W5-A3: Final Project

Final Project

Managers of any firm try to reach the optical capital structure. Capital structure consists of a mix of equity, debt, and common stock. “The optimal capital structure of a firm can be determined from its capital structure, which maximizes the firm’s stock price or minimizes its WACC” (My E-Class Online, 2014).

We will assume that MNQ Company's book value capital structure weights equal its market value capital structure weights. The MNQ Company's pre-tax cost of debt is 7 percent. I have calculated MNQ’s cost of capital as;

Risk-Free Rate of Return 5.0%

Market Risk Premium 6.0%

MNQ Company's common stock 0.85

Cost of Equity

Cost of equity is defined as the rate of return required by the company. This is the compensation that is demanded by the company in return to bearing the risk of ownership and owning the asset. For calculating the cost of equity, the book values of common stock, retained earnings and capital surplus are taken all together.

Capital Asset Pricing Model

According to Ross, Westerfield, & Jaffe 2013, “While academics have long argued for the use of the CAPM in capital budgeting, how prevalent is this approach in practice? One study finds that almost three-fourths of U.S. companies use the CAPM in capital budgeting, indicating that industry has largely adopted the approach of this, and many other textbooks. This fraction is likely to increase, since so many of the undergraduates and MBAs who were taught the CAPM in school are now reaching positions of power in corporations” (P. 402, Para. 2).

According to the CAPM (Capital Asset Pricing model), Cost of equity is calculated by adding Risk Free Rate and the value obtained after multiplying beta and the market risk premium. Market Risk Premium is derived by subtracting risk free rate of return from the expected market rate of return. The following formula is used to calculate Cost of Equity.

Cost of Equity = Risk Free Rate + Beta * Market Risk Premium

Cost of Equity...