ACCOUNTING You need to understand the various sources of capital and how their costs are calculated to provide the data necessary to determine the firm’s overall cost of capital.

This is the Team Assignement. This Portion of the assignement is mine. Please do in Excel and must be complete by Sunday 11.00PM (Due in 45 hours. I will also post what other member of the team has done… Tomorrow I will be on a flight all day. So cannot respond to email till Sunday morning(24hours from now)

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Resource: Principles of Managerial Finance, Ch. 9

Complete the Spreadsheet Exercise on p. 390, and The Interactive Case 4 Eco Plastics in Ch 9.

Create a spreadsheet with two tabs. Use one tab for the Spreadsheet Exercise on p. 390, and the other tab for The Interactive Case 4 Eco Plastics.

MY PORTION OF THE ASSIGNMENT:

f.

  • (1) Assuming that the debt financing costs do not change, what effect would a shift to a more highly leveraged capital structure consisting of 50% long-term debt, 0% preferred stock, and 50% common stock have on the risk premium for Eco’s common stock? What would be Eco’s new cost of common equity?
  • (2) What would be Eco’s new weighted average cost of capital?
  • (3) Which capital structure–the original one or this one–seems better? Why

CHAPTER 9

9 The Cost of Capital

Learning Goals

  • LG 1 Understand the basic concept and sources of capital associated with the cost of capital.
  • LG 2 Explain what is meant by the marginal cost of capital.
  • LG 3 Determine the cost of long-term debt, and explain why the after-tax cost of debt is the relevant cost of debt.
  • LG 4 Determine the cost of preferred stock.
  • LG 5 Calculate the cost of common stock equity, and convert it into the cost of retained earnings and the cost of new issues of common stock.
  • LG 6 Calculate the weighted average cost of capital (WACC), and discuss alternative weighting schemes.

Why This Chapter Matters to You

In your professional life

ACCOUNTING You need to understand the various sources of capital and how their costs are calculated to provide the data necessary to determine the firm’s overall cost of capital.

INFORMATION SYSTEMS You need to understand the various sources of capital and how their costs are calculated to develop systems that will estimate the costs of those sources of capital as well as the overall cost of capital.

MANAGEMENT You need to understand the cost of capital to select long-term investments after assessing their acceptability and relative rankings.

MARKETING You need to understand the firm’s cost of capital because proposed projects must earn returns in excess of it to be acceptable.

OPERATIONS You need to understand the firm’s cost of capital to assess the economic viability of investments in plant and equipment needed to improve or grow the firm’s capacity.

In your personal life

Knowing your personal cost of capital will allow you to make informed decisions about your personal consuming, borrowing, and investing. Managing your personal wealth is a lot like managing the wealth of a business in that you need to understand the trade-offs between consuming wealth and growing wealth and how growing wealth can be accomplished by investing your own monies or borrowed monies. Understanding the cost of capital concepts will allow you to make better long-term decisions and maximize the value of your personal wealth.

Alcoa Falling Short of Expectations

Often listed among America’s most admired corporations, Alcoa, Inc., is the world’s largest producer of aluminum, with more than 61,000 employees in 30 countries. A quick glance at its financial statements might suggest that the company has been doing very well in recent years. Alcoa increased its total sales from $18.4 billion in 2009 to $23.7 billion in 2012, an annual growth rate of almost 9 percent, far exceeding overall economic growth over the same period. In each of those years, Alcoa spent more than $1 billion on capital expenditures, expanding and upgrading its manufacturing facilities, entering new joint ventures, and making strategic acquisitions.

During that span, however, Alcoa’s stock underperformed. During the 5-year period ending in May 2013, Alcoa common stock lost almost 80 percent of its value, while the broader stock market (as measured by the Standard & Poor’s 500 Stock Composite Index) rose by about 20 percent. Why did Alcoa perform so poorly? A simple answer is that its business investments failed to earn a return sufficient to meet the expectations of investors. Despite Alcoa’s continued growth, the rate of return that it earned on the assets that it had invested was not sufficient to satisfy investors. When a firm’s operating results disappoint investors, its stock price will fall as investors sell their shares and move to a more attractive investment. According to some estimates, Alcoa’s cost of capital exceeded 12 percent, but its investments were consistently earning returns below 5 percent. That is a recipe for a declining stock price, which is precisely what Alcoa had been experiencing for several years.

For companies to succeed, their investments have to earn a rate of return that exceeds investors’ expectations. How, though, do companies know what investors expect? The answer is that companies have to measure their cost of capital. Read on to learn how firms do that.

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