Question

1. a. Explain why the cost of debt is lower than the cost of capital?

1. b. Explain what is meant by the statement- depreciation is a non-cash expense and how do companies use it.

1. c. How long does it take money earning 12% to double? Use both the rule of 72 and your financial calculator.

1. d. Explain the three ways a company can raise capital.

1. e. If an investor has a short term view on her investments and in a time of high interest rates - which is better stocks or bonds? Why?

1. f. Explain the difference between common and preferred stock.

1. g. If you own 3 stocks A, B, and C. What is your total return of your portfolio? Stock $ invested Return A $ 6,000 6 % B 9,000 9 % C 15,000 11 %

1. h. Explain the RISK/ REWARD theory?

1. i. GM issued a $ 1,000, 30-year bond 5 years ago at 9 % interest. Comparable bonds yield 6 % today. What should GM’ bond sell for now?

1. j Define each variable in the equation P = (D1 + P1) / (1 + R)

1.k Solve the NPV and solve for the Payback

YR Cash Flow

0 -$26,000

1 11,000

2 14,000

3 11,000

with the required rate equal to 6%

Answer 1

Note: As per answering guidelines, only the first four parts can be answered.

Solution:-

(a)

Debt investment carries the lease risk out of all investments that can be made. This is because the capital invested is to be refunded at the maturity and is generally secured against some assets. This is why the cost of debt is the lowest cost that a firm pays to its investors. Debt investors take far lesser risk than equity investors or preferred stock investors and thats why the return they get is lower too. So, debt is the lowest cost among all forms of capital.

Now, cost of capital is the weighted average of cost of all sources of capital, i.e. equity, retained earnings, preferred capital and debt. Since, debt has the least cost among all other components that together form the overall cost of capital, cost of debt is always lower than the cost of capital.

(b)

When a business invests in a fixed asset (e.g. a machine) which will be used for many years to come, the company wants to proportionately allocate that expense against the revenues of all the years in which the machine will be used for operations. The accounting method that lets a company achieve this objective is depreciation.

If the amount spent for the machine is charged as an expense in the income statement for the first year itself, it will distort profits and that's why it is allocated in the form of depreciation over the life of the machine. Thus, depreciation is the allocation of investment in fixed assets to the income statement over the life of the assets.

However, while it helps in calculating accurate yearly profits, we must remember that the company pays all cash for the fixed assets at once and thus, there is no cah outflow in future when depreciation is allocated to the income statements. It is just an accounting entry for the cash investment that company made in the past and therefore, it is a non-cash expense used by the company to allocate the cost of fixed assets to the operations of the business during their life.

(c)

As per rule 72, the number of years required for doubling of an investment can be calculated by simply dividing 72 by the rate of interest. Therefore, if the rate of interest is 12%,

No. of years to doubling of investment= 72/12 = 6 years

We can calculate it using CAGR fomula as follows:

Future value= Present value*(1+r)n

(Future value/Present value) = (1.12)ⁿ

2= (1.12)ⁿ

Log 2 = n*Log1.12n

n = Log 2/Log 1.12 = 6 years

(d)

The three ways company can raise capital are as follows:

• By issuing equity shares through IPO, private placement, private equity, venture capital, Further public offer, rights issue, etc
• By raising debt through bank loans, issuing bonds, debentures, etc
• By issuing preference shares in the market