Capital Structure and Cost on Capital - Essay Example

Capital structure and cost on capital TABLE OF CONTENTS Contents References 11 0 Capital structure The capital structure ofa firm is how the company finances its growth and overall operations by using various sources of funds. Debts to finance the activities come in the form of long-term future notes payable and bond issues. Equity to finance the activities is classified in the form of preferred stock. Ordinary shares and retained earnings. The capital structure will comprise of companys preferred and common equity, definite short-term and long-term debt. Working capital is also considered to form the capital structure (Bierman, 2003). The capital structure is analyzed using a companys proportion of long-term and short-term debts. The capital structure of a company will give a companys debt-to-equity ratio. The ratio gives the insights of how the company levels of risk are. A company that is more profoundly financed by debts has greater risks because the company is comparatively highly levered. When taking debts companies should be cautious to make sure that their financial management is sound (Bierman, 2003). The capital structure of a corporation is the backbone of the operations of a particular company. Competent staffs need to be hired to ensure that viable financial decisions are made at all times. Companies should make substantial equity investments to sustain its financial operations at all times. Capital structure is mostly divided into equity capital and debt capital (Bierman, 2003). 1.1 Equity Capital Equity capital refers to the money that is owned by the shareholders. Equity capital will comprise of contributed capital that is the money invested by the shareholders in exchange for stock of shares ownership. Shareholders will put this cash in a particular company to get a stake and be earning dividends at certain future dates. Equity capital also comprises of retained earnings that is made up of profits that was realized in the past years and have been kept by the firm to strengthen the fund growth or balance sheet, expand the business or use for acquisitions. Most people believe that equity capital is the most expensive type of financing a company because it depends whole on the returns that a company must make to attract investors. Investors will always invest their wealth with the companies that thrive well in the industry. A company that doesnt perform well in the market is not able to finance its operations from the equity capital (Bierman, 2003). 1.2 Debt Capital The debt capital of a company refers to borrowed money that is at work in the business operations. The most preferred debt capital is the long-term bonds because it gives a company time to pay up the principle and interest over an extended time. Other example of debt capital is the short-term commercial paper that is utilized by big companies such as General Electric and Wal-Mart.the companies 24 hours loan from the capital markets to finance their capital requirements like utility bills and payroll. The capital structure-debt capital financing will depend on the health ad capability of a companys balance sheet. Companies are advised to take finance structuring depending on the size of their balance sheet (Bierman, 2003). 2.0 Cost of Capital The cost of capital of a company is defined as the weighted average, cost after tax of a companys long-term debt, stockholders equity, and preferred stock that is associated with the common stock. The cost of capital of a company is given as a percentage. The cost of capital percentage is used to compute the net present value (NPV) of a companys cash flow in a planned investment. The cost of capital is taken as the least after tax in-house rate of return to be realized on new investments. For a corporation that is profitable, the costs of bonds and other long-term debts are the least expensive workings of the cost of capital. When a company gets capital from its owners and lenders, both investors will require having returns of their investments after a particular period. Lenders expect to be interest on their on their money borrowed and also the owners will expect to get returns as well. The returns given to the two or more financiers of a corporation gives the cost of capital of that particular company. Common stocks cost (retained earnings and paid-in capital) are measured to be the most expensive part of the cost of capital resulting from the risks that are involved (Pratt, 2008). Financial analysts will the costs of capital percentages to compute net present values that are essential in determining the levels of investment. The net present value figures will determine whether to commence an individual investment or not. Its an important tool for financial investment decision-making. A predictable and stable company will have a small cost of capital while a company that is risky will have unpredictable cash flows that are associated with increased costs of capital. In other words, a riskier firms potential cash flows are worth less in the current value terms; giving a reason shares of a stable company frequently look much expensive on the surface level (Pratt, 2008). The rates used to discount cash flows of a company if the company uses the ‘cash flow to the firms methods is the Weighted average cost of capital(WACC) of a company. A firms WACC accounts for both the cost of debt and cost of equity, weighted according to the scope of debt and equity in the firms capital structure (Pratt, 2008). 3.0 Risk and Return Returns are losses or gains from an investment after a particular period, and its usually quoted as a percentage. A number of factors will determine the amounts of returns that investors will get from the capital markets. For example risks and taxes (Blessing, 2011). 3.1 Risk The risk is the possibility that an investments real return will be different than what is expected. The outcomes can be lower or higher than expected. Risks suggest that investors have the possibility of losing some or even all of the amounts that were initially invested. Small margins of uncertainty (low risk) are linked with low possible returns. High margins of uncertainty (high risk) are connected with high potential returns. The concept of high risk, high yield is evident in investment analysis (Blessing, 2011). The tradeoff between return and risk is the balance between the wish for the lowest probable risk and the highest potential return. Many financial investors will wish to invest in the areas where there is less risk but expected to get the highest rates of return (Blessing, 2011). Investment risks are comprised of systematic and unsystematic types of risks. 3.1.1 Systematic Risk The systematic risks are also known as the un-diversifiable or markets risks. In systematic risk, there is uncertainty in the entire market. The risks are also referred to as volatility that is the daily changes in the price of the stocks. Volatility measures the riskiness of the investment in various portfolios made in stocks. Because market fluctuations are the reason investors make money from shares, volatility is crucial for returns and the more uneven the investments, the more the chances of the market experiencing dramatic variation in either direction. Systematic risks will emanate from wars, recession, and interest rates because they affect the whole markets, and the risks cannot be mitigated through diversification. The routine types or risks can only be avoided by hedging only (Blessing, 2011). 3.1.2 Unsystematic Risk Unsystematic risk is also known as diversifiable, residual or specific risk. The types of uncertainties will happen in industries or companies that investors put their money; however the risks can be reduced through diversification. For example, certain news affecting a company making the share price to fluctuate can be regarded as unsystematic risks. Unsystematic risks are not long term. The risks do not stay for long to affect the changes in the share prices, for example, an unplanned strike by company employees (Blessing, 2011). (Blessing, 2011). 4.0 NPV and Investment Criteria Net Present Value is the variation between present values of the cash outflows and the present value of the cash inflows. Financial analysts will always give reasons to the directors on why they think one investment criteria is viable than another one. They should convince the directors and shareholders why they their company should use method x instead of process y in forecasting the cash flows and the returns on investment. Some companies observe the book returns on the project t hand. In this case firms will decide which cash expenses are capital expenditure and go for the efficient rates to depreciate the costs. The company then computes the ratios of book returns of a particular investment. Few companies will nowadays observe the book rate of returns determine investment decisions. The shareholders are the only one that will keep the books rate of returns makes investment decisions (Fraser, 2004). There are companies that use the payback method in order to make sound investment decisions. These companies will only make investments in projects that recover the initial investment made after a particular period. The payment method of investment decision-making is an ad hoc rule. The method ignores the cash flows timing that are in line with the payback period. The method wholly ignores the consequent cash flows. The method does not take into account the opportunity cost of capital. The method only concentrates on the return of the initial capital investment that was made for a particular project. The financial analysts will only advice on the projects that they are 100% sure that the initial investments of the projects will be recovered after a particular period (Fraser, 2004). The IRR(internal rate of return) is another criterion that are used to make investments decisions.IRR is the rate of discount that will result in a project to have a zero NPV.The internal rate of return is extensively used in finance. The IRR rule says that a company should accept any investment decision or plan that gives an internal rate of return that surpasses the opportunity cost of capital. The IRR suggests that if an investment provides positive then negative cash flows, then the NPV can improve as the discount rate goes high. Such types of projects should be accepted if their internal rates of return are less than the opportunity cost of capital. With several rates of return; if the change are many in the indication of the cash flows, then the investment project can have many IRRs or even no internal rates of return at all. For mutually exclusive investment projects; the internal rate of return rule not gives the correct ranking of the mutually exclusive projects that are different in economic life or at the level of the required project investment. When using internal rates of return to rank mutually exclusive investments, a financial analyst must study the internal rate of return on every incremental investment. The costs of capital for cash flows that near are different from the costs of capital of the far cash flows. The internal rates of return require comparison of the opportunity cost of the project capital with the projects internal rates of return. In some cases, there is different opportunity costs of capital of one-year cash flows and that of two to three years cashflows.In such cases that are no criteria for carrying out an evaluation on the IRR of an investment project (Fraser, 2004). In the development of the Net Present Value Rule, assumptions are made that companies can maximize stakeholders wealth by accommodating all investment projects that are worth more than they costs. However with the limited capital it may be difficult to undertake all the investment projects that have positive Net Present Values. If the investment capital is only enough for one period, the company should follow one method; determine the profitability index for each project that gives the investments NPV per dollar of project investment. Then the projects with the biggest profitability indexes are picked up until the capital is over. Unfortunately, the method fails if the capital; s rationed in more than a single project or when there is the presence of other constraints on the project choice. Linear programming gives the solution. Hard capital rationing indicates market imperfections that give a barrier between the capital markets and the firms. If the barrier shows that a companys shareholders have no free access to an excellent capital market, then the foundations of the Net Present Value fails (Fraser, 2004). References Bierman, H. (2003). The capital structure decision. Boston: Kluwer Academic. Blessing, S. (2011). Alternative alternatives: Risk returns and investment strategy. Chichester: Wiley. Fraser, W. (2004). Cash-flow appraisal for property investment. Basingstoke: Palgrave Macmillan. Pratt, S., & Grabowski, R. (2008). Cost of capital applications and examples (3rd ed.). Hoboken, N.J.: John Wiley & Sons. Read More