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NORTHWESTERN UNIVERSITY J.L. KELLOGG GRADUATE SCHOOL OF MANAGEMENT

Tim Thompson Finance D42 Winter, 1995

Cost of Capital Notes: Teaching Note

0. Introduction The purpose of this teaching note is to discuss the estimation of the weighted average cost of capital for companies, divisions and projects. The cost of capital for an investment is an

opportunity cost: it is the expected rate of return that investors in a project could earn in the capital market on other investments of similar risk.1 Companies have many uses for such an opportunity cost of capital: 1. using a project’s cost of capital as a hurdle rate to determine whether to make an investment in the project (i.e., using the cost of capital to calculate the NPV of a project); 2. using the cost of capital of a division or a subsidiary to determine whether the unit should be sold by the parent company; 3. using the cost of capital (for a project, division, or entire corporation) as a benchmark for performance measurement; 4. using the cost of capital for the entire corporation to calculate the value of the firm, which can be used to estimate a "true value" for the company’s stock to compare with the "stock market" value of the company’s stock, the purpose being to assess the attractiveness of repurchasing (or issuing) shares of the company’s stock and to assess the vulnerability of the company to hostile attack by another company.

Similar investments are investments with similar maturity (or duration, or if you are really into buzzwords, tenor), similar tax status to the holder, similar liquidity, and perhaps many other dimensions, not only similar risk. But we get the most mileage out of risk.

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Cost of capital notes, page 2 Consider an investment which generates a perpetuity of expected pretax operating cash flow of E(OI) per year. The investment’s returns are taxed (at corporate level) at constant rate c; interest expense is tax deductible (at the corporate level). The investment is...