Reflective Percentage of the Company's Current Cost of Capital
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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?
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Solution Summary
The solution discusses if the percentage is reflective of the company's current cost of capital.
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What does a company's cost of capital represent, and how is it calculated? Explain in detail.
A company's cost of capital is used to represent the cost to a company when it employs debt and equity (preferred stock and common stock). The cost of capital can also be used to state what the required return is on a company's portfolio's current securities, though generally the former representation holds because investors want to know how much it costs the company to raise any additional dollar of debt or equity.
The cost of capital is calculated through separate calculations for all three items, which are them summed together to derive the total cost of capital on a weighted average basis. This is what is at times referred to as the Weighted Average Cost of Capital (WACC). The cost of debt is derived by multiplying the debt's interest expense with the inverse of the tax percentage, and dividing the result by the total amount of outstanding debt. The formula is:
Interest expense x [1 - Tax rate] [divided by] Amount of debt - Debt acquisition fees + Premium on debt - Discount on debt
Calculating the cost of preferred stock is calculated by dividing the interest expense of the stock by the total amount of preferred stock outstanding. This is easier since interest payments made on this form of funding are not tax-deductible. The ...
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