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Discussing the Cost of Capital

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Please give a brief explanation:

a. What are the main elements in calculating the cost of capital?

b. How would an increase in debt affect the cost of capital?

c. How would you identify the optimal cost of capital for a organization?

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a. What are the main elements in calculating the cost of capital?

Cost of capital is the sum of Cost of Debt and Cost of equity. If the Company finances the project only through debt, then cost of capital is the cost of debt.

Cost of debt:

The cost of debt is: The rate on a non-defaulting bond + Default premium.

The rate of other non-defaulting bonds in the market can be taken as the rate of interest of the debt provided that the term structure of debt should be similar to the debt of the other non-defaulting debt. When the amount of debt is more, the default premium will increase because the risk rises when the amount of debt increase. Interest on dent is a deductible expense as it is a charge against profit. Therefore, the cost of debt is computed after charging tax

Cost of Equity=Risk free rate of return + Premium expected for risk.

Risk free rate of return is usually the rate of return of Government bonds.

Default risk premium will vary from industry to industry and from one country to another country.

b. How would increase in debt affect the cost of capital?

Since cost of debt is calculated after tax, when there is a high amount of debt in the capital structure of the company, the ...

Solution Summary

In 850 words, this response provides a detailed outline of the cost of capital, discussing the steps in the computation of the cost of capital, the effect of change in debt and the steps involved in computing the optimum cost of capital.