essey Essay

Estimate the cost of capital for financing (Hint: Interest expense and total debt – Ascertain the return on equity to provide measures for the interest rate and the return to stockholders.

The purpose is that the cost capital will be used for capital budgeting, financial accounting, performance assessment, stock repurchases estimations. Also the cost of capital is a necessary basis for the expected growth and forecasted demand.

The cost of equity is the theoretical return that equity investors expect or receive from the company for investing their funds in the company. The risk free rate that is the Government Treasury bill rate is 3.1%, the market risk premium is 7% and the beta has been calculated as

We use Capital Asset Pricing Model (CAPM) approach to calculate the cost of equity. The formula of CAPM is re = rf + β × (E[RMkt] – rf).

Given that the cost of equity is 9.4% and the cost of debt is 12.2%, Star’s cost of capital can be calculated as 9.14% (Appendix B). The company was also considering raising the cost of debt to the industry average of 19%. At this cost of debt, Star Company would have a lower cost of capital of 8.24% (Appendix B) because interest on debt capital is deductible whereas dividend payments on equity capital are not.

Should the corporate cost of capital as developed above be used for all projects? If not, what type of adjustments should be made?

Therefore, the cost of common stock is obtained by using the dividends divided by the market price.

• Cost of capital must reflect current capital market conditions (current required returns) • Cost of capital must also reflect the optimal relative proportions of debt and equity the firm will

The mixture of debt-equity mix is important so as to maximize the stock price of the Costco. However, it will be significant to consider the Weighted Average Cost of Capital (WACC) as well so that it can evaluate the company targeted capital structure. Cost of capital (OC) may be used by the companies as for long term decision making, so industries that faced to take the important of Cost of capital seriously may not make the right choice by choosing the right project(Gitman’s, ).

At first, WACC and CAPM was attempted to be used as a source of cost of capital. However, for WACC, there is no available proportion of debt and cost of debt for MW. For CAPM, no available data seems to support the acceptable

The three components of the cost of capital are debt, preferred stock, and common stock.

There are two ways of increasing capital, (1) using debt and (2) issuing new shares. For profitable companies sometimes it is cheaper to use debt instead of issuing new shares since cost of debt is tax shielded. In this case company didn’t have any debt in past which means less default risk, it will affect total value in a positive way. It will decrease the taxes paid and increase net income, accordingly share values.

(Assume that the amount of debt issued to reach the target debt-to-capital ratio is going to be maintained forever. Use the tax rates assumed in the attached Excel file).

If the financing of the project comes partially from issuing debt and cash infusion from the owners, the available cash will increase without as much interest expense. This will cause the company books to look bad because of lower EPS, however the company will have a choice not to pay dividends if necessary rather than being bound to pay interest expense.

Already in 1958, Modigliani and Miller have pointed the discussion of capital structure towards the cost of debt and equity. According to their first proposition, in a world of no corporate taxes and with perfect markets, financial leverage has no effect on a firm’s value. In their second proposition, they state that the cost of equity equals a linear function defined by the required return on assets and the cost of debt (Modigliani and Miller, 1958).