p9-1 Problems All problems are available in MyFinanceLab P9-1 Concept of cost of
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p9-1
Problems All problems are available in MyFinanceLab P9-1 Concept of cost of capital Mace Manufacturing is in the process of anal 1 investment decision-making procedures. Two projects evaluated by the firm involved building new facilities in different regions, North and South. The basic variables surrounding each project analysis and the resulting decision actions are summarized in the following table. Basic variables Cost Life Expected return Least-cost financing North $6 million 15 years South $5 million 15 years 15% Equity 16% Debt Source Cost (after-tax) 7% Decision Don't invest 15% 7% costExplanation / Answer
MEANING OF COST OF CAPITAL:
The cost of capital is the cost of a company's funds (both debt and equity), or, from an investor's point of view "the required rate of return on a portfolio company's existing securities. It is used to evaluate new projects of a company. It is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.
BASIC CONCEPT
For an investment to be worthwhile, the expected return on capital has to be higher than the cost of capital. Given a number of competing investment opportunities, investors are expected to put their capital to work in order to maximize the return. In other words, the cost of capital is the rate of return that capital could be expected to earn in the best alternative investment of equivalent risk; this is the opportunity cost of capital. If a project is of similar risk to a company's average business activities it is reasonable to use the company's average cost of capital as a basis for the evaluation. However, for projects outside the core business of the company, the current cost of capital may not be the appropriate yardstick to use, as the risks of the businesses are not the same.
A company's securities typically include both debt and equity, one must therefore calculate both the cost of debt and the cost of equity to determine a company's cost of capital. Importantly, both cost of debt and equity must be forward looking, and reflect the expectations of risk and return in the future. This means, for instance, that the past cost of debt is not a good indicator of the actual forward looking cost of debt.
Once cost of debt and cost of equity have been determined, their blend, the weighted average cost of capital (WACC), can be calculated. This WACC can then be used as a discount rate for a project's projected free cash flows to firm.
COST OF DEBT
When companies borrow funds from outside lenders, the interest paid on these funds is called the cost of debt. The cost of debt is computed by taking the rate on a risk-free bond whose duration matches the term structure of the corporate debt, then adding a default premium. This default premium will rise as the amount of debt increases (since, all other things being equal, the risk rises as the cost of debt rises). Since in most cases debt expense is a deductible expense, the cost of debt is computed on an after-tax basis to make it comparable with the cost of equity (earnings are taxed as well). Thus, for profitable firms, debt is discounted by the tax rate. The formula can be written as
KD = (Rf + credit risk rate) (1- T)
where, T is the corporate tax rate and Rf is the risk free rate.
COST OF EQUITY
The cost of equity is inferred by comparing the investment to other investments (comparable) with similar risk profiles. It is commonly computed using the capital asset pricing modelformula:
Cost of equity = Risk free rate of return + Premium expected for risk
Cost of equity = Risk free rate of return + Beta × (market rate of return – risk free rate of return)
where Beta = sensitivity to movements in the relevant market. Thus in symbols we have:
Ke = Rf + Bs( Rm - Rf)
where,
Ke= expected return for a security;
Rf = expected risk-free return in that market (government bond yield);
?s is the sensitivity to market risk for the security;
Rm is the historical return of the stock market; and
(Rm – Rf) is the risk premium of market assets over risk free assets.
The risk free rate is the yield on long term bonds in the particular market, such as government bonds.
SOLUTION:
DECISION= The cost of raising $6million in North project is 7% and the returns expected from the same are 8% which is 1% extra that is benefits are more than costs which shows good profitability. However, cost of raising $5million in South project is 16% and returns expected are only 15% that means the this project reaps lesser benefits and costs are more.
Hence, we advice the company to invest in project NORTH due to its reurns being greater than costs.
PROJECT NORTH SOUTH COST OF FINANCING 7% 16% RETURN 8% 15% ANALYSIS COST<RETURN COST>RETURN DECISION INVEST DONT INVESTRelated Questions
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