Estimation of the Weight of Capital - Assignment Example

The cost of debt refers to the effective rate at which a firm pays to use debt finance. The value is considered to be the proportion of interest on the entire debt value. However, this can be viewed in two approaches namely cost of debt before tax and cost of debt after tax. As such, the cost of capital before tax will therefore refer to the effective rate an organization pays for it to use debt finance without incorporating tax while the cost of debt after tax will refer to the effective rate in which an organization will pay to use debt finance while considering tax. About GE, the company pays 5.56% for its debt finance annually before tax. The value will translate to 5.35% cost of debt after tax.

This implies that the proportion of interest on the entire debt value before considering tax is 5.56% while the proportion of interest considering tax is 5.35%. Also, the measure of the cost of debt reflects the risk level of an organization when compared to others. Therefore, when a company records a higher rate in its cost of debt than another, then it means investing in that company will be more risky. Therefore, a firm that has a cost of debt before tax greater than 5.56% and a cost of debt after tax greater than 5.35% is more risky to invest in than GE.

Cost of capital is another element that factors greatly in evaluating company performance. Cost of capital refers to the theoretical return an organization will pay for its equity finance as compensation for the risk they undertake in investing in that firm. Currently, GE has a cost of equity rate of 8.81%.

The value is averaged by summing the risk-free rate with measures of the reward for bearing systematic risk. Therefore, this implies that GE pays 8.81% annually over the long term as compensation to their equity finance providers. However, computing the rate using CAPM has some inherent flaws. The reason behind this view is that the approach uses the S&P average from the year 1950 to 2013. Also, the rate uses the US 10-year Treasury bill as its benchmark for the risk-free rate. The value is prone to daily changes in the market. However, despite the flaws, the value is a good estimator of the cost of equity. This is because the figure that is obtained has little material difference from other methods such as the Gordon model.

WACC refers to the computations of the cost of capital that aim at equally weighting the cost of capital of an organization. Therefore, the value of WACC outlines the amount of interest the organization pays for every dollar which is available as part of its capital. However, to compute WACC, tax rate, cost of capital, cost of equity, total debt, and total equity has to be known. Therefore, applying the relevant formulae to combine these values, the organization has a WACC value of 5.97%. The value means that the organization pays 5.97% on every dollar which translates to 0.597 cents for each dollar. Therefore, this will also mean that for every one-dollar investment that the organization makes, the organization has to realize a return of 0.597 for such investment to be feasible for the firm.

Question Two
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