RW4-McCorry

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University of Texas, Rio Grande Valley *

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6350

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Communications

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Feb 20, 2024

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docx

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Name: Ashton McCorry Reflective Writing 4 Question 1 Explain why the corporate cost of capital (CCC) as defined in our textbook should not be used to evaluate all projects that a company has under consideration. According to the book , the corporate cost of capital represents the blended , average , cost of a business 's financing mix . The cost is then used to determine the needed rate of return on the business's capital investment opportunities. Corporate cost of capital cannot be applied for all projects under consideration since various initiatives have varying levels of risk, and hence cannot be assessed using a single cost of capital. The cost of capital is determined for projects that have a particular amount of risk. As the risk of a project varies, so does its beta, and consequently the cost of capital associated with it. The cost of debt is determined by the return interest rate required by investors on debt instruments, and the cost of equity to investor-owned businesses is equivalent. The cost of equity is the rate of return that investors demand for a company's common shares. While retained profits may appear to be a costless source of capital, the opportunity cost concept must be used. A company must pay dividends or keep earnings for investment, and the opportunity cost arises when the company holds a portion of earnings that investors could have invested in securities. The company should earn as much as stockholders can from identical assets with equal risks. If a company cannot make as much, it should give dividends. The CCC may be calculated using three methods: capacity, debt cost, and the risk premium approach. The ultimate value should be determined by the manager's trust in the data.

The CCC is a measure of a company's financing mix that helps evaluate the needed rate of return on capital investment possibilities. However, it is not appropriate for all projects due to varying degrees of risk. The cost of debt is determined by the interest rate investors demand on debt instruments, whereas the cost of equity is the rate of return investors require on a company's common stock. Although equity created through retained earnings appears to be costless, the opportunity cost principle must be applied because the net income belongs to common stockholders. If a company keeps earnings that might have been dispersed as dividends, the opportunity cost is the return investors could have received by investing that money in securities. If this is not possible, the company should pay out dividends instead. The cost of equity can be calculated using the Capital Asset Pricing Model (CAPM), the Discounted Cash Flow (DCF) approach, or the debt cost plus risk premium technique. The final number should be determined by the manager's level of trust in the available data. Question 2 Explain the economic interpretation of the CCC. The corporate cost of capital is the required return a company needs to make a capital budgeting project worthwhile. It is not the same for all firms due to the individual cost of capital, which is influenced by the level and type of risk associated with each firm. “CCC monitors the life cycle of cash utilized for commercial purposes. It tracks funds as it is turned into inventory and accounts payable, then into costs for product or service development, sales and accounts receivable, and finally back into cash on hand. Essentially, CCC shows how quickly a corporation can convert invested funds from start to finish (returns). The lower the CCC value, the better.” The level of risk varies among companies based on factors such as industry, size, profitability, and cash flow stability. For example, a tech startup might have a higher cost of

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