Question_Lasher_12Dec

1. Compare the cost of capital concept with the idea of the required return on a stock investment
made by an individual. Relate both ideas to the risk of the investment. How would a very risky
investment/ project be handled in the capital budgeting/cost of capital context?
2. Define the idea of capital structure and capital components. Why is capital structure important
to the cost of capital concept? In many capital structure discussions, preferred stock is lumped in with
either debt or common equity. With respect to the cost of capital, however, it's treated separately. Why?
.
3. You are a new financial analyst working for a company that's more than 100 years old. The
CFO has asked you and a young member of the accounting staff to work together in reviewing the firm's
capital structure for the purpose of recalculating its cost of capital. As you both leave the CFO's office,
your accounting colleague says that this job is really going to be easy, because he already has the
information. In preparing the latest annual report, he worked on the capital section of the balance sheet,
and has the values of debt, preferred stock, and equity at his fingertips. He says that the two of you can
summarize these into a report in five minutes, and then go out for a beer. How do you react and why?
Is the fact that the firm is quite old relevant? Why?
4. The investor's return and the company's cost are opposite sides of the same coin—almost, but
not quite. Explain.
5. There's an issue of historical versus market value with respect to both the cost of capital
components and the amounts of those components used in developing weights. We're willing to accept
an approximation for the weights, but not for the cost/returns. Why?
.
6. A number of investment projects are under consideration at your company. You've calculated
the cost of capital based on market values and rates, and analyzed the projects using IRR and NPV.
Several projects are marginally acceptable. While watching the news last night you learned that most
economists predict a rise in interest rates over the next year. Should you modify your analysis in light
of this information? Why?
7. Establishing the cost of equity is the most arbitrary and difficult part of developing a firm's cost
of capital. Outline the reasons behind this problem and the approaches available to making the best of
it.
Because of this inaccuracy, we estimate the cost of equity based on projected growth rates and risk.
The growth rate approach uses the Gordon model. There are two risk approaches. One uses the CAPM
while the other adds a risk premium to the return the firm pays on its debt.
The Cost of Capital
8. Retained earnings are generated by the firm's internal operations and are immediately reinvested
to earn more money for the company and its shareholders. Therefore, such funds have zero cost to the
company. Is that statement true or false? Explain.
.
9. Define the marginal cost of capital (MCC) and explain in words why it predictably undergoes a
step function increase (breaks) as more capital is raised during a budget period.
10. After the break in the MCC caused by using up retained earnings, the schedule can be expected
to remain flat indefinitely. Is this statement right or wrong? If wrong, explain what can be expected to
happen to the MCC and why.
11. Why is it appropriate to define the WACC as the highest step on the MCC under the IOS? Is
anything lost by using this definition?