Question

Overview: For this task, you will explain the importance of cost of capital to organizational success and work through some calculations to understand their value. Prompt: First, review the module resources, especially Chapter 11 in the textbook. Then, address the following:

Answer the following questions based on your organization chosen for the final project. AMAZON INC

Write your response in a separate Microsoft Word document:

o Importance of Cost of Capital: Why is cost of capital important to an organization, and what does it measure?

o Meaning of Calculations: How do organizations calculate various costs, and what do these calculations mean to business?

Answer 1

Cost of Capital

Cost of capital is the minimum rate of return that the company must earn in order to fulfill investor expectations. To maximize shareholder’s wealth, a company has to earn more than the cost of capital. The cost of capital can be calculated by determining the weighted average cost of the different sources of capital.

Importance of the Cost of Capital:

1. Capital Budgeting Decisions: The cost of capital is required to make capital budgeting decisions. The acceptance and rejection of a project depends upon cost of capital.
2. Sources of capital: It helps to determine the cost of the various sources of capital. The source having the lowest cost of capital is selected.
3. Financial performance: Cost of capital helps to determine financial performance of projects by measuring the profitability with the cost of capital. If the profitability of the project is more than the cost of capital, then the project is termed as being successful.
4. Financial Decisions: Cost of capital is used to make other financial decisions such as payment of dividend.
5. Expected income and risks: Cost of capital helps to determine the expected income and inherent risks.
6. Capital Structure: Cost of capital helps to determine the optimum capital structure. It helps to choose a mix of debt and equity that minimizes the cost of capital.

The cost of capital measures the cost of the different sources of capital of the firm. It is measured in terms of the weighted average cost of capital. It consists of the cost of debt and equity for financing a business.

1.Calculation of the weighted average of capital:

The weighted average cost of capital is calculated using the below formula:

WACC=Wd*Kd(1-t)+Wps*Kps+We*Ke

Where:

Wd= Percentage of debt in the capital structure.

Kd= The before tax cost of debt

Wps= Percentage of preferred stock in the capital structure

Kps=Cost of preferred stock

We=Percentage of equity in the capital structure

Ke= The cost of common equity.

T= Tax rate

Cost of debt

The cost of debt is adjusted for the tax rate. The reason being the interest paid on corporate debt is tax deductible. The after tax cost of debt is calculated as Kd(1-t).

Cost of preferred stock

Cost of preferred stock is the price paid by a firm for the costing of issuing preferred stock. It is the return expected by the holders of preferred stock. It is calculated by dividing the preferred stock dividend paid in a year by the market price of the preferred stock.

Cost of preferred stock:

Kps=Dps/P

Where:

Kps= Cost of preferred stock

Dps=preferred dividend

P= Market price of preferred stock

Cost of Equity

Cod of equity is the required rate of return on the company’s common stock. The cost of equity is calculated using the Capital Asset Pricing Model (CAPM).

The formula for calculating the capital asset pricing model is given below:

Ke=Rf+[E(Rm)-Rf]

Where:

Rf=risk-free rate of return which is the yield on default free debt like treasury notes

Rm=expected rate of return on the market.

= Beta of the company

I hope that was helpful :)