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What are the main elements in calculating cost of capital?

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1. What are the main elements in calculating cost of capital? How would an increase in debt affect the cost of capital? How would you identify the optimal cost of capital for an organization?

2. What is an Initial Public Offering (IPO)? How does an IPO allow an organization to grow financially? When is a merger or an acquisition, rather than an IPO, a more appropriate way to grow?

3. What is meant by Weighted Average Cost of Capital (WACC)? What are the components of WACC? Why is WACC a more appropriate discount rate when doing capital budgeting? What is the impact on WACC when an organization needs to raise long term capital?

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1. What are the main elements in calculating cost of capital? How would an increase in debt affect the cost of capital? How would you identify the optimal cost of capital for an organization?

The cost of capital has three main elements:
1. Risk free rate of return
Return required from a completely risk free investment. E.g. yield on government securities.
2. Business risk premium
Increase in required rate of return due to uncertainty about future and business prospects.
3. Financial risk premium
Dangers of high debt levels, variability in equity earnings after payments to debt capital holders.

If the level of debt financing increases the cost of debt remains unchanged up to a certain level of gearing. Beyond this level, the cost of debt will increase. Cost of capital declines for each unit increase in debt as long as the firm has taxable profits. The cost of capital is strategically the minimum return required by capital providers. It is an opportunity cost of finance. For example for shareholders it is the dividend they expect to receive plus a capital gain on the value of their shares and for loan holders it is the rate of interest ...

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Umut Oltulu, MBA
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  • BSc, Dokuz Eylul University
  • MBA, Texas A&M University-Kingsville
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