Calculating cost of capital for Strident Marks
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Scenario:
You are a financial analyst in the finance division of Strident Marks, a manufacturing company that has recently gone through the initial public offering (IPO) process and has become a public company. Strident Marks has annual sales revenue of approximately $50 million and makes seven unique and distinct products (which serve seven different markets). Each product is represented by its own division within the company and has its own group of sales, marketing, and manufacturing personnel. Some departments, including human resources and the finance division, support the entire organization. Operations consist of a single headquarters and production (manufacturing) center.
In your role as financial analyst you are responsible for compiling and reporting on budget / forecast data, for assisting your investor relations department, and for assessing and valuing new business opportunities (which will ultimately be presented to upper management). You report directly to the Chief Financial Officer (CFO) and have the use of the accounting department's staff accountants to assist you with your budget / forecast responsibilities.
You have been informed by the CFO that Strident Marks will be aggressively pursuing new business opportunities, which may include expansion through acquisition and the development and implementation of new products. As a publicly traded company, Strident Marks is scrutinized by bankers and investors as never before. In fulfilling your responsibilities you must keep this in mind, and you must instill a new sense of financial discipline in the organization.
Problem: 1
Deliverable Length: 3 paragraphs, references
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? You are leading the review of these elements in a meeting with managers and accountants.
Problem: 2
Deliverable Length: 2 pages, including spreadsheet, references
Download the data provided in FIN310 p3 ips2 and calculate for the Strident Marks CFO, key financial metrics for this capital budgeting project. These key metrics must include payback period, net present value, internal rate of return and modified rate of return. Describe what each of these metrics tells us.
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Solution Summary
Then solution explains what cost of capital means and how to calculate it. It then shows how to calculate payback period, net present value, internal rate of return and modified rate of return for a project
Solution Preview
1. The cost of capital represents the returns required by the providers of capital. Capital can be raised either as debt or equity. Cost of Debt is the required return by the providers of debt capital and is reflected in the YTM of the debt and Cost of Equity is the required returns by the equity investors and is calculated either by using the Dividend Discount Model, or The Capital Asset Pricing Model or using Risk Premium over the cost of debt. The cost of capital is the weighted average of the cost of debt and cost of equity, where the weights are the proportions in which these two type of capital is used.
The cost is always dependant on the risks and returns. The cost of debt is dependant on the market rates and the credit rating of the company. On the risk free rate, a risk premium is added up to arrive at the cost of debt for the particular credit rating. If the risk free rate in the market moves up, the YTM on the debt also moves up and the cost of debt rises. Similarly, the cost of equity is dependant on the risks inherent in the company. In the CAPM Model, these risks are captured in a factor called beta and get reflected in the cost of equity calculated.
The cost of capital is the weighted average of cost of debt and cost of equity. As the proportion of debt and equity in total capital employed change, the overall cost of capital also changes. Use of debt, also increases the cost of equity, since use of debt exposes the company to financial risk also in addition to the business risk. The cost of capital changes due to change in ...
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