Cost of Capital

Cost of capital is a financial concept that Strident Marks should not take lightly. Cost of capital is labeled as how much the corporation must receive monetarily in order to keep its stock value level (Gitman, 2006, p. 498). Another definition in terms of Strident Marks is the amount that Strident Marks is required to earn to efficiently uphold the marketable price of the stock. In order to make investment decisions we must figure the cost of capital. In order to analyze the cost of capital, we will be utilizing the weighted average cost of capital model.

Before analyzing the weighted average cost of capital (WACC), we must first calculate three other figures: cost of long-term debt, preferred stock, and common stock equity (Gitman, 2006, p. 501-507). The long-term debt cost is actually the net expense of borrowing (Sibley, n.d.). Long-term debt cost (k_i) can be calculated by multiplying the debt cost before taxes (k_d) by one less the tax rate (T) (Gitman, 2006, p. 505; Sibley, n.d.). The formula used to express this is k_i = k_d X (1-T) (Gitman, 2006, p. 505).

"The cost of preferred stock is the dividend yield on the preferred stock" (Monaco, n.d.). The preferred stock cost is a ratio that compares the preferred stock dividend to the after tax sales of the stock (Gitman, 2006, p. 506). The preferred stock cost (k_p) is capable of being computed by dividing the preferred stock dividend (D_p) by the after tax sales of the stock (N_p) (Gitman, 2006, p. 506). A formula used to express the preferred stock cost is k_p =D_p/ N_p (Gitman, 2006, p. 506).

The common stock equity cost is "the rate at which investors discount the expected dividends of the firm to determine its share value" (Gitman, 2006, p. 507). There are two ways to determine the general stock equity cost: constant-growth valuation model, and the CAPM (Gitman, 2006, p. 507). The constant-growth valuation pattern calculates the cost of common stock equity (k_s) by dividing the dividend per-share that is expected at the first year closing (D₁) by the value of common stock (P₀) all added by the continuous growth rate in dividends (g) (Gitman, 2006, p. 507). Using the CAPM form, we use the following equation: k_s =R_F + [b X (k_m - R_F)] (Gitman, 2006, p. 508).

In both models k_s equals k_r (Gitman, 2006, p. 509). We can now compute the WACC by using the following formula: k_a = (w_i X k_i) + (w_p X k_p) + (w_s X k_r) (Gitman, 2006, p. 511). The w represents the weights of each of the figures and all equal one (Gitman, 2006, p. 511).

In consideration of the debt-equity mix, we must understand that initially if the debt-equity mix is increased the cost of capital will decrease (Manning, 1998). After it reaches a certain point, the increased debt usage will increase the cost of financing the company (Manning, 1998) Therefore it is not always true that increased debt will help the company. A slump in the stock market would drastically increase the cost of capital (Lai, 2006). If market value rises, the cost of capital will decrease. However, if the market value decreases, the cost of capital escalates. References

Gitman, L.J. (2006). Principles of managerial finance (11^th ed). Boston, Massachusetts: Pearson Addison Wesley

Lai, R.K. (2006, January 6). Inventory and the stock market. Retrieved March 19, 2007, from Social Science Resource Network Web site: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=789884

Manning, F.C. (1998). Business core. Retrieved March 19, 2007, from Acadia University Web site: http://plato.acadiau.ca/courses/busi/newcore/2206/ch11sols.htm

Monaco, S. (n.d.). Cost of capital. Retrieved March 19, 2007, from Indiana University Web site: http://www.bus.indiana.edu/smonaco/f402/class8_9_cost_of_capital.ppt#275,1,Cost of Capital

Sibley, A.M. (n.d.). Fin 300-chapter 12: The cost of capital. Retrieved March 19, 2007, from Loyona University Web site: http://www.loyno.edu/~sibley/FIN%20300/Fin300_Ch12.pdf