You have considered expanding your line of equipment and apparel for high school athletic teams to

QUESTION

You have considered expanding your line of equipment and apparel for high school athletic teams to include soccer teams and gathered information on the increase in sales for your division and the investment needed in new manufacturing equipment without having to hire additional manufacturing personn
1) The cost of capital represents the funds that are raised for a company to use. To raise or borrow funds costs money. Let us consider an example. A bank or mortgage company will loan you funds to purchase a home, however they require you to pay them interest to borrow these funds, in addition if you dont pay back the loan with interest, they can come and take your home, your asset. We need to look at each type of cost of capital in order to understand how to calculate the cost. The cost of debt is the interest rate after taxes. The reason we look at this as after taxes is we must calculate the savings to the company. We calculate the cost of debt by the before-tax cost of debt multiplied by one minus the firms marginal tax rate. The next type of cost is the cost of preferred and common stock. This is not taxable. We find the cost of preferred stock by the amount of expected preferred stock dividend divided by the current price of the preferred stock minus flotation cost per share. The last type of cost is the cost of common equity. “This is the required rate of return on funds supplies by the existing common stockholders”. We find this figure by taking the dollar amount of common dividend expected one period divided by the required rate of return per period on this common stock investment minus the expected growth rate per period. WACC = (E/V) x RE (P /V) x RP (D / V) x RD x (1-TC) 2) 2) The expected market risk is calculated using the Capital asset pricing model.

ng to CAPM, E(R) = Rf [ E(RM Rf)] Rf is the risk-free rate is the systematic risk [ E(RM Rf)] is the market risk premium. The market risk is normally characterized by the beta parameter. The risk-free rate is taken from the lowest yielding bonds in the particular market, such as government bonds. The risk premium varies over time and place. The market risk premium historically has between 3-5%. The sensitivity to market risk () is unique for each firm and depends on everything from management to its business and capital structure. As the management approaches the market for large amounts of capital relative to the firms size, the investors required rate of return may rise. Generally, as the level of risk rises, a larger risk premium must be earned to satisfy the companys investors. This, when added to the risk-free rate equals the firms cost of capital. Determining the capital structure mix:The individual cost of capital will be different for each source of capital in the firms capital structure. If the company uses 50% level of debt then the cost of debt should be 50% weighted in the capital structure. The higher the amount of debt, the higher would be cost of capital. The debt-equity mix depends on the under the industry that is operating. 3) The risk inherent to the entire market is market risk. The day-to-day potential for an investor to experience losses from fluctuations in securities prices. This risk cannot be diversified away. The beta is a measure of stocks market risk. The larger the beta, the greater should be the expected rate of return. 4 )The standard deviation is a statistical measurement that measures the volatility in the required rate of return. According to the CEO, the standard deviation is a measure of the deviation in the market values of debt and equity. The coefficient of variation allows you to determine how much volatility you are assuming in comparison to the amount of return on the investment. Coefficient of variation = Standard deviation / Expected return on marketThe greater the standard deviation, the greater the expected return on market. Therefore, the standard deviation measures the volatility of returns whereas the coefficient of variation measures the relative dispersion of returns.

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