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What does a company's cost of capital represent

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You have considered expanding your line of equipment and apparel for high school athletic teams to include soccer teams and gathered information on the increase in sales for your division and the investment needed in new manufacturing equipment without having to hire additional manufacturing personnel. After this, 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 the company's current cost of capital.

Include the following in your assessment:

â?¢What does a company's cost of capital represent, and how is it calculated? Explain in detail.
â?¢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?
â?¢What is market risk, and how is it measured?
â?¢Don mentioned using standard deviation and the coefficient of variation to measure risk. What does that mean?

Solution Preview

1. Company cost of capital=
Determine how a company can raise money through debt or equity. This is the rate of return that a firm would receive if it invested in a different vehicle with similar risk.
or
the opportunity cost of an investment; that is, the rate of return that a company would otherwise be able to earn at the same risk level as the investment that has been selected.

WACC:
(Weight of Debt)*(Cost of Debt) + (Weight of Equity)*(Cost of Equity)
or

the combination of cost of debt + cost of equity
cost of Debt = The after-tax cost of debt-capital = The Yield-to-Maturity on long-term debt x (1 minus the marginal tax rate in %)
Cost of equity = Risk free rate of return + Beta x (market rate of return- risk free rate of return)
Where Beta= sensitivity to movements in the

2.
Tax advantages on debt issuance make it cheaper to issue debt rather than new equity. The cost ...

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