of return calculations should be
done on an after tax basis.
3. SHOULD THE COSTS BE HISTORICAL (EMBEDDED) COSTS OR NEW (MARGINAL) COSTS?
In financial management the cost of capital is used primarily to make decisions which involve raising new
capital. Thus the reinvestment component costs are todays marginal costs rather thin historical costs.
C. 2. COX'S PREFERRED STOCK IS RISKIER TO INVESTORS THAN ITS DEBT, YET THE
PREFERRED'S YIELD TO INVESTORS IS LOWER THAN THE YIELD TO MATURITY ON THE
DEBT. DOES THIS SUGGEST THAT YOU HAVE MADE A MISTAKE? (HINT: THINK ABOUT
TAXES.)
Corporate investors own most preferred stock; because 70% of preferred dividends received by
corporations are nontaxable. Therefore, preferred often has a lower before tax yield than before tax yield
on the debt issued by the same company.
D. 1. WHAT ARE THE TWO PRIMARY WAYS COMPANIES RAISE COMMON EQUITY?
A firm can raise their common equity in two ways:
1) By retaining earnings and 2) by issuing new common stocks.
D. 2. WHY IS THERE A COST ASSOCIATED WITH REINVESTED EARNINGS?
Management pays the earning in the form of dividends or else retained earnings for reinvestment in the
business. If part of the earnings is retained, an opportunity cost is incurred: stockholders could have
received those earnings as dividends and then invested that money in stock, bonds, real estate, and so
on.
E. 3. COULD THE DCF METHOD BE APPLIED IF THE GROWTH RATE WAS NOT
CONSTANT? HOW?
Yes we can use the DCF using non-constant growth. We would find the pv of the dividends during growth
period and add this values to the pv of the series of inflows when growth is assumed to become constant.
p) WHAT ARE FOUR COMMON MISTAKES IN ESTIMATING THE WACC THAT COX SHOULD
AVOID?
Managers and students make the following mistakes when estimating the cost of capital. Although we
have discussed these errors previously at separate places in the chapter, they are worth repeating here:
1. Never use the coupon rate on a firms existing debt as the pre-tax cost of debt. The relevant pre-tax
cost of debt is the interest rate the firm would pay if it issued debt today.
2. When estimating the market risk premium for the CAPM method, never use the historical average
return on stocks in conjunction with the current risk-free rate.
3. Never use the book value of equity when estimating the capital structure weights for the WACC. Your
first choice should be to use the target capital structure to determine the weights. If you are an outside
analyst and do not know the target weights, it is better to estimate weights based on the current market
values of the capital components than on their book values. This is especially true for equity. In short if
you dont know the target weights, then use market values of equity rather than book values to obtain the
weights used to calculate WACC.
4. Always remember that capital components are funds that come from investors. If its not from an
investor, then its not a capital component.
J. WHAT ARE THE THREE TYPES OF RISK, AND WHICH IS MOST RELEVANT FOR
ESTIMATING THE COST OF CAPITAL?
I. A projects stand-alone risk is the risk the project would have if it were the firms only asset and
if stockholders held only that one stock. Stand-alone risk is measured by the variability of the
assets expected returns.
II. Corporate, or within-firm, risk reflects the effects of a project on the firms risk, and it is
measured by the projects effect on the firms earnings variability.
III. Market, or beta, risk reflects the effects of a project on the risk of stockholders, assuming they
hold diversified portfolios. Market risk is measured by the projects effect on the firms beta
coefficient.
The most relevant for estimating the cost of capital in theory would be market risk. But unfortunately the
market risk is also the most difficult to estimate this why Most decision makers consider all three risk
measures in a judgmental manner and then classify projects into subjective risk categories. Using the
divisional WACC as a starting point, risk-adjusted costs of capital are developed for each category.

K. WHAT ARE TWO WAYS TO ESTIMATE DIVISIONAL BETAS?
Two ways are the pure play method and the accounting beta method. In the pure play method company
tries to find several single product companies in the same line of business as the project being evaluated,
and it then average those betas to determine the cost of capital for its own project. In the accounting beta
method, we run a regression of our companys accounting data against the average for a large sample of
companies. We would do this with return on assets for instance.
G. what factors influence a companys wacc?
Factors That Affect the Weighted Average Cost of Capital
The cost of capital is affected by a number of factors. Some are beyond the firms control, but others are
influenced by its financing and investment policies.
Factors the Firm Cannot Control: The three most important factors that are beyond a firms direct
control are (1) the level of interest rates, (2) the market risk premium, and (3) tax rates.
Factors the Firm Can Control: A firm can affect its cost of capital through (1) its capital structure policy,
(2) its dividend policy, and (3) its investment (capital budgeting) policy.