2. What are the concept underpinnings of the cost of capital (i.e.

the importance of
estimating a firms cost of capital)?

The cost of capital of a company is denoted by the markets required rate of return on
capital invested in that business. It is equivalent to the rate of return on an investment or project
with similar risk. The cost of capital of a business represents the markets required rate of return
on capital invested in that company. It is equivalent to the rate of return on a project or
investment with similar risk. A companys cost of capital is the rate of return the company would
earn if it invested its capital in a company of equivalent risk. View from a corporate project, cost
of capital is equals to the rate of return on an investment or project of similar risk. This is
because, the project cost of capital is the required rate of return, or hurdle rate that bring in the
company must achieve minimum rate of return in order to be profitable or to generate value for
the project. The expected returns of the project or investment must greater than the project cost
of capital for the project to be considering a worthwhile in investment opportunity.

The basic concept of cost of capital is referring to cost of company fund which bring in
cost of debt and cost of equity to financing a business. By using companys capital structure, cost
of debt refers to the companys costs of raising funds through debt financing while cost of equity
refers to the companys costs of raising funds through offerings equity. Royal Mails business
should estimate their firms cost of capital because of following reasons:

i. Making the investment decision

The main reason to compute cost of capital is to evaluate a project. The investment
decision here is achieve by comparing the actual rate return of project and cost of capital
of the firms. As had been stated, if actual return is higher than cost of capital, it were
considered creating value for investor since the expected return is exceed what investor
could generate on their own with similar investment risk. Therefore, cost of capital
provides a rational mechanism for making the optimum investment decision.
 ii. Designing capital structure

Capital structure is a combination of debt and equity. In order to achieve optimal capital
structure, company should minimize the cost of capital and maximize the value of the
firm. Theatrically, the most common way that financial analyst used to measure capital
structure is by using debt-to-equity ratio. Some analysts compare it with other companies
that in same industry. From this point, analysts can select a few of the best-performing or
high-growth companies in the industry for comparison. The assumption holds but is less
significant. Besides, analysts also can use this thinking way like a bank where they utilize
other debt ratio to put the company into a credit profile by seeing their bond rating. The
default spread attached to the bond rating can then be used for the spread above the risk-
free rate of an AAA-rated company.

4. Estimate the WACC of the comparable firms. Are the estimates of the WACC for
Comparable firms helpful to Hillary Hunt?

Regarding exhibit 6, the Weighted Average Cost capital (WACC) comparable firms that Kyle
brooks assumed for National Grid, Seven Trent, Tesco, United Utilities and Vodafone are
3.853%. 3.136 %, 5.475%, 5.281% and 5.660% respectively. This WACC estimation for
comparable firms is helpful to Hillary Hunt when valuing and selecting investments. In
discounted cash flow analysis, for instance, WACC is used as the discount rate applied to
future cash flows for deriving a business's net present value. WACC can be used as a hurdle
rate against which to assess ROIC performance. It also plays a key role in economic value
added (EVA) calculations. Moreover, investors use WACC as a tool to decide whether to
invest. The WACC represents the minimum rate of return at which a company produces
value for its investor has a WACC of 3.828 %. However, it also has limitation in certain
point where the cost of equity is not consistent values Instead of is not take into consideration
the floatation cost of raising the marginal capital for new projects. Another problem with
WACC is that is based on an impractical assumption of sum capital mix which is very
difficult to maintain.