Question

13.2 Which is easier to calculate directly, the expected rate of return on the assets of a firm or the expected rate of return on the firm's debt and equity? Assume that you are an outsider to the firm.

13.4 Your friend has recently told you that the federal government effectively subsidizes the use of debt financing (vs. equity financing) for corporations. Do you agree with that statement? Explain.

13.10 Your boss just finished computing your firm's weighted average cost of capital. He is relieved because he says that he can now use that cost of capital to evaluate all projects that the firm is considering for the next four years. Evaluate that statement.

Answer 1

Answer to 13.2

The expected rate of return on the assets of the firm is needed to be taken into consideration when it comes to easier method of calculation. It is important to know the return generated by the company by utilizing the assets which are associated with the business. As an outside the return on asset of the company will further help the individual to understand the current financial position in terms of effectiveness in utilising the assets of the company. The propensity of return generated out of the utilization of assets must be analyzed with the help of the tools and techniques associated with it.

Answer to 13.4

I don't agree with the statement as it is completely based on the regulator which is the Security Exchange Board of India (SEBI). In terms of investment there are various investment strategy which is associated in the business which completely depends on choice of the investors. Generally in order to minimize the risk associated with the business it is needed to have a have safe proportion of debt equity investment ratio which is 7:3 or 6:4 where the proportion of debt is higher than the equity. In case of the aggressive investment strategy, the proportion of equity is higher than that of the debt i.e, 4:6 or 5:5.

Answer to 13.10

By considering the weighted average cost of capital it is actually important to understand the return generated from the initial investment made in the business after 4 years. The project will only be accepted if that particular instrument whether it is debt or equity it is needed by the business to generate positive return in order to get the acceptance of such project. Hence it is significant for the company to evaluate the cost of capital so that the company can generate return by effectively utilizing the funds in the business instruments.