Question

What is a weighted average cost of capital (WACC), and what is a target capital structure?

What is the project cost of capital and how does it differ from the WACC?

Should a company use the cost of the specific source of funding for a project or the WACC as its basis for evaluating the project?Explain your answer.

What factors affect a company’s weighted average cost of capital?

Define operating leverage and financial leverage. How does each relate to risk?

What is reserve borrowing capacity and why should a firm seek to maintain it?

What is business risk and what are the factors upon which it is based?

What are the factors that influence capital structure decisions?

What is an optimal capital structure?

What is times interest earned and what does it tell us about a firm’s degree of financial leverage?

How does the decision to finance with a greater percentage of debt versus stock impact:

A. shareholders’ earnings per share

B. company risk exposure

C. the WACC for the company

What is the breakeven quantity for producing a product? How would a higher breakeven quantity relate to a) a company’s risk, and b) profit earned per unit sold, once a company exceeds the breakeven point.

Answer 1

WHAT IT IS:

Weighted average cost of capital (WACC) is the average rate of return a company expects to compensate all its different investors. The weights are the fraction of each financing source in the company's target capital structure.

HOW IT WORKS (EXAMPLE):

Here is the basic formula for weighted average cost of

capital:

WACC = ((E/V) * R_e) + [((D/V) * R_d)*(1-T)]

E = Market value of the company's equity
D = Market value of the company's debt
V = Total Market Value of the company (E + D)
R_e = Cost of Equity
R_d = Cost of Debt
T= Tax Rate

Target Capital Structure:-

The target (optimal) capital structure is simply defined as the mix of debt, preferred stock and common equity that will optimize the company's stock price. As a company raises new capital it will focus on maintaining this target (optimal) capital structure.