Question

Mini Case-Your answers must be in your own words to earn credit. Assume that you recently graduated and have just reported to work as an investment advisor at the brokerage firm of Balik and Kiefer Inc. One of the firm’s clients is Michelle DellaTorre, a professional tennis player who has just come to the United States from Chile. DellaTorre is a highly ranked tennis player who would like to start a company to produce and market apparel she designs. She also expects to invest substantial amounts of money through Balik and Kiefer. DellaTorre is very bright, and she would like to understand in general terms what will happen to her money. Your boss has developed the following set of questions you must answer to explain the U.S. financial system to DellaTorre.

 

3. How do free cash flows and the weighted average cost of capital interact to determine a firm’s value?

4. What do we call the cost that a borrower must pay to use debt capital? What two components make up the cost of using equity capital? What are the four most fundamental factors that affect the cost of money, or the general level of interest rates, in the economy? 

Answer 1

3. The free cash flows refer to the operating cash flows of the business after disregarding the capital expenditures. Value of the business can be computed using free cash flow for a particular period of time. These cash flows should be discounted at a particular rate to arrive at the present value of the future cash flows which represents the value of the business. For using this discount rate the weighted average cost of capital is generally taken into account since that is the opportunity cost of the funds. Hence the value of the business is computed by discounting the free cash flows at the weighted average cost of capital.

4. The cost that a borrower pays to use debt capital is called interest rate. The cost of using equity capital is made up of two components which are the capital gain and dividend. The four most fundamental factors which affect the general level of interest rate in the economy are expected inflation and risk as well as time preferences and production opportunities.