Cost of capital and risk

After considering expanding your line of apparel and gathering information on the increase in sales for your division and the investment needed in new manufacturing equipment, without having to hire additional manufacturing personnel, you arrange a meeting with the CFO. During the meeting Don listened to your proposal, reviewed your information, but questioned your use of a 6% cost of capital. He indicated to you that the head of treasury could raise debt at 7% in today's market. Taking into consideration how a company's cost of capital is calculated, and how market rates and the company's perceived market risk impacts a firm's cost of capital, provide your viewpoint on whether 6% is reflective of On Your Mark's current cost of capital. Include in your assessment the following:

What does a company's cost of capital represent and how is it calculated?

How do market rates and the company's perceived market risk influence its cost of capital, and how does the company's debt to equity mix impact this cost of capital?

What is market risk and how is it measured?

Don mentioned using standard deviation and the coefficient of variation to measure risk. What does that mean?

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Regarding the use of a 6% cost of capital, this is low compared to raising debt by treasury at 7%. This action will definitely increase the company's cost of capital (ie. higher than 6%). In addition, if the market rates and the company's perceived market risk (known as market risk premium), it will cause the cost of equity to increase (rs). This is because by the CAPM approach, cost of equity (rs) is equal to risk-free rate (rRF), which is the market rates plus market risk premium (RPm), scaled up or down to reflect the particular stock's risk exposure as measured by its beta coefficient.

rs = rRF + (RPm) b, Remember rs is in the equation of finding cost of capital (WACC). Therefore, an increase in rRF and/or RPm will increase rs, and thus, increase the cost of capital.

The company's debt to equity mix impact this cost of capital by the amount of rates it has on its debt and equity. When both the cost of debt and cost of equity increase, it increases the company's cost of capital. However, it is safer to have higher portion of cost of equity than cost of debt. This is so that stockholders will keep investing in the company. In ...