CALMU Debt and Cost of Equity Managerial Finance Discussion
Order ID 53563633773 Type Essay Writer Level Masters Style APA Sources/References 4 Perfect Number of Pages to Order 5-10 Pages Description/Paper Instructions
CALMU Debt and Cost of Equity Managerial Finance Discussion
TOPIC:
Do you think increasing proportion of debt in capital structure is going to increase cost of equity? Is it going to increase cost of debt? explain.
PROFESSOR’S GUIDANCE FOR THIS WEEK’S LE:
Many factor influence cost of capital of a company, how much it costs to borrow or issue shares. The question we pick here is whether the cost of debt and cost of equity are impacted by the amount of debt a company has.
response to:
by Jana Kmetova
Capital structure is the amount of debt/equity employed by a company to fund its operations, capital expenditures (money that company invests in maintaining and fixing its buildings, factories, properties, equipment, and technology), acquisitions, and finance its assets. This structure is usually expressed as a debt to ratio or debt to capital ratio. Most of the time company has to find a balance between debt and equity in the case of new investment. This is called the best optimal structure. The theoretical aspect it is defined as a portion of debt and equity that results in the lowest average cost of capital of the company (CFI, 2021). Riggins (2019) claims that all accountants should be looking to take actions and organize funding methods with the intention of minimizing their company’s Weighted Average Cost of Capital (WACC) – because any increase in WACC will later indicate a decrease in company value and at the same time will raise the risk for investors.
Cost of equity is the amount of return a company needs to provide on its shares through dividends and appreciation. In other words, it is a measurement of the company’s risk since the investors will demand a higher payoff from the shares from a company that is in higher risk in return, exposing the investor to higher risk. Furthermore, increasing the company’s debt increases its risk, leading to raising the company’s cost of equity (Slovin, n/a). The company increases its funds by debt because it is cheaper than increasing equity (the interest fees are deductible from the taxable income/dividend are not). Also, debt can be refinanced if rates move lower and eventually are repaid; once distributed, shares represent the lasting obligation of dividends and a dilution of company control. On the other hand, Riggins (2019) states that equity is a better way to fund a company’s operations. However, the expectation and the pressure on the investors and are higher.
response two:
by Hanan IrsheidDo you think increasing the proportion of debt in capital structure will increase the cost of equity? Is it going to increase the cost of debt? Explain.
Capital structure refers to the amount of debt and or equity that a company uses to fund operations and finance assets. And, the debt-to-equity or debt-to-capital ratio is a common way to characterize a company’s capital structure.
Debt and equity capital are used to fund operations, capital expenditures, acquisitions, and other investments in a corporation. When deciding whether to finance operations with debt or equity, companies must weigh the pros and cons, and management must strike a balance between the two to arrive at the best capital structure.
Optimal capital structure:
The proportion of debt and equity that results in the lowest weighted average cost of capital (WACC) for a company is sometimes referred to as its optimal capital structure. This technical definition isn’t always followed, and companies often have their own strategic or philosophical ideas on the ideal structure.
A company might issue more debt or equity to optimize its structure. As a kind of recapitalization, the newly obtained capital might be utilized to invest in new assets or to repurchase debt/equity that is currently outstanding.
Capital costs
The weighted average cost of capital (WACC) is a weighted average of the cost of stock and debt for a company (WACC). And, we can use the following formula to calculate it:
WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))
Where:
E = market value of the company’s equity (market cap)
D = market value of the company’s debt
V = total value of capital (equity plus debt)
E/V = percentage of capital that is equity
D/V = percentage of capital that is debt
Re = cost of equity (required rate of return)
Rd = cost of debt (yield to maturity on existing debt)
T = tax rate (CFI, 2015)
Debt versus equity:
Although the cost of debt is cheaper than the cost of equity, debt is riskier. The following are the reasons for this:
1- The lender receives a guaranteed rate of interest and capital payback.
2- Interest on debt is a tax-deductible expense, lowering a company’s tax obligation, whereas dividends are paid after taxes from profit.
Debt is riskier for a firm since it increases the financial risk it faces. Any inability to pay interest or repay the principal amount may result in the company’s collapse.
Leverage in Finance:
Financial Leverage, also known as Capital Gearing, is the percentage of debt in a company’s total capital. When a company’s total debt grows, the cost of financing decreases since debt is a less expensive source of capital.
When the proportion of debt in total capital is high, the company is said to be highly levered; when the balance of debt in total capital is low, the company is said to be low levered (toppr, 2018).
References:
CFI. (2015). Capital Structure – What is Capital Structure & Why Does it Matter? Corporate Finance Institute. https://corporatefinanceinstitute.com/resources/kn…
toppr. (2018, July 2). Toppr-guides. Toppr-Guides. https://www.toppr.com/guides/business-studies/fina…
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