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Chapter 4: QBDQ (page 319)

Question:In computing the cost of capital, do we use the historical costs of existing debt and equity or the current costs as determined in the market? Why?(LO11-3)

Short Answer

Expert verified

Answer

While computing the cost of capital, current costs determined by the market are used because wants to know the future cost of capital.

Step by step solution

01

Definition of cost of capital

The minimum anticipated rate of return to meet the cost of capital budgeting is cost of capital.

02

Reason why the cost of debt is less than the cost of preferred stock.

While computing the cost of the capital, always use the current cost for various sources of financing which is determined by the market rather than the historical cost of existing debt and equity. This is because the company should consider what will be the cost of the funds to finance the projects in the future rather than their past costs.

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Most popular questions from this chapter

Home Security Systems is analyzing the purchase of manufacturing equipment that will cost \(50,000. The annual cash inflows for the next three years will be:

Year

Cash flow

1

\)25,000

2

23,000

3

18,000

a. Determine the internal rate of return.

b. With a cost of capital of 18 percent, should the machine be purchased?

Assume a \(250,000 investment and the following cash flows for two products:

Year

Product X

Product Y

1

\)90,000

$50,000

2

90,000

80,000

3

60,000

60,000

4

20,000

70,000

Which alternatives would you select under the payback method?

Dixie Dynamite Company is evaluating two methods of blowing up old buildings for commercial purposes over the next five years. Method one (implosion) is relatively low in risk for this business and will carry a 12 percent discount rate. Method two (explosion) is less expensive to perform but more dangerous and will call for a higher discount rate of 16 percent. Either method will require an initial capital outlay of \(75,000. The inflows from projected business over the next five years are shown next. Which method should be selected using net present value analysis?

Year Method 1 Method 2

1 .................................... \)18,000 $20,000

2 .................................... 24,000 25,000

3 .................................... 34,000 35,000

4 .................................... 26,000 28,000

5 .................................... 14,000 15,00

Question: Determine the amount of money in a savings account at the end of 10 years, given an initial deposit of $5,500 and a 12 percent annual interest rate when interest is compounded (a) annually, (b) semiannually, and (c) quarterly.

If your uncle borrows $60,000 from the bank at 10 percent interest over the seven-year life of the loan, what equal annual payments must be made to discharge the loan, plus pay the bank its required rate of interest (round to the nearest dollar)? How much of his first payment will be applied to interest? To principal? How much of his second payment will be applied to each?
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