Weighted Average Cost of Capital

Running Head: Exchange Rate Risk and Capitalization

Weighted Average Cost of Capital Phase 2 Individual Project Jeremiah Stockwell Professor Crystal Gifford FIN356-1103A-01: International Finance July, 2011

Weighted Average Cost of Capital

In order to save money and make the best of what money a company may hold companies will research and seek out the lowest average rate of financing costs in order to capitalize the business. There are several ways of doing so. Some ways are preferred stock equity, common stock equity, and bond debt. As with any endeavor such as this there are risks. The biggest risks to preferred stock equity, common stock equity, and bond debt are default risk, inflation, interest rate risk, and stock and market volatility. To understand how each risk affects each of the sources of finance each one must be understood first. A common stock is a particular form of equity ownership in an organization the reason it is referred to as common is to differentiate it from that of a preferred stock holding. Common stock equity is designed to raise funds for investment for an organization. When an organization initially releases a common stock it is released as an initial public offering or an IPO. In theory, a preferred stock is an advanced form of equity ownership when compared to that of a common stock. The terms of a preferred stock can be sorted out with an organization, thusly the nomenclature of preferred. Additionally, preferred stocks may have precedence over common stock in dividends and in asset liquidation proceedings. Common stocks generally perform better than preferred stocks in the long run and also come with corporate voting rights whereas preferred stocks do not (Fitzsimmons, 2011). A debt investment is when an investor will loan money to an organization or even a government with the purpose to use the funds for a specified period of time at an agreed upon fixed interest rate. Bonds are used by governments, organizations, and municipalities to float the bill for a variety of activities such as projects, but probably the best known bond was the US war bonds during World War II. A Bond is simply an IOU. The investor will agree to loan a set amount of money to an entity (organization or government) and in exchange they are to be

Weighted Average Cost of Capital

refunded the investment plus an agreed upon interest rate (Kennon, n.d.). If an organization or government has an enlarged bond debt they would be considered a high risk investment. Associated with bonds and bond debt, default risk is the possibility that the entity issuing the bond may default on the loan which would lead to the inability to repay those investors who bought those specific bonds (Investorwords.com, 2011). Another major contributing factor in every corner of an entity, be it an organization or an entire country, is inflation. Inflation is an increase in prices or a fall in the value of money. Inflation can be attributed to many factors, one factor can be caused by a country that has printed too much money or experienced financial disaster such as the earthquake and the ensuing effects to Japan and the organizations that are located in the effected areas. When situations such as happen it can cause its currency to plunge. Other causes of inflation can be higher costs in transportation such as gas, when this occurs it makes the shipment of goods to stores more expensive and in turn that cost is handed down to the consumers of those goods. This makes it much harder for consumers to afford even the simplest items such as toothpaste, toilet paper, clothing, vehicles, and food to name just a few. This is the beginning of a vicious cycle in which when this happens the consumer must then ask its employer for a pay raise in order to afford the cost of living, when that happens a pay is increased the cost of the employers goods are then raised to offset the raise in wages (Kennon, n.d.). Uncertain futures add to interest rate risk in which the earnings or market value of an entities interest rate. Interest rate risk can be confusing due to the fact that there are basically two drastically different ways of perceiving interest rates and the risk that is associated. The two points of view are the book value viewpoint were its effect on an organizations accounting earnings and the market value perspective were the point of view is that its the risk in terms of

Weighted Average Cost of Capital

its effect on the market value. Interest rate risks can be categorized in different ways, and there is usually some overlap between categories (Holton, 2005). Stock market volatility is a measure of how far and fast an organizations stock price moves. With every penny stock broker working out of their home office and companies such as e*trade, Scott Trade, and many more individuals are keeping a closer eye on what stocks their money is in. Over the years several indicators have been developed to help keep an eye on the volatility of any stock, such as the S&P 500 Volatility Index (VIX) and the Nasdaq Volatility Index (VXN). Stock market volatility is significant and understanding it is imperative to any entity that has an interest in an organizations stock. Some short-term traders prefer to trade volatile stocks because they can make an impressive profit quickly, while conservative longerterm investors usually like to stay away from volatile securities (Demand Media, Inc., 2011). Obviously, default risk, inflation, interest rate risk, and stock and market volatility of an organization will affect how an organizations stocks will perform be it common or preferred and the bond debt that they may hold and their ability to pay back their investors by the bonds maturity date. Business in this sense is even more sensitive then normal and the bottom line is that anyone of these risks will affect an organizations weighted average cost of capital.

Weighted Average Cost of Capital

References Demand Media, Inc. (2011). What is stock market volatility? Retrieved from http://www.ehow.com/facts_5024423_stock-market-volatility.html#ixzz1SVr1PTVH Fitzsimmons, C. (2011). What is the definition of common stock equity? Retrieved from http://www.ehow.com/about_5554416_definition-common-stockequity.html#ixzz1SVZx5xLF Holton, G. (2005). Interest rate risk. Retrieved from http://www.riskglossary.com/link/interest_rate_risk.htm Investorwords.com. (2011). What is default risk? Retrieved from http://www.investorwords.com/1351/default_risk.html Kennon, J. (n.d.). What is a bond? Retrieved from http://beginnersinvest.about.com/cs/bondbasics/f/whatisabond.htm Kennon, J. (n.d.). What is inflation? Retrieved from http://beginnersinvest.about.com/od/inflationrate/a/inflation.htm