•Explain with examples how the cost of capital is determined.
•Calculate the differences in cost and risk. Explain why the costs and risks of external financing are important for the organization to understand.
•Explain why rapid growth plans are important to a small company. Would there be a more efficient way to fund a growing company? Why or why not? Justify your answer
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//Cost of Capital is the significant cost in making investment decisions that involved both cost of debt and cost of equity. In the managing finance, appropriate determination of cost of capital is essential and thus, this section of the assignment has presented a way of determining the cost of capital with good examples.//
Cost of Capital
The overall cost of capital of a company is determined having regard to the capital structure of that company. Among the primary components of the capital structure are included debt capital such as debentures and loans, preferred equity and common equity (Pratt & Grabowski, 2008).
Cost of Common Equity
The cost of common equity can be calculated by applying the Gordon's dividend model, in case the company is paying the dividend to stockholders. The financial economist Myron Gordon applied the concept of present value of continuing stream of future dividends and derived the following formula (Pratt & Grabowski, 2008).
Where, Po = The current price of common stock.
D1 = The expected dividend one year from now.
Ks = Required rate of return per period on this common stock.
G = Growth rate of dividends
For Example: A company, XYZ Ltd. is presently trading on stock exchange at $40.00. Next year, expected dividend is $4.20 and an expected growth rate of dividends is assumed to be 5% per year indefinitely. You are required to calculate cost of common equity by manipulating the above formula, we will have:
Cost of Preferred Equity
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