The WACC is mainly used in making an investment choice that serves for a long period of time also called long term. Thus, the WACC should involve the different types of payment options used to pay for assets acquired for a long period of time in form of debt, a preferred stock and a common stock. Capital acquired in a short period of time includes a liability and debt which does not bear interest.
- Assignment 4 Principles of Finance I
- Assignment 4 Principles of Finance I
- (1) What sources of capital should be included when you estimate Jana’s weighted average cost of capital?
A company should involve a debt component for a short period when it uses a debt. The debt usually has an interest bearing for a short period of time to buy fixed assets rather than financing the capital needs for work. The debt which does not bear interest is usually not used when estimating cost of capital because the net capital is used in capital expenses rather than gross capital (Certo, Lester & Dalton, 2006).
(2) Should the component costs be figured on a before-tax or an after-tax basis?
The component costs should be figured after tax basis. The Stockholders put more effort and interest and time in the corporate cash flows because they are easily accessible and available for them to use. The stockholders use the cash flows to reinvest or for the payment of dividends, this makes it clear that the after tax dollars is used for reinvestment.
(3) Should the costs be historical (embedded) costs or new (marginal) costs?
The costs should be marginal costs. Marginal costs are the difference in the total amount of cost that is acquired from making and production of an additional item. Marginal costs are analyzed because they show the advantage of increasing costs from production. They are the component costs considered relevant. The cost of capital is usually used in raising new capital and deciding on tasks that involve contributing the capital. (MS Dorfman, DA Cather, 2012)
The market interest rate is the rate of interest on debts that are determined by using credit, where the demand of the credit and supply as well as the time it takes is looked into. If the debt takes a long time then interest rate becomes higher, when the security of the debt has a higher quality then the interest rate becomes low.
- What is the market interest rate on Jana’s debt, and what is the component cost of this debt for WACC purposes?
The market interest rate on Jana’s debt is 10%. This interest is usually taxed, and the component cost of debt in question is the after-tax cost.
The preferred stock issue is perpetual. This is because the floatation costs for the preferred stock is very important. There is also no reason to make changes in tax since the dividends acquired from the preferred stock are not made to be any less to the issuer. Nominal cost is always used to determine the debt’s cost at a yearly basis. (Dorfman & Cather, 2012)
- (1) What is the firm’s cost of preferred stock?
(2) Jana’s preferred stock is riskier to investors than its debt, yet the preferred stock’s yield to investors is lower than the yield to maturity on the debt. Does this suggest that you have made a mistake?
No, it does not suggest that I have made a mistake. Most investors found in the corporate world have most preferred stock. The most preferred stock is advantageous in that a large percentage of it is usually not taxed. This thus makes the preferred stock have a low before tax yield than that which is given on the company’s debt. (Brammer, Brooks & Pavelin, 2006).
A company can acquire common equity in two ways, either by retaining earnings which are the profit earnings retained by the firm so they can be invested back to the business. The other primary way is by giving out new common stock in the market. (Certo, Lester & Dalton, 2006)
- (1) What are the two primary ways companies raise common equity?
(2) Why is there a cost associated with reinvested earnings?
There is cost associated with reinvested earning. Reinvesting earnings is all about using the money acquired from the profits in the business. An opportunity is acquired where the management use dividends to finance their earnings or when they decide to hold om to their earnings, put it back to the business in order to make more money for them. In this case the cost is being incurred (Brammer, Brooks & Pavelin, 2006).
(3) Jana doesn’t plan to issue new shares of common stock. Using the CAPM approach, what is Jana’s estimated cost of equity?
The 7% is the risk free rate. 1.2 is the risk measure of the stock. The market risk premium is 6%, this is derived from the subtraction of the expected market with the risk free rate. After the calculation, we get a 14.2% as the expected return for the stock.
Rs= 7% + ((6%) * 1.2)
rs = 0.07 + (0.06)1.2
- = 14.2%.
S Brammer, C Brooks, S Pavelin, (2006), Corporate social performance and stock returns: UK
evidence from disaggregate measures, Financial management
MS Dorfman, DA Cather, (2012), Introduction to risk management and insurance
ST Certo, RH Lester, CM Dalton, (2006), Top management teams, strategy
and financial performance: A meta‐analytic examination, Journal of Management
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