14. 1A. The primary determinants of the cost of capital for an investment is the level of risk.

The firms
overall cost of capital reflects the average risks of all its securities. The cost of capital depends on the use
of funds, not the sources.
14. 1B. Cost of capital refers to the expected returns on the securities issued by a company, whereas the
required rate of return tell about the return premium required on investments to justify the risk taken by
the investor. It is possible the required rate of return is equal to the cost of capital.
Businesses are concerned with their cost of capital. Every company must determine when it makes sense
to raise capital and then decide the amount to raise and the method to acquire it. Required rate of return
comes from the investors point of view.
14. 2A.
14. 2B. The two approaches to determine the cost of equity is Dividend Growth Model Approach and
Security Market Line Approach.
Dividend growth model approach is an approach that assumes dividends grow at a constant rate. The
value of stock equals next years dividends by dividing the difference between the required rate of return
and assumed constant growth rate in dividends.
Po= DO *(1+g)/RE-g
=D1/RE-g
Where as
DO= Dividend just paid
D1=net periods projected dividend

Or

RE= D1/po+g

RE is the return of the shareholders require on the stock, it can be called as cost of equity of the firm.
Security Market Line approach is a line that graphs the systematic or market, risk versus return of the
whole market at a certain time and shows all the risky marketable securities.
RE depends upon:
1) The risk free rate (Rf)
2) The expected market premium; E (Rm) Rf
3) The amount of systematic risk; measured by beta
RE= RF+ Beta {(Rm)-Rf}

14.3A. A coupon rate is a bad estimate of a firm cost of debt, as it is only a reflection of the firms cost of
debt when the bonds are issued, not the current cost of debt.

14.3B. Preferred stocks are issued with a fixed par value and they pay dividends to shareholders based on
a percentage of that value at a fixed rate. The cost of preferred stock is calculated as:
Rp = D/P0
D= fixed dividend
P0= current price per share of the preferred stock
14.4A. Weighted average cost of capital (WAAC) is the average after tax cost of companys various
capital sources, including common stock, preferred stock, bonds and any other long term debt. In simple
words, WAAC is the average cost of raising that money. WAAC is calculated as:

((E/V) RE) + ((D/V) * RD * (1 - T)) + ((P/V) * RP)

Where:

Re = cost of equity

Rd = cost of debt

E = market value of the firms equity

D = market value of the firms debt

V=E+D

E/V = percentage of financing that is equity

D/V = percentage of financing that is debt

Tc = corporate tax rate

14.4B. The debt side of the equation (D/V* Rd) is then multiplied by (1 - Tc) to get the after- tax cost of
debt.
14.4C.
15.5A.
15.5B.
16.6A. Flotation Cost are the costs incurred by a publicly traded company when it issues new securities.
Flotation cost are paid by the company that issues new securities and includes expenses such as
underwriting fees, legal fees and registration fees.
16.6B.