explain-this-concept-the-the-cost-of-capital-depends-primarily-on-the-use-of-funds-not-the-source

 

Finance for Managers

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1. Explain this concept the: “The cost of capital depends primarily on the use of funds, not the source.”

Cost of capital depends on risks; it has two modes of financing which might be through the cost of equity or the cost of debt. Cost of equity is financed through equity whereas the cost of debt is solely obtained from debts and loans acquired by the company. Most companies use both debt and equity to finance their companies, and by this, the overall cost of capital is obtained by calculating the average of the applied capital sources (Adrian, 2015). A company must give returns to the cost of capital before it can start generating profit, capital budgeting helps to predict if the project is viable and can be carried out.

Cost of equity is not specified because the rate of return to the equity investors varies time after time depending on the profit generated. Unlike the cost of equity, the cost of debt can be easily obtained by either indirect or direct methods this is simply because the cost of debt is the interest rate required by the lending firm that the company must pay on new borrowing. Interest rates can also be obtained from financial markets (Patterson, 2013).

Optimal financing for a company is obtained by mixing the various funding sources depending on the cost of capital required. Most companies strive to obtain the optimal financing for their project to run smoothly without any delays. It has been proved that debt financing is more advantageous than equity financing this is because debt financing is more tax efficient, unlike equity financing which is less tax efficient. Debt is more tax efficient because they are deducted from taxation (Pratt, 2014). Too much tax can, however, be dangerous because it results to high leverage which in return results to higher interest rates which affect the overall performance of the company and can scare away equity investors (Patterson, 2013).

The investment decisions are separate from financial decisions a company makes. The Capital structure is the mixture of various sources of obtaining capital which include debt and equity which is referred to as a managerial variable. Taking the company’s financial policy as clearly stated we now assume that there is a fixed debt-equity ratio that is maintained at a given constant (Pratt, 2014). This ration indicates the optimal capital structure.

If the Company uses both equity and debt capital the overall cost of capital will be referred to as a mixture. The returns obtained from this firm will be used to compensate the equity investors and the creditors. Every firm’s cost of capital should indicate the cost of debt and the cost of equity capital, hence by this we can deduce that the cost of capital depends primarily on the use of funds such as debt and equity funding, not the source the funding is obtained from (Patterson, 2013).

2. WACC and taxes: Why do we use an after-tax figure for the cost of debt but not for the cost of equity? Explain you findings.

WACC (Weighted Average Cost of Capital) is the calculation of the firm’s capital cost in which each category of capital is proportionally weighed. Weighing in this context means comparing them to the amount of finance invested. After tax is the amount remaining after tax deductions. We use the after-tax figure for debts because the interest is tax deductible. Interest paid is an expense that should be taken into consideration because it is taxable. Interest depends on the amount of profits produced. Interest is the money you are to pay but since it is taxable calculations involving it should be reduced by the amount of taxes to be paid.

The formula x (1-t) is used

Where x is the interest

t is the tax rate

In situations where the amount in question is a bank loan, the tax rate is replaced by the Weighted Average Cost of Capital. The cost of capital on the other side is pre-determined, making the value relatively fixed since it is not dependent on the interest to be paid. The amount to be paid is usually stated and the expected income depending on the duration and the amount. Also explained by the line equity has no definite price the company must pay. It, however, has a cost of value. Shareholders usually expect a given return on their investments in the company.  The equity holders required the rate of return is a value from the companies’ point of view. It the company fails to raise the given amount shareholders to sell off their shares which affects the company’s value since the share price is reduced.  The pretax (amount before tax deductions) and after tax of the cost of equity are the same therefore we do not use the after tax. This is because the amount payable is definite.

3. Write two paragraphs on the answer to this question: Why is the use of debt financing referred to as using financial “leverage”?

To leverage means to use borrowed money with expectations of making profits greater than the interests. The use of debt financing is also referred to financial leverage because it lengthens the effect of the gains and losses.  It usually increases the company’s chances of bankruptcy as well as returns. Leverage usually returns on equity. This can be justified by the fact that if debt financing is used instead of equity financing, then the owners’ equity is not diluted by using more shares of stock.

Financial leverage in most cases positively impacts company’s values in most Americans firms (Obradovich &Gill, 2013). The finance provider would come up with a limit that the finances are likely to be exposed too for instances taxes and interest rates. It also specifies the types of assets it can permit and which can are taken as collateral. The business firms use the asset in their daily production bringing the aspect of gain and paying the debt at the stipulated times.

4. What is the impact of a stock repurchase on a company’s debt ratio? Does this suggest another use for excess cash and if so, express your solution?

Stock repurchase involves the action of a given company that has been publicly traded buying its shares from the market. The share repurchase assists in providing an opportunity to the shareholders to return their cash. This repurchase of the shares may help in restructuring the capital structure of the company with minimal debt load (Akyol, Kim & Shekhar, 2014). It can also give stockholders value without changing the dividend policy as the taxable gains on capital are lower than those on dividends.

The debt ratio focuses on the company’s use of leverage in its percentage form. In this case, repurchasing of shares has an equal effect on the income statement of the company. The repurchase engages in the reduction of the outstanding shares, and as a result, it also affects other financial statements of the company. The amount spent in the buyback will have a similar reduction in the company’s cash holding that will have an equal effect on the total asset base when assessing the balance sheet. This aspect will have a simultaneous reduction in the equity and liability of the shareholder with the same value (Bradley, Pantzalis & Yuan, 2016). The changes in financial ability due to the repurchase of the stock leads to a reduction in debt ratio of the company.

A stock repurchase has been associated with increasing the price of the stock and hence increasing the amount of cash used. Repurchase of the stock rises the ownership percentage held by the shareholders as there is reduced the number of shares available in the market. As a result, the company concentrates on the value of the investor by spreading same market cap on few shares increasing the returns (Bradley et al. 2016). It thus artificially boosts the earnings giving the stock a better push in the market. This action in return causes short-term inflation that increases the amount of cash spent in the repurchase of stock.

5. In calculating flotation costs, the ZZZ Company needs to raise $80 million to finance its expansion into new markets. The company will sell new shares of equity via a general cash offering to raise the needed funds. If the offer price is $45 per share and the company’s underwriters charge an 8% spread, how many shares need to be sold?

To calculate the shares needed to be sold we first take the amount the company needs to raise to finance its expansion and then add it to the percentage charge for issuing the shares. The charge for issuing the shares is obtained by multiplying 8% spread to the total money to be raised for expansion of the company.

$80 million + 8 %*( 80,000,000) = $80,000,000 + $6,400,000

=$86,400,000

We then divide the total shared per unit offer price to get the amount of shares to be sold in total which is calculated as:

86,400,000 / $45 = 1,920,000 shares

By this, we can deduce that the company needs to sell a total of 1,920,000 shares

References

Obradovich, J., & Gill, A. (2013). The impact of corporate governance and financial leverage on the value of American firms.

Shannon P. Pratt (2014). Cost of Capital: Applications and Examples. Wiley Publishers.

Adrian T., E Friedman & T Muir (2015). The Cost of Capital of the Financial Sector. Federal Reserve Bank of New York Staff Report.

Cleveland S. Patterson (2013). The Cost of Capital: Theory and Estimation. Greenwood Publishing Group

Fernandes, Nuno. (2014). Finance for Executives: A Practical Guide for Managers. McGraw Hill

Bradley, D., Pantzalis, C., & Yuan, X. (2016). Journal of Financial Economics, 119(1), 186-209.

 

 

 

 

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