Cost of Equity and Debt Case Study

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Week 7 Case StudyQuestion 1: WACC (Weighted Average Cost of Capital)· On the most basic level, if a firm’s WACC is 12 percent, what does this mean?WACC is the average rate of return a company needs to pay to finance its assets. If a firm\'s WACC is 12%, it means that the company has to have a 12% return on its investments to be able to maintain its payments to stakeholders and on loans (Menifield, 2020).Question 2: Cost of Capital· (a) The stock currently sells for $50 per share, and the dividend per share will probably be about $5. Tom argues, “It will cost us $5 per share to use the stockholders’ money this year, so the cost of equity is equal to 10 percent (= $5/$50).” What’s wrong with this conclusion?It is a totally accurate conclusion—that is why it is wrong. First, it only considers the dividend yield ($5/$50 = 10%). That is not the whole cost of equity, though. Tom also needs to think about the expected growth rate of the dividends. It can be estimated using models like the Gordon Growth Model. If he ignores the growth component then he underestimates the true cost of equity (Menifield, 2020).· (b) Based on the most recent financial statements, Bedlam Products’ total liabilities are $8 million.

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Total interest expense for the coming year will be about $1 million. Tom therefore reasons, “We owe $8 million, and we will pay $1 million interest.…

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…the investment projects because their return would be higher than the hurdle. However, there would need to be a risk-adjusted basis established to properly consider where the projects go.· (c) If you were to try to estimate the appropriate cost of capital for different divisions, what problems might you encounter?The first main challenge is identifying the risk profiles for each division. They are not all going to be the same. Second is going to be finding comparable companies for benchmarking. After this, one needs to be able to make an accurate assessment of the factors that are specific to each division that affect the cost of equity and debt. On top of all this, market conditions and changes in the business environment….....

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