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# Explanation to "Cost of capital" question

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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.

Objective:
must define the cost of capital and explain why marginal capital is important. An understanding of the Capital Asset Pricing Model (CAPM) and the inter-relationship between a company's perceived market risk (as defined by beta) and the market risk-free rate and risk premium is essential. Cost of capital is a firm's borrowing rate (AKA Ke, hurdle rate, discount rate) and marginal is important because it illustrates what our next venture's cost of capital will be.

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What does a company's cost of capital represent and how is it calculated?

The rate we use to discount a company's future cash flows back to the present is known as the company's required return, or cost of capital.

A company's cost of capital is exactly as its name implies. When a company raises capital from its lenders and owners, both types of investors require a return on their investment. Lenders expect to be paid interest on their loans, while owners expect a return, too.

The rate you would use to discount cash flows if using the "cash flow to the firm" method is actually a company's weighted average cost of capital, or WACC. A company's WACC accounts for both the firm's cost of equity and its cost of debt, weighted according to the proportions of equity and debt in the company's capital structure. Here's the basic formula for WACC:

(Weight of Debt)(Cost of Debt) + (Weight of Equity)(Cost of Equity)

The cost of debt is relatively straightforward: It's the interest rate a company must pay to borrow money, based on the current yield on any of the bonds the company has issued. Just as a person with an excellent credit rating can borrow from banks at lower rates than someone who has missed payments in the past, financially strong and stable companies can borrow at lower rates than riskier firms.

The cost of equity is a little more complicated and is often a topic of debate in both academia and the business world. Modern finance theory says that a given company's cost of equity is determined by measuring the risk-free rate investors can achieve (typically the ...

#### Solution Summary

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.

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## Company Financias: Sample Questions And Explanations

1. At the beginning of 2007, Beta Company's balance sheet reported Total Assets of \$195,000 and Total Liabilities of \$75,000. During 2007, the company reported total revenues of \$226,000 and expenses of \$175,000. Also, owner withdrawals during 2007 totaled \$48,000. Assuming no other changes to owner's capital, the balance in the owner's capital account at the end of 2007 would be:

A. \$174,000.
B. \$78,000.
C. cannot be determined from the information provided.
D. \$120,000.
E. \$123,000.

2. The accrual basis of accounting:

A. Is generally accepted for external reporting because it is more useful for most business decisions.
B. Is flawed because it gives complete information about cash flows.
C. Recognizes revenues when received in cash.
D. Recognizes expenses when paid in cash.
E. Eliminates the need for adjusting entries at the end of each period.

3. If a company mistakenly forgot to record depreciation on office equipment at the end of an accounting period, the financial statements prepared at that time would show:

A. Assets overstated and equity understated.
B. Assets and equity both understated.
C. Assets overstated, net income understated, and equity overstated.
D. Assets, net income, and equity understated.
E. Assets, net income, and equity overstated.

4. On January 20, 2005, Jennifer Nelson, the accountant for Travon Enterprises, is feeling pressure to complete the annual financial statements. The company president has said he needs up-to-date financial statements to share with the bank on January 21 at a dinner meeting that has been called to discuss Travon's obtaining loan financing for a special project. Jennifer knows that she will not be able to gather all the needed information in the next 24 hours to prepare the entire set of adjusting entries that must be posted before the financial statements accurately portray the company's performance and financial position for the fiscal period ended December 31, 2004. Jennifer ultimately decides to estimate several expense accruals at the last minute. When deciding on estimates for the expenses, she uses low estimates because she does not want to make the financial statements look worse than they are. Jennifer finishes the financial statements before the deadline and gives them to the president without mentioning that several accounts use estimated balances. a. Identify several courses of action that Jennifer could have taken instead of the one she took. b. If you were in Jennifer's situation, what you have done? Briefly justify your response.

5. What accounts are affected by closing entries? What accounts are not?

6. The acid-test ratio differs from the current ratio in that:

A. Liabilities are divided by current assets.
B. Prepaid expenses and inventory are excluded from the calculation of the acid-test ratio.
C. The acid-test ratio measures profitability and the current ratio does not.
D. The acid-test ratio excludes short-term investments from the calculation.
E. The acid-test ratio is a measure of liquidity but the current ratio is not.

7. Which of the following inventory costing methods will always result in the same values for ending inventory and cost of goods sold regardless of whether a perpetual or periodic inventory system is used?

A. FIFO and LIFO
B. LIFO and weighted-average cost
C. Specific identification and FIFO
D. FIFO and weighted-average cost
E. LIFO and specific identification

8. A company had net sales and cost of goods sold of \$752,000 and \$543,000, respectively. Its net income was \$17,530. The company's gross margin and expenses are ________ and ____________, respectively.

A. \$209,000; \$191,470
B. \$191,470; \$209,000
C. \$525,470; \$227,000
D. \$227,000; \$525,470
E. \$734,000; \$191,470

9. The understatement of the ending inventory balance causes:

A. Cost of goods sold to be overstated and net income to be understated.
B. Cost of goods sold to be overstated and net income to be overstated.
C. Cost of goods sold to be understated and net income to be understated.
D. Cost of goods sold to be understated and net income to be overstated.
E. Cost of goods sold to be overstated and net income to be correct.

10. The operating cycle for a merchandiser that sells only for cash moves from:

A. Purchases of merchandise to inventory to cash sales.
B. Purchases of merchandise to inventory to accounts receivable to cash sales.
C. Inventory to purchases of merchandise to cash sales.
D. Accounts receivable to purchases of merchandise to inventory to cash sales.
E. Accounts receivable to inventory to cash sales.

11. The inventory valuation method that results in the lowest taxable income in a period of inflation is:

A. LIFO method.
B. FIFO method.
C. Weighted-average cost method.
D. Specific identification method.
E. Gross profit method.

12. Goods on consignment:

A. Are goods shipped by the owner to the consignee who sells the goods for the owner.
B. Are reported in the consignee's books as inventory.
C. Are goods shipped to the consignor who sells the goods for the owner.
D. Are not reported in the consignor's inventory since they do not have possession of the inventory.
E. Are always paid for by the consignee when they take possession

13. A company has the following per unit original costs and replacement costs for its inventory:
Part A: 50 units with a cost of \$5, and replacement cost of \$4.50
Part B: 75 units with a cost of \$6, and replacement cost of \$6.50
Part C: 160 units with a cost of \$3, and replacement cost of \$2.50
Under the lower of cost or market method, the total value of this company's ending inventory is:

A. \$1,180.00.
B. \$1,075.00.
C. \$1,112.50 or \$1075.00, depending upon whether LCM is applied to individual items or the inventory as a whole.
D. \$1,112.50.
E. \$1180.00 or \$1075.00, depending upon whether LCM is applied to individual items or to the inventory as a whole.

14. Cost of goods sold:

A. Is another term for merchandise sales.
B. Is the term used for the cost of buying and preparing merchandise for sale.
C. Is another term for revenue.
D. Is also called gross margin.
E. Is a term only used by service firms.

15. A company's net sales were \$676,600, its cost of good sold was \$236,810 and its net income was \$33,750. Its gross margin ratio equals:

A. 5%.
B. 9.6%.
C. 35%.
D. 65%.
E. 285.7%.

16. Identify similarities and differences between the acid-test ratio and the current ratio. Compare and describe how the two ratios reflect a company's ability to meet its current obligations. Break down your answer into three paragraphs: Similarities; Differences; and Description.

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