Companies Have Little Control over Their Cost of Capital  57
companies (say, the S&P 500), adjusted for the riskiness of the company rela-
tive to the average of all companies.
Within a company, individual business units can have different costs of 
capital if their risk profiles differ. The company’s overall cost of capital is 
simply a weighted average of its business units’ costs of capital. In banking, 
for example, risky trading operations carry much higher costs of capital than 
more stable retail banking units.
Executives often fail to adequately incorporate the idea of opportunity cost 
in thinking about their cost of capital. Sometimes they mix up the opportunity 
cost of capital by associating different funding streams with different invest-
ments. For example, when one company acquires another, the buyer might 
raise enough debt to pay for the entire company. It is tempting to say that the 
cost of capital for the acquisition is the cost of the debt. But this would be a 
mistake, because the risk of the target’s free cash flows does not equal the risk 
of the bondholders’ cash flows.
To illustrate, say Company A is considering buying Company B. Both op-
erate in the same product area with similar risk. Company A has no debt and 
an opportunity cost of capital of 8 percent. Suppose Company A can borrow at 
4 percent after taxes. For a target company growing at 3 percent with $1 billion 
in earnings and a 15 percent return on capital, the value of the target would 
be $80 billion at a 4 percent cost of capital and $20 billion at an 8 percent cost 
of capital. To get a sense of how absurd it would be to use the 4 percent cost 
of capital, consider that the implied price-to-earnings ratio (P/E) at 4 percent 
is 80, compared with 20 at an 8 percent cost of capital. Companies growing at 
3 percent don’t trade at a P/E of 80.
In addition, if you apply the cost of debt to the acquisition, you end up 
with a perverse situation: Company A’s existing businesses are assigned an 8 
percent cost of capital, and the acquired business is assigned a 4 percent cost 
of capital. In addition, the only reason Company A can borrow 100 percent 
of the cost of the acquisition is that it has unused debt capacity in its existing 
businesses. And don’t forget, the cost of capital is determined by the acquired 
company’s riskiness, not that of the parent company (although their risk pro-
files are likely to be the same if they are in the same industry).
Companies Have Little Control over Their Cost of Capital
It might be surprising to learn that the cost of capital for a company with 
steady revenues, like Procter & Gamble, isn’t that different from a company 
like LyondellBasell, a chemical company in an industry known for having 
more variable earnings and cash flows. In 2019, most large companies’ WACC 
fell in the range of 7 to 9 percent. The range is small because investors pur-
posely avoid putting all their eggs in one basket. The ability of investors to 
diversify their portfolios means that only nondiversifiable risk affects the cost 

58  Risk and the Cost of Capital 
of capital. Furthermore, because nondiversifiable risk also generally affects 
all companies in the same industry in the same way, a company’s industry is 
what primarily drives its cost of capital. Companies in the same industry will 
have similar costs of capital.
Stock market investors, especially institutional investors, may hold hun-
dreds of different stocks in their portfolios. Even the most concentrated in-
vestors have at least 50. As a result, their exposure to any single company is 
limited. It is possible to show how the total risk of a portfolio of stocks de-
clines as more shares are added to the portfolio (Exhibit 4.1). The risk declines 
because companies’ cash flows are not perfectly correlated. Over any period 
of time, some will increase while others decline.
One of the durable tenets of academic finance concerns the effect of diver-
sification on the cost of capital. If diversification reduces risk to investors and 
it is not costly to diversify, then investors will not demand a higher return for 
any risks that can be eliminated through diversification. They require com-
pensation only for risks they cannot diversify away.
The risks they cannot diversify away are those that affect all compa-
nies—for example, exposure to economic cycles. However, since most of the 
risks that companies face are, in fact, diversifiable, most risks don’t affect 
a company’s cost of capital. One way to see this in practice is to note the 
relatively narrow range of P/Es for large companies. Most large compa-
nies have P/Es between 12 and 20. If the cost of capital varied from 5 to 15 
percent instead of 7 to 9 percent, many more companies would have P/Es 
below 8 and above 25.
Whether a company’s cost of capital is 7 percent or 9 percent or somewhere 
in between is a question of great dispute (as we explore in Chapter 15). For 
decades, the standard model for measuring differences in costs of capital has 
been the capital asset pricing model (CAPM). The CAPM has been challenged 
EXHIBIT 4.1  Volatility of Portfolio Return Declines with Diversification
0
5
10
15
20
Volatility of 
portfolio return 
Number of stocks in portfolio
Total risk
Market volatility 
Nondiversifiable risk
Diversifiable risk