Principles of Finance

¶ … capital is defined as the "return expected by those who provide capital for the business" (Gallo 2025). Both managers and investors may calculate the cost of capital, investors to determine whether the company is a worthwhile risk and managers to determine if particular ventures are worth the risk in relation to the return (Gallo 2015). In 2009, ExxonMobil (XOM) acquired XTO Energy for $41 billion. The acquisition provided ExxonMobil an opportunity to engage in the development of shale and unconventional natural gas resources within the continental United States.

This acquisition added to ExxonMobil's existing upstream (exploration and development) activities. In addition to this business segment, ExxonMobil was also engaged in chemicals and downstream operations related to the refining of crude oil into a variety of consumer and industrial products.

How do you think the company should approach the determination of its cost of capital for making new capital investment decisions? "The process of making a capital investment decision involves these steps: identification of a project; definition of a project and screening; analysing and accepting; implementation; monitoring;" and "post audit" ("Capital investment," 2015). Exxon Mobile must calculate the possible costs associated with upstream activities and long-term payoffs vs. The short-term profits and lower levels of risk by focusing on downstream activities.

In this instance, upstream activities seem more risky but have a higher potential payoff. 9-3. Why do firms calculate their weighted average cost of capital? The "weights" placed on the average reflect the different types of financing available to the company ("WACC," 2015). Whether bonds or stocks are sold or other forms of financing like loans and angel investors are used will affect the level of risk of the investment. 9-4.

In computing the cost of capital, which sources of capital should be considered? Sources include debt capital, equity capital, and the capital structure of the firm "Online tutorial 8," 2001). 9-5. How does a firm's tax rate affect its cost of capital? What is the effect of the flotation costs associated with a new security issue on a firm's weighted average cost of capital? "Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt decreases, decreasing the cost of capital" ("Factors," 2015).

However, flotation costs can increase costs, as when a firm sells securities initially there are inevitable bureaucratic costs to the transaction. 9-6. a.) Distinguish between internal common equity and new common stock. Internal common equity has existed since the business has been in existence, i.e. money it has saved 'for a rainy day.' In contrast, new common stock is issued after the business has been existence to raise revenue ("What is retained earnings," 2015).

b.) Why is there a cost associated with internal common equity? Internal or retained equity has an opportunity cost of the money the firm could be spending on different investments and pursuits or what it could be using to generate more capital ("What is retained earnings," 2015). c.) Describe two approaches that could be used in computing the cost of common equity. "Common equity is equal to value of common stock+ surplus.