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# Discussing the Cost of Capital

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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?

#### Solution Preview

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.

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## Capital Structure Discussion

Guidelines for the answer ( 5.1 to 5.11 need to be answered taking into consideration the guidelines given below

1. A Contents page showing clearly the page number and /contents of each page of your project.
2. An executive summary showing the most important findings and research which was covered in the discussion.
3. An introduction to your topic and how you have carried out your research.

4. The discussion of your topic with -footnotes of all your source of research and websites that you have accessed.
5. A conclusion page which summarizes all your findings clearly referring to the topic.
6. A Bibliography showing all the books, websites, that you might have visited .

5. Topic and Research Analysis ( Question to be answered based on Financial statements attached )

5.1 ldentify any company in the listed on a Stock Exchange.

5.2 Go to the company's website and print out the Financial Statements for the last two years.
(Income Statements and Balance Sheet)

5.3 Analyze the Financial Report and include the following in your analysis:

5.4 Determine the composition of the Equity of the company (Common stock,
Preferred stock and Bonds issued by the company.

5.5 Calculate the average cost of Equity of the company.

5.6 Determine the Dividend policy of the company.

5.7 What is your opinion regarding the financial risk the company's
management is prepared to take.

If the company's management is prepared to take risk, does it reflect in the Return on Equity? think the management is not taking adequate financial risks by having the
optimum financial structure for optimum returns.

5.8 Assuming this company wish to expand their operations and become a
global player in their industry, how in your opinion must this company
finance its operations to achieve the lowest weighted cost of capital as well
as achieve maximum return on capital.

5.9 Did the company's shareholders become wealthier or poorer over the last
financial period as a result of the financial policy of the company?

5.10 Did the Debt position improve or worsen during the last financial
period. If the debts did increase, did the Return on Equity increase or
decrease.

5.11 Write a paragraph (as part of your conclusion) of at least a typed?
page as your future predictions for this company based on your findings ,/
after you have made the above observations. Also recommend to the
Board of directors a future financial policy that the company

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