Question_Lasher_12Dec

1. Compare the cost of capital concept with the idea of the required return on a stock investmentmade by an individual. Relate both ideas to the risk of the investment. How would a very riskyinvestment/ 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 importantto the cost of capital concept? In many capital structure discussions, preferred stock is lumped in witheither 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. TheCFO has asked you and a young member of the accounting staff to work together in reviewing the firm’scapital 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 theinformation. 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 cansummarize 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, butnot quite. Explain.5. There’s an issue of historical versus market value with respect to both the cost of capitalcomponents and the amounts of those components used in developing weights. We’re willing to acceptan 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 calculatedthe 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 mosteconomists predict a rise in interest rates over the next year. Should you modify your analysis in lightof this information? Why?7. Establishing the cost of equity is the most arbitrary and difficult part of developing a firm’s costof capital. Outline the reasons behind this problem and the approaches available to making the best ofit. 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 CAPMwhile the other adds a risk premium to the return the firm pays on its debt.The Cost of Capital8. Retained earnings are generated by the firm’s internal operations and are immediately reinvestedto earn more money for the company and its shareholders. Therefore, such funds have zero cost to thecompany. Is that statement true or false? Explain..9. Define the marginal cost of capital (MCC) and explain in words why it predictably undergoes astep 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 expectedto remain flat indefinitely. Is this statement right or wrong? If wrong, explain what can be expected tohappen to the MCC and why.11. Why is it appropriate to define the WACC as the highest step on the MCC under the IOS? Isanything lost by using this definition?

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