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Solutions to - 306-310 ENGINEERING ECONOMY SOLUTIONS TO PROBLEM SET#5 SOURCES OF FUNDS AND COST OF CAPITAL 1 The cost of capital is the

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1 3 0 6 - 3 1 0 E N G I N E E R I N G E C O N O M Y SOLUTIONS TO PROBLEM SET #5 – SOURCES OF FUNDS AND COST OF CAPITAL 1. The cost of capital is the weighted-average cost of a firm's long-term sources of funds. Therefore, it is the minimum return on investment that a firm must earn to satisfy its obligations towards its suppliers of permanent capital, i.e. its long-term creditors and shareholders. Thus, the cost of capital is considered a hurdle rate, and may be used as a discount rate when evaluat- ing new projects. The acceptance of a project with a return greater (lower) than the cost of capi- tal will increase (decrease) the firm's value and therefore affect the wealth of its shareholders. The acceptance of a project with a return equal to the cost of capital should not influence the firm’s value, which implies that the firm is expanding without affecting the wealth of its share- holders. It is important to distinguish between a firm's current cost of capital, i.e. the cost of funds invested in all of its present assets, and a firm's marginal cost of capital, i.e. the cost of raising additional capital. 2. Financial leverage refers to the use of fixed-cost sources of funds such as debt in a firm's capital structure. Fixed tax-deductible interest charges are incurred when using such sources. The debt ratio and the debt to equity ratio are commonly used as measures of financial leverage. The higher the debt to equity ratio, the higher the financial leverage. In times of healthy profits, financial leverage increases a firm's return on equity (ROE) and earnings per common share (EPS), because the after-tax cost of debt capital is lower than the cost of equity capital. In bad times however, the situation may be reversed, because the fixed interest charges must be paid whether there are profits or not. The resulting downside sensitivity of the ROE and EPS in- creases the firm's financial risk. An optimal capital structure leading to the minimum cost of capital is achieved by balancing the potential benefits of financial leverage on the one hand, and
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This note was uploaded on 04/10/2008 for the course MIME 310 taught by Professor Bilido during the Spring '08 term at McGill.

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Solutions to - 306-310 ENGINEERING ECONOMY SOLUTIONS TO PROBLEM SET#5 SOURCES OF FUNDS AND COST OF CAPITAL 1 The cost of capital is the

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