Determining the Cost of Capital: Can One Size Fit All?

1003 Words Feb 2nd, 2012 5 Pages
Determining the Cost of Capital
Can One Size Fit All?

1. Why do you think Larry Stone wants to estimate the firm’s hurdle rate? Is it justifiable to use the firm’s weighted average cost of capital as the divisional cost of capital? Please explain.

Larry wants to estimate the firm's hurdle rate because it would provide him with a standard with which to measure feasibility of future investment proposal. The firm had thus far been using a ‘gut feel’ approach and although most of the decisions had turned out to be good ones, Larry was strictly concerned that the his luck could end and put the firm into dire situations.

If the divisional projects were deemed to be of similar risk, using the weighted- average cost of
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Can flotation costs be ignored in the analysis? Explain.

Flotation costs can be ignored in calculating the weighted average cost of capital. However, when analyzing the Net Present Value of projects, the weighted flotation cost must be accounted for before a decision is made.

For example, a project has an initial cost of $1,000,000 and assuming there's no retained earnings available.

Weighted average flotation cost = Weight of debt*Flotation cost of debt + Weight of equity * Flotation cost of new equity

Component Price # outstanding Market Value Weight ____
Debt $915 40,000 36,600,000 17.297%
Equity $35 5,000,000 175,000,000 82.71%
Total MV of Capital 211,600.000 100%

Total Flotation Cost= 17.29% 5% + 82.71% 10% = 9.135%

Since the project costs 1,000,000 without flotation costs, the cost after including flotation costs would be 1,000,000/(1-.09135) = $1,100,533.75 assuming there are no retained earnings
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