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Cost of Capital:

Company can raise capital through equity, preferred stock and/or debt. It costs company to raise capital. Company will have different cost of capital if it raises capital through equity, preferred stock or debt. There is a concept of Weighted Average Cost of Capital (WACC) which tells what is actual cost of capital of the company.

WACC can be calculated as follows:

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Where, W (d), W (p) and W (e) are the weights used for the debt, preferred equity and common equity respectively.

eg. Company raises capital of $100,000. Out of it, debt is $50,000 Equity of $20,000 and Preferred stock is of $30,000

Weight of Debt W(d) = 50,000/100,000 = 0.5

Weight of preferred stock = 30,000/100,000 = 0.3

Weight of equity = 20,000/100,000 = 0.2

A project is accepted if it generates return greater than the cost of capital of the company. If the project generates return less than the cost of capital, there is no point in accepting that project.

How do market rates and the company's perceived market risk influence its cost of capital, and how does the company's debt to equity mix impact this cost of capital?

Cost of capital includes cost of equity. The cost of equity includes all the market risk associated with the company. CAPM formula calculates cost of equity of the company.

The CAPM formula is : Cost of equity = Risk free rate of return + Premium expected for risk

=> Cost of equity = Risk-free rate + (Market rate - Risk-free rate) x Beta

Here, beta is the systematic risk associated with the company. Along with beta the risk premium is included in the calculation of cost of equity to consider the market risk and rates.

The cost of debt is cheaper than the cost of equity for any company . So, if weight of debt is more, cost of capital of the company will be less and if weight of equity is more, cost of capital will be more. But it is not always true. If debt to equity ratio is very high, solvency risk of the company increases. This results in higher cost of debt as well as high cost of equity. So, after a particular point, any increase in debt results in higher cost of capital.

Market risk and its measurement:

Market risk is the risk that arises for a company or industries due to certain unfavorable market factors. Market risk is common for all securities. These market risk include the reinvestment risk, interest rate risk, foreign exchange risk etc.

There are various ways to calculate market risk this includes measuring the market risk based on price volatilities. The market risk is normally characterized by the beta parameter. Beta is sensitivity to market risk. Due to market risk, investors want some risk premium over risk free return from their investment.

Risk premium = Market return – Risk free rate of return

From different companies, investors expect different return. This is explained by CAPM formula.

Expected return = Risk-free rate + (Market rate - Risk-free rate) x Beta

Here, beta is sensitivity to market risk. Different companies are having different level of sensitivity towards market risk. If beta =1 then we can expect normal return from the investment in that company. Higher beta companies share price show more volatility. Lower beta companies are comparatively insulated from market risk.

Don mentioned using standard deviation and the coefficient of variation to measure risk. What does that mean?

Expected value of return is weighted average of possible returns, with the weights being the probabilities of occurrence. Standard deviation is measure of risk based on the distribution return in the past by assigning probabilities to them.

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Here k(i) = ith possible outcome of return

[pic] = expected rate of return

P(i) = is the probability of the ith outcome

Hence the standard deviation is used to find out the volatility in the return. The higher the standard deviation the higher the risk associated with the return.

The standard deviation can be misleading in comparing the risk relating to the alternative returns if they differ in size. To adjust for size , the standard deviation is divided by expected return. This is called Coefficient of variation (CV).

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Here the coefficient of variation shows the risk per unit of return and is used as tool to provide more meaningful basis for comparison whenever the expected return of the two alternatives are not same.

Cost of capital of Abel Athletic:

Cost of capital includes cost of equity, cost of debt and cost of preferred stock. Cost of debt is lower than cost of equity and cost of preferred stock. When risk free return is 7%, cost of equity will be higher than 7% as there is some market risk associated with the investment in Abel Athletics. As CAPM model states, investors expect risk premium on their investment in any security. Same applies on preferred stock also and so cost of preferred stock will also be higher than 7%.

When risk free return is 7%, it is unlikely that cost of debt of Abel Athletic will be lower than 7%.

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It is unlikely that cost of capital of the company would be 6%.

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