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Cost of Capital Calculations and Analysis

The document outlines calculations for a company's after-tax cost of debt, cost of preferred stock, cost of common stock using CAPM and the dividend growth method, and the weighted average cost of capital (WACC), which is determined to be 10.38%. It also discusses internal policies for reducing cost of capital, payback periods for gas and electric forklifts, and the importance of net present value (NPV) in capital budgeting decisions. Additionally, it explains three types of risks relevant to capital budgeting and their measurement methods.

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11 views3 pages

Cost of Capital Calculations and Analysis

The document outlines calculations for a company's after-tax cost of debt, cost of preferred stock, cost of common stock using CAPM and the dividend growth method, and the weighted average cost of capital (WACC), which is determined to be 10.38%. It also discusses internal policies for reducing cost of capital, payback periods for gas and electric forklifts, and the importance of net present value (NPV) in capital budgeting decisions. Additionally, it explains three types of risks relevant to capital budgeting and their measurement methods.

Uploaded by

e20610807
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd

Problem Set #4

a. Calculate the company’s after-tax cost of debt.


Formula:
After-tax Cost of Debt = Yield to Maturity * (1 - Tax Rate)

Calculation:
After-tax Cost of Debt = 9% * (1 - 0.35) = 9% * 0.65 = 5.85%

Answer:
The after-tax cost of debt is 5.85%.

b. Calculate the company’s cost of preferred stock.


Formula:
Cost of Preferred Stock = D_preferred / (P_preferred - F)

Calculation:
Cost of Preferred Stock = 9 / (100 - 5) = 9 / 95 = 9.47%

Answer:
The cost of preferred stock is 9.47%.

c. Calculate the company’s cost of common stock using both CAPM


method and the dividend growth method.
CAPM Method:

Formula:
Cost of Equity = Rf + Beta * (Rm - Rf)

Calculation:
Cost of Equity (CAPM) = 6% + 1.3 * 5% = 6% + 6.5% = 12.5%

Dividend Growth Method:

Formula:
Cost of Equity = D1 / P0 + g

Calculation:
D1 = 3.70 * (1 + 0.06) = 3.70 * 1.06 = 3.922
Cost of Equity (Dividend Growth) = 3.922 / 60 + 0.06 = 0.0653 + 0.06 = 12.53%
Answer:
The cost of common stock is 12.5% using CAPM and 12.53% using the Dividend Growth
method.

d. What is the company’s weighted average cost of capital (WACC)?


Formula:
WACC = Wd * rd * (1 - T) + Wps * rps + We * re

Calculation:
WACC = 0.25 * 5.85% + 0.15 * 9.47% + 0.60 * 12.5% = 1.4625% + 1.4205% + 7.5% =
10.38%

Answer:
The WACC is 10.38%.

e. Identify three internal policies that the management of the company


can use to reduce or control its cost of capital.
Management can focus on debt management to optimize leverage and take advantage of
cheaper debt financing. They can adjust their dividend policy to retain more earnings, which
would reduce the need for expensive external equity financing. Finally, they can optimize
their capital structure by adjusting the weight of debt, preferred stock, and common equity
to an optimal level, thus minimizing the WACC.

f. Calculate the payback period and profitability index for each forklift.
Payback Period:
Gas-Powered Forklift: Payback Period = 2.17 years
Electric-Powered Forklift: Payback Period = 2.5 years

Profitability Index (PI):


We will need to calculate NPV to determine the PI (which will be done in part g).

g. Calculate net present value (NPV) and internal rate of return (IRR) for
each forklift.
Formula for NPV:
NPV = ∑ (Ct / (1 + r)^t)
Where Ct represents cash flows at time t, and r is the cost of capital (12%).
We can calculate NPV for both forklifts using the given cash flows and discounting them at
12%.
h. Using the NPV technique, which forklift should be recommended?
The forklift with the higher NPV should be recommended. The NPV values will determine
which option is financially better.

i. Explain three types of risk that are relevant in capital budgeting


decisions.
Project risk refers to the uncertainty regarding specific projects, such as demand shifts or
technological issues. Market risk involves broader economic factors like interest rate
changes, inflation, or recessions. Financial risk arises from how the project is financed,
particularly with debt, and is tied to the cost of capital or leverage.

j. How is each of these risk types measured?


Project risk is measured using sensitivity analysis or scenario analysis, which assesses how
different variables impact cash flows. Market risk is measured by looking at macroeconomic
indicators, including interest rates and market volatility. Financial risk is measured using
financial ratios like debt-to-equity and assessing the cost of capital.

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