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Market Rates and Cost of Capital

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What does a company's cost of capital represent and how is it calculated? How do market rates and the company's perceived market risk impact its cost of capital, and how does the company's debt to equity mix impact this cost of capital? Using the information provided, develop a spreadsheet to calculate weighted average cost (WAC) and marginal weighted average cost (MCC) of capital for Strident Marks?

You have developed the following table concerning the cost of capital sources for Strident Marks:
The future investment opportunities and the corresponding Internal Rate of Return (IRR) follow. As a result of operating its business operations profitably, Strident Marks has $1,000,000 to invest. Considering Strident Marks' weighted average cost of capital and MCC, rank the investment opportunities and indicate which ones would be accepted, which (if any) would be rejected and why.

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What does a company's cost of capital represent and how is it calculated? How do market rates and the company's perceived market risk impact its cost of capital, and how does the company's debt to equity mix impact this cost of capital? Using the information provided, develop a spreadsheet to calculate weighted average cost (WAC) and marginal weighted average cost (MCC) of capital for Strident Marks?
A firm's long-term success depends upon the firm's investments earning a sufficient rate of return. This sufficient or minimum rate of return necessary for a firm to succeed is called the cost of capital.

The cost of capital can also be viewed as the minimum rate of return required keeping investors satisfied. Thus it is used to know the rate of return expected by the investors. Thus cost of capital is used to evaluate the project. It is also know as discount rate.

We measure marginal cost of capital because we want to measure the cost of new capital used to finance new investments. Thus it is the relevant cost in the investment decisions is the future cost or the marginal cost.

Marginal cost is the new or the incremental cost that the firm incurs if it were to raise capital now, or in the near future. The historical cost that was incurred in the past in raising capital is not relevant in financial decision-making. Hence single weighted average cost of capital is not used.
Break point refers to the level of new financing at which the cost of one of the financing components rises, thereby causing an upward shift in the marginal cost of capital.
Marginal cost of capital is the firm's average cost of capital associated with its next dollar of total new financing.

Cost of capital (WACC)=
(Cost of Equity x Proportion of equity from capital)+ (Cost of debt x Proportion of debt from capital)+ (Cost of Preference share x Proportion of preference share from capital).
Equity includes retained earnings and the cost of R/E is taken at cost of equity. Cost of equity capital is the opportunity return from an investment with same risk as the company has. Cost of equity is usually defined with Capital asset pricing model (CAPM). The estimation of cost of debt is naturally more straightforward, since its cost is explicit. Cost of debt includes also the tax shield due to tax allowance on ...

Solution Summary

This solution of 1,516 words looks at how a firm calculates its cost of capital and identifies that factors that affect this variable such as market risk and debt to equity mix. It also provides a spreadsheet to calculates the weighted average cost and the marginal weighted average cost of capital. References used are included.

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FIN500 Graduate Case- Cost of Capital

annual interest at a 12% coupon rate. As a result of current interest rates, the bonds can be sold for $1,010 each. Flotation costs of $30 per bond will be incurred in the process (which implies that
f = 2.97%, or 0.0297 in decimal form) and the firm is in a 40% tax bracket.
a. Find the net proceeds from the sale of each bond for Warren Industries.
b. Calculate the before-tax and the after-tax cost of debt for Warren Industries.

2. Drywall Systems, Inc., is presently in discussions with its investment bankers regarding the issuance of new bonds. The investment banker has informed the company that different maturities will carry different coupon rates and sell at different prices. Drywall Systems must choose among several alternatives. In each case, the bonds will have a $1,000 par value and flotation costs will be $30 per bond. This implies that the firm will net $970 per bond, before the adjustment for the premium (+) or discount (-). The company is taxed at a rate of 40%. Calculate the after-tax costs of financing with each of the following alternatives.

Alternative Coupon Rate Time to Maturity Premium (+) or Discount (-)
A 9% 16 years + $250
B 7% 5 years + $50
C 6% 7 years Par
D 5% 10 years - $75

3. Gem Systems has recently issued preferred stock. The stock has a 12% annual dividend based on a par value of $100 per share. The stock is currently selling for $97.50 per share in the secondary market (so that Po = $97.50). Finally, flotation costs of $2.50 must be paid for each new share Gem Systems issues.
a. Calculate the cost of preferred stock based on the outstanding issue, given the current market price.
b. If Gem Systems sells a new issue of preferred stock carrying a par value of $100 but with an annual dividend of 10% of par, what is the cost of this newly issued preferred stock if the firm nets $90.00 per share after flotation costs?
4. Calculate the cost of preferred stock (rPS) for each of the following:

Preferred Stock Par Value Current Price (Po) Flotation Cost Annual Dividend
(% of Par)
A $100 $101 $9.00 11%
B $40 $38 $3.50 8%
C $35 $37 $4.00 $5.00
D $30 $26 5% of par $3.00
E $20 $20 $2.50 9%

5. JPM Corporation common stock has a beta of 1.2. The risk-free rate is 6%, and the market return is 11%.
a. Derive the risk premium on JPM common stock.
b. Determine JPM's cost of common equity using the CAPM.

6. Reynolds Textiles wants to measure its cost of common equity. The firm's stock is currently selling for $57.50 per share. The firm expects to pay a $3.40 dividend at the end of 2011 (so assume that
D1 = $3.40 for purposes of calculation). The dividends for the last 5 years are as follows:

Year Dividend

2010 $3.10
2009 $2.92
2008 $2.60
2007 $2.30
2006 $2.12

After incurring flotation costs, Reynolds Textiles expects to net $52 per share on a new issue.
a. Determine the growth rate of dividends (g).
b. By applying the constant-growth valuation model, determine the cost of retained earnings common equity (rs).
c. By applying the constant-growth valuation model, determine the cost of newly-issued common equity (re).

7. Brite Lighting Corporation wants to investigate the effect on its cost of capital based on the rate at which the company is taxed. The firm wishes to maintain a capital structure of 30% debt, 10% preferred stock, and 60% common stock. The cost of financing with retained earnings is 14% (i.e.,
rs = 14%), the cost of preferred stock financing is 9% (rps = 9%), and the before-tax cost of debt is 11% (rd = 11%). Calculate the weighted average cost of capital (WACC) given the tax rate assumptions in parts (a) to (c) below.
a. Tax rate = 40%.
b. Tax rate = 35%.
c. Tax rate = 25%.

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