1. How is an investor's required return rate of return related to an opportunity cost? 2....

1. How is an investor's required return rate of return related to an opportunity cost?

2. How do flotation costs impact the firm's cost of capital?

Expert Solution

1] An investors required rate of return can be considered as the rate of return that he would obtain if he invested his money in similar securities. Similar securities would mean securites having the risks similar to the security in which he has invested.

Hence, the required rate of return can be considered as an opportunity cost, the opportunity cost being the return that he would have earned on similar securities.

2] Flotation costs will increase the cost of capital.

Cost of capital is essentially the IRR of the cash flows associated with the financing source.

The inflow occurs first [the issue of debt or equity] followed by the cash outflow [interest/dividends and principal repayment, where applicable].

The cash inflow is the net amount of the issue, which is face value-discounts/underpricing-flotation costs. Thus, flotation costs reduce the cash inflow at t0, which will have the effect of increasing the IRR [or the cost of capital].

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