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The Weighted Average Cost of Capital - Essay Example

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The Weighted Average Cost of Capital is the firms cost of capital which is calculated while taking the weights of each source in mind. Sources include the cost of debt and the cost of equity. The Formula for weighted average cost of capital is:
In the beginning when there's no debt, the weighted average cost is equal to the cost of equity…
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The Weighted Average Cost of Capital
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However, this point is only hypothetical, in reality this point is impossible to be obtained. What managers can do is get as much cheap debts as possible and avoid expensive equities. How do you get cheap debts A corporation should do whatever it can to reduce the value of its beta. The beta is a tool for decreasing the cost of capital.A stock with stable returns is less risky than a stock with fluctuating returns. A beta defines the amount by which a stock's returns are fluctuating. The value of returns fluctuates because of changes in present profitability and future expectations. So actions should be taken to keep them stable. (Steven M. Bragg, 2008) The costs and benefits of debts and equities must be evaluated properly. Other than this, the optimal level of capital varies from company to company and industry to industry. For example, a monopoly with very strong demand for a product can invest in capital to a higher extent than a company which is in a competitive market with limited resources and limited future prospects. (Gallagher and Andrew, 2008)
Describe how uncertainty is calculated into cash flows. ...
(Gallagher and Andrew, 2008)
Describe how uncertainty is calculated into cash flows. Why should two projects with equal cash flows but unequal risks produce different financial results Would you prefer a low-risk, low-return project or a high-risk, high-return project, and why
When cash flows are created, it is assumed that all cash flow will be exactly like you expected, but in real life the cash flow is different, for this reason we calculate uncertainty.
(Johnathan Mun, 2005) One way to calculate uncertainty in cash flows is to use a discount rate that reflects the riskiness of cash flows. How do you choose the risk associated with cash flows By risk we are referring to uncertainties of future cash flows. (Gil Fried, Steven J. Shapiro, Timothy D. DeSchriver, 2007)
A certain Discount rate (risk rate) is set that accounts for a percentage of cash flow that might not be there. Therefore, (1-Discount rate) is the proportion which will be there. The formula to calculate the discounted cash flow is as following:
Discounted Cash Flow = Nominal Cash Flow * (1-Discount Rate) ^ Number of years
Now suppose that Ben and Joe expect to have $1000 at the end of 5 years. Ben feels that the inflation would be high in the coming years so he keeps the discount rate (or risk rate) as 6 percent per annum while Joe keeps the discount rate as 4 percent. Financial results for Ben after 5 years would be $734 while the financial results for Joe would be $815. Therefore, this is how their financial results will differ. (12manage, 2008)
All investors prefer less risk to more. They are also called risk averse and this is a law of finance. But being a risk averse does not mean that investors would not take risks. It just means that an investor is able to ...Download file to see next pagesRead More
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