Amba 630 International Capital Investments

AMBA 630 9042 – Week 7 Discussion Questions

Question 1:

Remember that your discussion should begin with a clear and logical step-by-step explanation of the theory behind the concept of "required return" on proposed capital investments.  Explain how cost of equity, cost of debt, WACC, and allowances for various risk factors are involved in determining the "required return" on proposed international capital investments. Please write at least one paragraph for each step in the WACC process.

Required return is the most important financial calculation to make for evaluating any financial investment proposal (Wilkinson, 2013).  Calculating required return helps investors determine the factors to use in order to discount the future cash flows that a proposed project EXPECTS to receive.  Required return represents the growth in value that needs to be achieved in order to justify the initial investment in a project (Faloppa, 2015).  Required return represents the minimum rate of return (profit) an investment must have for investors to accept as payment for the risk associated with the investment.  Required return is the expected profit generated over a given period of time using cash flow assumptions (Wilkinson, 2013).  The initial investment or price reflects the probability that the forecasted cash flows will be achieved.  According to Faloppa (2015), cash flow assumptions done properly and recognized by investors as achievable become a matter of probability of achieving them and to account for this probability investors apply discount rates.  When investors are looking at difference investment opportunities the required return becomes a critical part of their analysis.  By analyzing required returns, investors identify their expectations on repayment of their investment capital and the borrowers must agree to repay the investment over a set period of time and frequency.

There are three components of required return:  cost of equity, cost of debt, and cost of preferred stock.  

Cost of equity is the annual rate of return that an investor expects to earn when investing in shares of a company. Cost of equity (Re) is calculated as annual dividend per share divided by stocks current market value, and then adding the growth rate of the dividends (Financial Times, n.d.).

Cost of debt is the effective rate of interest that a company must pay on its debt.  The cost of debt is a calculation that takes into consideration the risk premium, risk-free rate, and taxes.  Cost of debt (Rd) is calculates as the risk-free rate plus the credit risk rate times 1 minus tax rate (Boundless.com, 2016).

Cost of preferred stock is the rate of return required by the shareholders of a company’s preferred stock.  Cost of preferred stock is calculated at annual dividend payment on preferred stock divided by the current market price of the stock (XplainD, 2015).

The weighted average cost of capital (WACC) is a calculation of the required returns on a project. WACC is the average of the minimum after-tax required rate of return a company must earn for all its security holders (both common and preferred stock holders and debt holders). WACC is a complicated. Calculating WACC requires determining the cost of each component of total capital (financing sources) and calculating the proportionate cost of each financing source, and then multiplying each of the component averages to arrive at a weighed average cost of capital (AccountingExplained, 2013).   WACC is calculated as the Market Value of Equity divided by Total Market Value of Financing (equity and debt) added to the Market Value of Debt divided by Total Market Value of Financing (equity and debt), then multiplied by Cost of Debt multiplied by the value of (1 – Corporate Tax Rate) (InvestingAnswers.com, 2016).