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Cost of capital and risk

After considering expanding your line of apparel and gathering information on the increase in sales for your division and the investment needed in new manufacturing equipment, without having to hire additional manufacturing personnel, 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 On Your Mark's current cost of capital. Include in your assessment the following:

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 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 Preview

A firm's overall Cost of capital is an average of the costs of the various types of funds it uses. According to the division explained above, they finance with debt. A company's cost of capital is calculated as a weighted average, or composite, of the various types of funds used over time, regardless of the specific financing used to fund projects in a given year. Each firm has an optimal capital structure, defined as the mix of debt, preferred, and common equity that causes its stock price to be maximized. Therefore, a value-maximizing firm will estimate its optimal capital structure, use it as a target, and then raise new capital in a manner designed to keep the actual capital structure on target over time. The target proportions of debt (wd), preferred stock (wp), and common equity (wc), along with the costs of those components, are used to calculate the firm's weighted average cost of capital (WACC).

Therefore, WACC = wdrd(1 - T) + wprp + wcrs, where rd is interest rate on the firm's new debt, rp is the component cost of preferred stock, and rs is the component cost of common equity raised by retaining earnings, or internal ...

Solution Summary

A detailed explanation is given to each of these questions, including discussion on calculating WACC and beta coefficient. It is about 800 words.