Question 3 You are the treasurer of a mid-cap company and you are analyzing two equity opportunities as potential investments for your working capital of US$100 million. You are given the following information and can only choose one investment. Investment A (cash flows in US$millions) Year Cashflow Year Cashflow 0 Investment B (cash flows in US$millions) Market Return -100 Market Variance 0 -100 1 Investment A (COV/Market) 54 Investment B (COV/Market) 1 67 11% 24% 28 2 31 76 2 89 3 You are also given the following information to aid with your investment decision: Risk Free Rate 3.50% 98 3 98 4 121 4 176
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
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