You have considered expanding your line of equipment and apparel for high school
ID: 2663031 • Letter: Y
Question
You have considered expanding your line of equipment and apparel for high school athletic teams to include soccer teams and gathered information on the increase in sales for your division and the investment needed in new manufacturing equipment without having to hire additional manufacturing personnel. After this, you arrange a meeting with the CFO. During the meeting, Don listened to your proposal, reviewed your information, but questioned your use of a 6% cost of capital. He indicated to you that the head of treasury could raise debt at 7% in today's market. Taking into consideration how a company's cost of capital is calculated and how market rates and the company's perceived market risk impacts a firm's cost of capital, provide your viewpoint on whether 6% is reflective of the company's current cost of capital.Include the following in your assessment:
•What does a company's cost of capital represent, and how is it calculated? Explain in detail.
•How do market rates and the company's perceived market risk influence its cost of capital, and how does the company's debt-to-equity mix impact this cost of capital?
•What is market risk, and how is it measured?
•Don mentioned using standard deviation and the coefficient of variation to measure risk. What does that mean?
Explanation / Answer
1) The cost of capital represents the funds that are raised for a company to use. To raise or borrow funds costs money. Let us consider an example.
A bank or mortgage company will loan you funds to purchase a home, however they require you to pay them interest to borrow these funds, in addition if you don't pay back the loan with interest, they can come and take your home, your asset.
We need to look at each type of cost of capital in order to understand how to calculate the cost. The cost of debt is the interest rate after taxes. The reason we look at this as after taxes is we must calculate the savings to the company. We calculate the cost of debt by the before-tax cost of debt multiplied by one minus the firm's marginal tax rate. The next type of cost is the cost of preferred and common stock. This is not taxable. We find the cost of preferred stock by the amount of expected preferred stock dividend divided by the current price of the preferred stock minus flotation cost per share.
The last type of cost is the cost of common equity. "This is the required rate of return on funds supplies by the existing common stockholders". We find this figure by taking the dollar amount of common dividend expected one period divided by the required rate of return per period on this common stock investment minus the expected growth rate per period.
WACC = (E/V) x RE + (P /V) x RP + (D / V) x RD x (1-TC)
2) 2) The expected market risk is calculated using the Capital asset pricing model.
According to CAPM, E(R) = Rf + ß [ E(RM – Rf)]
Rf is the risk-free rate
ß is the systematic risk
[ E(RM – Rf)] is the market risk premium.
The market risk is normally characterized by the beta parameter.
The risk-free rate is taken from the lowest yielding bonds in the particular market, such as government bonds. The risk premium varies over time and place. The market risk premium historically has between 3-5%. The sensitivity to market risk (ß) is unique for each firm and depends on everything from management to its business and capital structure.
As the management approaches the market for large amounts of capital relative to the firm’s size, the investor’s required rate of return may rise. Generally, as the level of risk rises, a larger risk premium must be earned to satisfy the company’s investors. This, when added to the risk-free rate equals the firm’s cost of capital.
The beta is a measure of stocks market risk. The larger the beta, the greater should be the expected rate of return.
The coefficient of variation allows you to determine how much volatility you are assuming in comparison to the amount of return on the investment.
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