Dialogue on Concepts for Shared Understanding (Due Tuesday)
Each person should pick a topic that has not yet been posted.
Explain the concept from your reading in the text, providing appropriate citations.
Considering Lawrence Sports and the company’s situation, identify how your topic relates
to the scenario in terms of presenting issues and opportunities, presenting potential
topics to research for solutions and/or manage risks.
Costs of Capital
Company Cost of Capital
The company cost of capital is the expected return on a portfolio of all the company’s existing
securities. Basically, it provides the “opportunity” for inventing in the company’s assets. Also, it
provides a viable benchmark for future projects (Brealey, 2005, p. 215).
Project Cost of Capital
When a company is contemplating a new project or a future project, finding out whether or not to
take or proceed with the project is a delicate blend of capital costing. Typically, company’s use
the weighted average cost of capital or “WACC” when considering a project. The WACC takes
both debt and equity into consideration and estimates a “beta” for the company when measuring
the cost of equity (Brealey, 2005, p. 219). If a beta is not set, then a discount rate is used. Both
are dependent on the market rate of return and stock movement.
Another way to approach and adjust for risk is calculating “certainty equivalents.” Certainty
equivalents plan for uncertainty by calculating the present value of uncertain cash flows and
recalculating for certain cash flows. This is known as the certainly-equivalent cash flow.
For example, if Lawrence Sports were to construct a new facility and then sell it after one year for
$500,000. Of course, this is the amount they would like; however, they must consider the risk of
not getting $500,000. Therefore, they discount the rate of interest and calculate the present value.
Subsequently, they get a fixed offer on the building after completion. The finance manager now
needs to calculate a “certain cash flow” (since he has been provided a fix amount) to see if he
should accept the offer. He would use the risk-free interest rate (not the risk-adjusted rate) and
the present value amount to calculate the present value and the “certain cash flow” amount.
Therefore, if the present value is $400,000, he would need a return of $100,000 ($500,000 -