Cost of Capital and Financing Strategies

Question 1

Define “business risk”.

Answer 1

The risk of loss or other unfavorable outcome that results as variability in operating results increases; the higher the variability in a firm’s expected operating earnings, the greater the business risk (i.e., the increased chance that it may not be able to meet its debt obligations).

Question 2

Generally, how do the costs compare of financing using long-term debt, Preferred Stock, and Common Stock?

Answer 2

Generally, the cost of Long-term debt is lower than either Preferred Stock and Common Stock and the cost of Preferred Stock is lower than the cost of Common Stock. However, as the level of Long-term debt increases relative to equity, the cost of marginal debt increases due to the increased risk of default.

Question 3

Define the “hedging principle” of financing (also called the “principle of self-liquidating debt”).

Answer 3

Principle that focuses on matching cash flows from assets with the cash requirements needed to satisfy the related financing. Thus, long-term assets should be financed with long-term sources of capital and short-term assets should be financed with short-term sources of financing.

Question 4

What macroeconomic conditions affect the cost of capital?

Answer 4

Market conditions and expectations concerning economic factors such s interest rates, tax rates, and inflation/deflation rates.

Question 5

What are some factors that influence the cost of capital to a firm?

Answer 5

1. Macroeconomic conditions (e.g., interest rates, tax rates, and inflation/deflation rates, etc.).
2. Past performance of the firm
3. Amount of total financing used
4. Relative level of debt financing
5. Length of debt maturity
6. Relative level of collateral provided

Question 6

What is the objective of Optimum Capital Structure?

Answer 6

To minimize a firm’s aggregate cost of capital financing by using an optimum mix of debt and equity components; to achieve the lowest possible weighted cost of capital.