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Cost of Capital, NPV and IRR

The weighted average cost of capital which is 9.48%. Explain how the cost of capital is used in net present value analysis. Explain how cost of capital is used in internal rate of return analysis.

Assume that 40% of Company A's capital structure is in the form of bonds and other debt. Total common stockholder equity provides 50% of the capital, and preferred stock provides 10%. The company has determined that the after-tax cost of its bonds and other debt is 6.2%. The cost of preferred stock is 8%, and the cost of common stock and retained earnings is 12.4%.

I got my weighted average cost of capital which is 9.48% but I am not sure how to how to explain how the cost of capital is used in net present value analysis, or explain how cost of capital is used in internal rate of return analysis. Especially when I have to think of at least 1 Ã?½ paragraphs for each. What is confusing is that this is all I was given.

Solution Preview

Assume that 40% of Company A's capital structure is in the form of bonds and other debt. Total common stockholder equity provides 50% of the capital, and preferred stock provides 10%. The company has determined that the after-tax cost of its bonds and other debt is 6.2%. The cost of preferred stock is 8%, and the cost of common stock and retained earnings is 12.4%.

The weighted-average cost of capital assumes that the company will finance the project under consideration from its general available resources. (In other words, it will not use the funds from a particular debt or equity issue to finance the project.) Because all of the company's sources of capital are intermingled to fund the project, the company uses a measure which weighs the relative portion of the company's capital which comes from each source, determines the cost of each source, and uses the source's weight to determine the company's overall (weighted-average) cost of capital. In this case, the company's cost of capital is:

Type of Capital Weight in ...

Solution Summary

This solution illustrates how to compute a company's weighted-average cost of capital, discusses the assumptions behind that computation, explains how it is used in net present value and internal rate of return analysis, and compares net present value to internal rate of return.

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