Question

Answer any 4 questions. You are advised to be as analytical as possible in your answers 1 A. Ex plain the main theoretical underpinnings of minimum cost analysis. B. Discuss how you would reduce the heat loss and energy costs of a building that you own. A. Explain the concept of weighted average cost of capital (WACC). B. The firm's cost of capital is affected by two sets of factors- one that is under the firm's control, and the other that is not under the firm's. Discuss: i) the factors that are under the firm's control; ii) the factors that are not under the firm's control. 2. 3. A. What does the name component cost of capital refer to? B. Discuss: 1) common stock; ii) preferred stock; iii) debt Analyze the main theoretical underpinnings of breakeven analysis. Discuss the main differences between minimum cost analysis and breakeven analysis. 4. 5. 6. Assume compan> ABC has a target capital structure calling for 5% debt, 15% e erred stock, and 590 common stock. preferred stock, rps, is 8.2 %; its cost of common equity, rs, is 11.6%; its marginal tax rate is 40%. All of ABC's new equity will come from reinvested earnings. Calculate ABC's ABC's before-tax cost ofdebt, rd, is 9%; its cost of weighted average cost of capital: (% of preferred stock) (Cost of Formula: WACC = (% ofdebt) (After,tx cost of debt) + preferred stock) + (% of common stock) (Cost of common equity) Where: rd - Interest rate on the firm's new debt-before-tax component cost of debt. rd(I-T After-tax component cost of debt, where T is the firm's marginal tax rate. rd(l the debt used to calculate the weighted average cost of capital. rps -Component cost of preferred stock, found as the yield investors expect to earn on th preferred stock. rs Component cost of common equity raised by retaining earnings, or internal equity re Component cost of external equity, or common equity raised by issuing new stock W - Wd, Wps, Ws, We target weights of debt, preferred stock, internal equity (reta earnings) and external equity (new issues of common stock). the firm's weighted average, or overall cost of capital. WACC

Answer 1

2)

A)

The weighted average cost of capital is the cost of capital for each type of sources of funds - equity, preferred stock

and debt wieghted by the share of each component in the entire capital structure.

B)

The factors that are under firm's control are the proportion of equity, debt and preferred stock in the capital structure

While the risk free rate is something which is not in control of the firm and an increase or decrease in the risk free rate

would impact the cost of capital of the firm

3)

Component cost of capital refers to the yield for each component that comprises the overall capital structure.

This includes the cost of debt, cost of equity and the cost of preferred stock

Common stock is the equity or share capital invested by shareholders. They are provided a share of profits through dividends paid to share holders

Preferred stock is the preferred shares which commands that a fixed amount of dividend be paid to preferred stock holders irrespective of the profits of the company

Debt is the component of capital structure wherein the funds are provided by bonds or loan from banks and the debt has to be repaid to the bond holders or bank

5)

Minimum cost analysis tends to focus on the production level which amounts to minimum cost for the firm. While breakeven implies the level of

production and sales wherein the company is left with no profits or loss

6)

Component

Proportion

Cost (pre tax)

Cost (post tax)

Debt

35.0%

9.00%

5.40%

Equity

50.0%

11.60%

11.60%

Preferred stock

15.0%

8.20%

8.20%

WACC

8.92%