Key Learnings Article 5 The Financial Accounting Standards Board (FASB) undertook a project in order to gather information about

t FMA members opinion regarding disclosure of financial statements. This was done in response to the concerns about non-reporting of newly created financial instruments (interest rate swaps, options, forward interest rate contract etc) in financial statements. The FASB in the exposure draft had made tentative decisions concerning information about credit risk, future cash receipts and payments, interest rates, and market values. The exposure draft requires disclosures about all financial instruments, but does not affect recognition, measurement, or classification in the financial statements. The FMA members agreed with the following major exposure draft positions. Reasonably possible and probable credit risks for financial instruments should be disclosed for all companies. Group concentration of credit risk should be disclosed in all financial statements. Interest rates for financial instruments and information regarding items contracted to reprice or mature within one year should be disclosed. Market value for each class of financial asset and liability should be disclosed unless the entity is unable to determine or estimate that value. Information about future cash receipts and payments arising from financial instruments should be disclosed.
THE MARGINAL COST OF CAPITAL AND SHAREHOLDER RISK.

The weighted average cost of capital can be used for project evaluation when two conditions are fulfilled: The funds raised maintain the target capital structure of the firm The project has the same asset risk as that of the firms existing assets.

In the event that either of these conditions is not met, undertaking the project would alter the risk presented to the current shareholders and thus the project would have to earn a sufficient rate of return to compensate the existing shareholders at the new risk level. In order to calculate what this sufficient, or hurdle rate is, we use the Marginal Cost of Capital (MCC) methodology. The MCC calculation takes into account the total after tax cost of new debt capital, new preferred capital as well as the cost of equity before and after the project.

Here, k d is the marginal after-tax cost of new debt capital; D2 is the amount of new debt capital Kp is the marginal cost of new preferred stock, P2 is the amount of new preferred stock, k e1 and ke2 represent the cost of equity before and after the project E1 is the market value of equity before the project E2 is new common equity and NF is new funds raised to finance the project. The MCC is expressed in this way to illustrate the components which must be estimated by the firm. The costs of existing debt and preferred stock are not affected as they are fixed to the firm by contract. k d and Kp are determined and fixed by contract at the time of issue while D2, P2, and E2 are determined by the decision on how to fund the project, which is linked to the optimal capital structure decision. The MCC is appropriate for any capital structure chosen. If the asset beta or capital structure is not altered, the MCC is equal to the weighted average cost of capital as the risk to shareholders is not altered (ke1= ke2), but if either is changed then the risk to shareholders changes and the MCC formulation yields the required rate of return to compensate them for the change in risk.