Cost of Capital
To date, we have focused on debt (liabilities) and equity. Define the following specific forms of
debt and equity and why a firm may use these types of financing.
1. Commercial paper; 2. Convertible bond; 3. Preferred stock; and 4. Common stock.
Cost of Capital: Downgrade Mania/There goes the Cheap Money
1. Why might a company’s cost of debt be increased?
2. How is cost of capital stated-- as a percentage or dollar amount?
3. How might a company’s decisions (e.g., capital budgeting, financing) change from an
improvement in its debt rating?
4. What should the funds from commercial paper be used for?
5. Are commercial paper buyers (money market funds) traditionally conservative or
aggressive investors?
6. What is the advantage of issuing commercial paper over long term debt? How did Kmart
get in trouble issuing commercial paper over long term debt? Why might a chief
financial officer convert cheaper short term debt (e.g., commercial paper) for more
expensive long term debt?
7. How might a financial manager use the yield curve to help him/her determine what
financing alternatives to use?
8. Bonds and commercial paper are financing sources not available to the small business.
What is the advantage of a small business owner having a general understanding of bonds
and the commercial paper market?
9. If you are a small business, the commercial paper market is not available to you. What
type of financing is similar to commercial paper for the small business?
10. How might you determine the cost of debt for a publicly traded company?
11. How does a small business owner determine the company’s cost of debt?
12. What does “prime + 1” mean?
13. What is a line of credit? What is more likely to be a variable rate loan, a line of credit or
a long term loan?
14. Why do banks oftentimes require a company to “clean-up” its line of credit for 30 days
per year?
15. Is the after-tax cost of debt equal to the before tax cost of debt? Explain.
16. How do you determine the cost of equity for a publicly traded company?
17. How do you determine the cost of equity for a small business?
18. If a company obtained funding from a venture capitalist, would you expect the cost of
capital to be higher compared to traditional funding through the stock market?
19. If the interest on debt is tax deductible and dividend payments are not tax deductible,
does the tax difference favor debt or equity financing? Explain.
20. Is the weighted average cost of capital the same as cost of capital?
21. What is collateral? Does collateral increase or decrease the cost of debt?
22. What factors determine a company’s cost of capital?