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Defining the Cost of Capital, Risks, Rates, and Depreciation

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1. Cost of Capital - If you were going to start a company, let's say a restaurant, and I was going to take $400,000 to get it opened, how would you finance the initial investment? Things to consider are debt, equity, terms, and sources.
2. Risk & Return - Given that you know the risk as well as the expected return for two stocks, discuss what process you might utilize to determine which of the two stocks is better to buy.
3. Hurdle Rate - Explain why the cost of capital is referred to as the "hurdle" rate in capital budgeting.
4. Cost Structure - You own a firm with a single new product that is about to be introduced to the public for the first time. Your marketing analysis suggests that the annual demand for this product could be anywhere between 500,000 units and 5,000,000 units. Given such a wide range, discuss the safest cost structure alternative for your firm.
5. Depreciation - How is the MACRS depreciation method under IRS rules different from the straight-line depreciation allowed under GAAP rules? What is the implication on incremental after-tax free cash flows from firms' investments?
6. Call Option - What variables affect the value of a call option?

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Solution Summary

This solution provides explanations for the following concepts: cost of capital, risk and return, hurdle rate, cost structure, depreciation, and call option.

Solution provided by:
Robert Reinhart, MBA
Education
  • MBA, Merage School of Business, Univ of Cal, Irvine
  • BA, Univ of Cal, Irvine
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