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Jackson Technology's Average Cost of Capital

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1. Weighted average cost of capital
Jackson Technology's capital structure is as follows:
Debt 35%
Preferred stock 15
Common equity 50
The after-tax cost of debt is 6.5 percent; the cost of preferred stock is 10 percent; and the cost of common equity (in the form of retained earnings) is 13.5 percent. Could you calculate Jackson Technology's weighted average cost of capital?

2. How does the capital asset pricing model help explain changing costs of capital?

3. Will you explain to me in detail the relationship between the cost of capital, bond ratings, and the capital budgeting decision-making process?

Solution Preview

Q1
WEIGHTED AVERAGE COST OF CAPITAL
1 2 1*2
Proportion Cost
Long Term Debts 0.350 6.5% 2.28%
Common Stocks 0.500 13.5% 6.75%
Preferred stock 0.150 10.0% 1.50%
WACC= 10.53%

2. How does the capital asset pricing model help explain changing costs of capital?
The capital asset pricing model (CAPM) is a model that provides a framework to determine the required rate of return on an asset and indicates the relationship between return and risk of the asset.
Assumptions of CAPM
? Market efficiency
? Risk aversion and mean-variance optimization
? Homogeneous expectations
? Single time period
? Risk-free rate
CAPM is used to estimate the cost of equity. It describes the relationship between the required rate of return and the non-diversifiable risk.
In a competitive market the expected risk premium varies in direct proportion to beta.

Symbolically
Ke= Rf +b(Km-Rf)

Ke= Cost of Equity
Rf= rate of return required on a risk free asset/ security/investment
Km= the required rate of return on the market portfolio
B= beta coefficient.

1. This method correlates market return and security return
2. This method also takes care of Beta as discussed above.
3. Investors can expect returns from their investment according to the risk.

Limitations of CAPM
1. It is based on unrealistic assumptions.
2. It is difficult to test the validity of CAPM.
3. Betas do not remain stable over time.

Conclusion
Capital asset pricing model is considered a "demand side" model. Its results, although similar to those in the APT (Arbitrage pricing theory), arise from a maximization problem of each investor's utility function, and from the resulting market equilibrium (investors are considered to be the "consumers" of the assets).
The APT method offers a faster approach to planning. This method has proved more reliable to the CAPM method and is now a widely used planning technique.

3. Will you explain to me in ...

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