Financial Management Discussion and response

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Assignement 1

Think about Unit VII and the importance of understanding the cost of capital to a business. Comment on why it is important, and explain why as debt increases (in capital structure), eventually the WACC will increase (despite the fact debt is usually the lower cost component cost of capital). How does your current or past company, or one you know of, decide on its cost of capital? Finally, What assignments/assessments from this course aligned with your profession? How can the lessons you have learned positively affect your career success (now or in the future)?

Textbook: Titman, S., Keown, A. J., & Martin, J. D. (2014). Financial management: Principles and applications (12th ed.). Upper Saddle River, NJ: Pearson.

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Assignment 2 - Please respond to my classmate discussion response below:

According to Titan, Keown, & Martin (2014), WACC includes the cost of capital (costs of borrowing money), taxes, and the cost of raising capital from common stockholders.

Generally speaking, the cost of capital is decided for a company when the cost of capital is up there is a loss for the project. If the cost of capital is down, there is value and gives the go ahead for investment (Jacobs & Shivdasani, 2012).

At the moment, this class and the information given will be new for me in the business. I hope to use the balance sheet and its information in the future with event planning. The other information has familiarized me for possible upcoming discussions I may be involved in.

Reference

Jacobs, M. T. & Shivdasani, A. (2012). Do you know your cost of Capital? Retrieved from https://hbr.org/2012/07/do-you-know-your-cost-of-c...

Titman, S., Keown, A. J., & Martin, J. D. (2014). Financial management: Principles and applications (12th ed.). Upper Saddle River, NJ: Pearson.

Unformatted Attachment Preview

UNIT VIII STUDY GUIDE Cost of Capital Course Learning Outcomes for Unit VIII Upon completion of this unit, students should be able to: 1. 2. 3. 4. 5. 6. 7. 8. Explain foundational finance theories. Analyze a forecast using relevant data. Apply time value of money techniques to various pricing (valuation) and budgeting problems. Apply measures of risk in financial analysis. Conduct preliminary financial statement and ratio analysis. Evaluate stock and bond valuation. Perform a capital budgeting analysis. Calculate weighted average cost of capital used in capital budgeting analysis. 8.1 Calculate cost of capital components. 8.2 Determine weighting factors for each component. 8.3 Calculate weighted average cost of capital. Reading Assignment Chapter 14: The Cost of Capital, pp. 444-473 Chapter 15: Capital Structure Policy, pp. 480-511 Unit Lesson In the last unit, Jerry Hampton (of United Drone Company) used capital budgeting techniques to evaluate sites for a new distribution center. Hampton used United's cost of capital to evaluate three potential locations. In this unit, we will look at how Hampton can calculate United's cost of capital more accurately. Hampton first wanted to calculate United's cost of capital components. United's capital mix includes bonds, preferred stock, and common stock. United has 10,000 8%, 20-year bonds outstanding with a $1,000 face value with interest paid semiannually. Market interest rates are at 7.5% and the company pays taxes at a 35% rate. United has 10,000 shares of 8.75% preferred shares with a par value of $30 a share and a market price of $25 a share and 1,000,000 shares of common stock currently selling at $42 share with a par value of $63.75 a share. United expects to pay dividends of $2.75 a share next year and anticipates the company will grow at a rate of 3% indefinitely. Using this information, Hampton calculates the market value of bonds as follows: BBA 3301, Financial Management 1 UNIT x STUDY GUIDE Title Next, Hampton calculates the market value of the preferred and common stock as follows: Hampton uses this information to calculate the weighting factors as follows: The weighting factors are simply a percentage to the total of the market values of each cost of capital component. Hampton made this calculation by dividing each components market value by total market value for all three components. Next, Hampton calculates the cost of capital for each component. For example, the cost of debt Hampton calculates using the following formula (Titman, Keown, & Martin, 2014, p. 453): Cost of debt π‘˜π‘‘π‘Žπ‘‘ = π‘˜π‘‘π‘π‘‘ (1-t) .08 x (1-.35) = .056875 or 5.69% where π‘˜π‘‘π‘Žπ‘‘ equals after tax cost of debt, π‘˜π‘‘π‘π‘‘ equals before tax cost of debt, and the tax rate equals t. This formula results in the after tax cost of debt. Remember interest payments yield a tax benefit because they reduce taxable income. Another cost of capital component Hampton needs to calculate is cost of preferred stock. Hampton calculates cost of preferred stock using the following formula (Titman, Keown, & Martin, 2014, p. 455): π‘˜π‘π‘  = 𝑑𝑖𝑣𝑝𝑠 𝑃𝑝𝑠 BBA 3301, Financial Management 2 where 𝑑𝑖𝑣𝑝𝑠 equals the fixed dividend on preferred stock and 𝑃𝑝𝑠 is the price ofUNIT preferred stock.GUIDE π‘˜π‘π‘  is the cost x STUDY of preferred stock. Using this formula Hampton plugs in the following numbers:Title π‘˜π‘π‘  = $2.625 $25 = 10.5% The dividend is 8.75% x $30 par value or $2.625, but because the market value is less par investors demand a higher return. Last, Hampton uses the Gordon Growth model to calculate cost of common stock as follows (Titman, Keown, & Martin, 2014, p. 457): π‘˜π‘π‘  = 𝐷1 𝑃𝑐𝑠 +𝑔 where 𝐷1 is the current dividend, 𝑃𝑐𝑠 is the price of common stock, and 𝑔 is the growth rate. π‘˜π‘π‘  = $2.75 $42 + 3% = 9.5% To calculate weighted average cost of capital, Hampton has to apply the weighting factors to each cost of capital component. This calculation is as follows: Although in Unit VII, Hampton estimated 9.5% as United's cost of capital, this calculation shows cost of capital slightly lower at 8.97%, which should improve net present value for each location. Hampton may have used the capital asset pricing model (CAPM) as another alternative to estimate cost of capital at 9.5%. For example, assuming market interest rates are 8.25%, the risk free rate is 2%, and United's beta is 1.2 Hampton could calculate cost of common stock as follows: π‘˜π‘π‘  = π‘Ÿπ‘“ + (π‘Ÿπ‘š βˆ’ π‘Ÿπ‘“ )𝛽𝑐𝑠 π‘˜π‘π‘  = 2% + (8.75% - 2%)1.2 π‘˜π‘π‘  = 2% + (6.75%)1.2 π‘˜π‘π‘  = 2% + 8.1% π‘˜π‘π‘  = 10.1% Weighted average cost of capital using CAPM is as follows: Weighted average cost of capital using CAPM can result in a different weighted average cost of capital and may explain why Hampton used 9.5% in the capital budgeting analysis performed in Unit II as a rough estimate. BBA 3301, Financial Management 3 In summary, weighted average cost of capital (WACC) is an important conceptUNIT because it serves as the x STUDY GUIDE discount rate in capital budgeting decisions. A firm can use a weighting factor Title based on market value or it can use the book value of cost of capital components. Most firms prefer to use market value because it improves the accuracy of the rate. Firms should carefully calculate cost of capital components to ensure a firm uses an accurate WACC. Weights factors applied to each cost of capital component results in a weighted average cost based on the mix of the components. Reference Titman, S., Keown, A. J., & Martin J. D. (2014). Financial management: Principles and applications (12th ed.). Upper Saddle River, NJ: Pearson. Learning Activities (Nongraded) The following video tutorials will help you with the concepts covered in the textbook chapters. It is strongly encouraged to watch these videos prior to starting the unit assessment. Click here for Cost of Capital Click here for Capital Structure Nongraded Learning Activities are provided to aid students in their course of study. You do not have to submit them. If you have questions, contact your instructor for further guidance and information. BBA 3301, Financial Management 4 ...
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