Question

1. What’s the cost of each component of capital and which need to be adjusted?
   • What do the IRR and NPV tell us?
   • what it means for a stock to be in equilibrium?
   • what is a callable bond, when will a bond be called and how that helps/hurts an investor?

Answer 1

1) Cost of various component of capital

Cost of debt-   The cost of debt is the amount of interest that a firm pays to the person who has provided debt to the firm.The firm also get the tax benefit on the amount of interest paid.

Formula for cost of debt = [{Interest *(1-taxrate)}/total debt]*100

Cost of prefered stock- The cost of prefered stock is the amount of prefered dividend that a firm pays to preferred shareholder.

Formula for cost of preferred stock = (preferred dividend/Preferred share captal)*100

Cost of equity - Cost of equity is the return expected by the shareholder for their investment in the firm.There can also be cost of retained earning which is more or less similar to cost of equity.

formula for cost of equity = [(Expected Divident for next year/Share price today)*100]+growth rate

Out of the above components Cost of debt needs to be adjusted for tax benefits.

2) What do NPV &IRR tells us

NPV- NPV gives the net benefit that a project will generate in terms of today's value.It serves an important tool in determining whether to undertake a project or not.

IRR-IRR gives the rate of return that we are going to earn by investing in an project.It can be compared against firms cost of capital in deciding capital budgeting projects (whether to undertake or not).

3) Stock in a equilibrium means that the stock is correctly valued.There is no mispricing in the share value at equilibrium.

4)Callable bond- Bonds which are issued with a option to be called at or after a prefixed date are called callable bond.The bond can be called at option of the holder after the eligible date.

It can hurt/help the investor.

If the company has the option to call the bond and it calls the bond when Interest rates are increasing resulting in falling bond prices ,it hurts investor as they will be forced to sell their bonds at lower rate.Similarly when the bond holders has the option surrender the bond to company and it surrenders the bond when interest rates are falling resulting in increase in bond prices ,it helps investors as they will be able to sell their bonds at higher rate.