11 Jul Please answer below in 500 word limit in APA format. Need to reply to 3 other classmates with 150 word limit each(Please see attached document for 3 classmate posts) Co
Please answer below in 500 word limit in APA format.
Need to reply to 3 other classmates with 150 word limit each(Please see attached document for 3 classmate posts)
Cost of Capital
In the links below, you will explore how companies compute their cost of capital by computing a weighted average of the three major components of capital: debt, preferred stock, and common equity. The firm's cost of capital is a key element in capital budgeting decisions and must be understood in order to justify capital projects.
For this Discussion, imagine the following scenario:
You are the director of operations for your company, and your vice president wants to expand production by adding new and more expensive fabrication machines. You are directed to build a business case for implementing this program of capacity expansion. Assume the company's weighted average cost of capital is 13%, the after-tax cost of debt is 7%, preferred stock is 10.5%, and common equity is 15%. As you work with your staff on the first cut of the business case, you surmise that this is a fairly risky project due to a recent slowing in product sales. As a matter of fact, when using the 13% weighted average cost of capital, you discover that the project is estimated to return about 10%, which is quite a bit less than the company's weighted average cost of capital. An enterprising young analyst in your department, Harriet, suggests that the project is financed from retained earnings (50%) and bonds (50%). She reasons that using retained earnings does not cost the firm anything since it is cash you already have in the bank and the after-tax cost of debt is only 7%. That would lower your weighted average cost of capital to 3.5% and make your 10% projected return look great.
Based on the scenario above, post your reactions to the following questions and concerns:
What is your reaction to Harriet's suggestion of using the cost of debt only? Is it a good idea or a bad idea? Why? Do you think capital projects should have their own unique cost of capital rates for budgeting purposes, as opposed to using the weighted average cost of capital (WACC) or the cost of equity capital as computed by CAPM? What about the relatively high risk inherent in this project? How can you factor into the analysis of the notion of risk so that all competing projects that have relatively lower or higher risks can be evaluated on a level playing field?
Classmate 1: I agree with Harriet's idea concerning the implementation of the cost of debt. This is because it will assist in understanding the overall rate that an organization pays through debt financing. It will also ensure that the investors are given an idea concerning the level of risk as compared to other companies. This will be crucial in assisting the organization in overcoming various expenses (Botosan, 2006). The cost of debt is vital in paying the average interest rate the organization pays across all debts. The cost of debt is essential in calculating the debt obligations of the organization. The estimation of the costs of debts helps in the forecasting rate of new debt issuance. Calculating the average rate of outstanding debt or the organization's average historical rate of borrowings is essential.
The capital projects consist of the cost of capital rates for planning dedications instead of implementing weighted average cost. The organization can raise funds from different sources of finance and funding. Through this, the organization can understate the available funds in the organization (Botosan, 2006). It is critical to calculating essential metrics such as the net present values and the economic value-added, which will assist the investors in evaluating their organizations. It is critical to understand that the organization’s cost of capital can effectively pay for using the capital of both owners and the debt holders. It is essential to understand the risk and capital structure of the organization.
The CAPM is critical in risk calculation, using the equity cost. Through this, the investor can get compensation for the time and value used in investing money. The cost of equity will usually apply only to equity investments, while the WACC will account for equity and debt investments. It is crucial to consider the inherent risk present in the project (Pratt & Grabowski, 2008). Capital budgeting is a financial tool that can evaluate a long-term project's value. WACC and CAPM are standardized methods, ensuring easy calculation of capital budgets required in this project. This will assist in practical decision-making capacities, leading to better overall outcomes for the organization.
The project risk will also be essential to consider, which may impact the chance that the project will not be profitable as expected due to different errors the organization faces in its different practices. The organization will need to focus on optimal capital budgets, which will impact the utilization of the capital. It will be critical to have higher earnings while preventing losses in the organization's processes (Pratt & Grabowski, 2008). It will be critical to have accurate calculations, which will impact the understanding of any inherent risks. The outcomes of risk analysis will directly impact decision-making processes. Using the premium cost of capital rates will play an essential role in surveying outcomes in the investment decisions the organization has made.
The cost of capital should build a company where the association examiners talk about the weighted average of the mandatory expenses and the cost of the company's value with the current organization's capital drawing. The fundamental goal of organizing development is to produce more profit, and the organization's experts should evaluate the typical value and liability spending using the specific weighted capital expenditure (WACC). (Bakers, 2018). Assume your organization's weighted normal capital is 13%, preferred stock is 10.5%, liability expenses are 7%, and normal value is 15%. If so, speculation would be dangerous for the organization. as item offers are declining.
Response to Harriet's idea
There are numerous ways the organization can increase resources. The best-known strategy for expanding resources is to use the organization's bond from banks or use equity, and interest would be paid regularly. Harriet's idea is to engage the organization's current obligation and retained earnings to an equivalent extent for new speculation. Harriet's idea is horrible since, assuming the organization implies the responsibility for the new venture, then, at that time, the interest will be added to the monthly obligation, which would be played with the current business. of the organization. (Michalsky, 2014). If the organization is using the responsibility, there should be detailed research of the existing company that seeks and offers preferable assistance to the customer over the competitor, thus creating benefits for the organization. The organization must be exceptionally positive about the use of obligations. The company does not have to pay interest using the offering capital, but the value share has to be distributed among the investors. Retained earnings are the company's total extra profit after delivering the profits to the company's investors, which is a horrible idea proposed by Harriet.
Capital budgeting model or WACC or CAPM
The association will consider each situation before deciding that capital planning is the new capital expenditure for the organization's business where the stakes are high and complex. (Brennan, 2020). The WACC and CAPM models are generalized ideas. The vast majority of associations use these ideas for speculation, which is essential for the capital building of the association, which includes the financial sponsors and the management of the association to decide the value of the company considering the obligation and value of the organization less.
There is a bet for every speculation. However, the management of the organization must analyze the scale of the chance considering the weighted average capital and the cost of the bond, which in this situation are 13% and 7%, and also the element of the organization. Offers are decreasing The organization's primary goal is to limit risk and reduce the cost of borrowing costs and rates by using the idea ofWACC and also planning techniques to avoid similar problems from now on. There must be a point-by-point assessment of the organization's expenses, which is defended, and the financial situation must affect the association.
The capital rates are lost, and the savings have to be paid because it is a bad idea. The cost of giving back a job is higher due to the cost of savings—part of the WACC. It is terrible to use only the loan value as it has value for money saved. Harriet's recommendation that it be used only to cover the cost of plans is incorrect. While he advises using the proceeds as a repository for the project, he should understand that these proceeds will be shared with business owners and company owners. Therefore, it is untrue that earnings are not valuable to the company. The retention rate is 13%, and the income value is the fair value in retaining income; this is the income that the company or its subsidiaries can earn using the income stored in other investments. Retained earnings are free, with a membership fee. If members do not put this money into the company, they will make money from this business (Vélez-Pareja, & Tham, 2009).
The organization's advantages include both the current capacity of the operations and the benefits of the actual options, which consider the use of such options. While CAPM gives the right idea to look back at previous resources (plans), it often gives the impression that it did not return to the original asset selection options. CAPM is too much to estimate the equivalent value of capital for publicly traded government entities. The following discussion summarizes the highlights of CAPM. This discussion also provides insight into the concepts in CAPM. CAPM is generally defined as Equity for an object's property, or Equity is equal to the risk value the gun has additional risk.
The WACC could work better due to the new assessment measures that the following two perspectives are proper for these new plans. He felt that the risk involved in completing new operations was similar to the company's current business. However, its recommendation to use 50% savings and 50% loans is perfect.
According to the WACC for the new position 13 * .5 + 7 * .5 = 10% = Earnings recovered from the new position. When we want to see affordable costs, then plans must be adopted. If the new activity is as risky as the current activity, a reasonable cost will be set for the WACC discount. If not, the WACC should be adjusted to indicate the job's risk, which may be more or less than the risk of the current job. WACC calculations are made to estimate the cost and fairness of the contribution to the companies' total value at any given time and calculate each component's revenue to the WACC after-tax(Vélez-Pareja & Tham, 2009).
If the cost is eligible, it must have its investment, which is not equal to the WACC or financial cost rate because the WACC or equity cost is the donor's current cost. They are at risk in subsequent operations. If the risk in a new project is greater than the present risk, it should be used because there is more investment than the current WACC, and it should be used because the risk in the new position is less than the present risk and the lower cost is less than the current WACC. Each project's cash flow conversion coefficient can be used to adjust the WACC to obtain a reasonable discount. Plan completion is an important business goal for investing in many areas, especially in business. Still, the current research planning team provides a brief overview of how planning affects our core investment outcomes: cost, time, and efficiency(Scott-Young & Samson, 2008).
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