Weighted Average Cost of Capital - Research Paper Example

Table of Contents Table of Contents Research Question 2 Cost of Capital 2 Capital Components 3 Debt Financing 3 Common Stock 5 Preferred Stock 5 Optimal Debt-Equity level 6 Advantages and disadvantage 6 Conclusion 7 Research Question ‘Which sources of financing can a company employ and in what optimal debt-equity combination?’ Cost of Capital A pivotal decision for any financial manager is the cost of capital employed to finance assets. This is usually represented by a measure known as WACC (Weighted Average Cost of Capital). The understanding of Wacc for managers is very important, because it represents a major component in cost of doing business. Cost here doesn’t only refer to finance cost but in fact describes the return expected by the investors. A firm can employ various forms of capital for purpose of operations. These are called capital components. The three most frequently used capital components are debt, common stock and preferred stock. Each capital component has a capital cost, which is the rate of return demanded by the lender or investor. The average capital cost of all the capital components employed by a firm is called WACC. To further understand the dynamic of Wacc we must further understand the concept of required rate of return. Return of particular investments, is measured on two levels. An investor will first of all asses the size of return, for example 10% return is always better than an 8% return. The second measure is the timing of returns; this is because investors always prefer payments today rather than tomorrow. For this purpose present values of all returns are first calculated when analyzing attractiveness. Return that investors and lenders expect from each investment is different. For example a loan to Microsoft will have a lower expected return than a loan issued to a startup firm. This is because investors always prefer low risk. Risk is the threat that a firm will fail to fulfill future obligations. There are many different types of risk associated with a firm such as DRP (default risk premium), Liquidity premium and MRP (market risk premium). The lower is the risk associated with a particular investment consequently less will be the rate of return required by the investor. Capital Components As mentioned there are three main sources of financing that a firm can employ. They have their own benefits and limitations. Debt Financing Debt financing is the borrowing of money from individuals or financial institutions, under an agreement that the principal along with interest payments will be paid in the future. In case of debt financing, lenders have no ownership in the company and therefore do not share in the risk of doing business. This gives them first charge in case of liquidation. This means that lenders have the first right to a company’s assets if it goes bankrupt. Estimating the cost of capital for debt is a very complex process. This is because there is much difference in different types of debt instruments that a company can use. These include fixed rate debt, floating rate debt, straight debt, convertible debt etc. There are two main sources of debt that companies use to finance their operations. There are commercial paper and long term bank loans. Commercial papers are bonds issued by firms to raise capital. They issue paper to investors promising a fixed (or floating) payment each period along with the return of par value at maturity. The risk as mentioned is an integral part of return these investors will require. The return on a bond is usually called Yield or Yield to maturity. Each international firm is rated by agencies such as Standard and Poor and Moodys. This rating is a summary of the risk associated with a company. For example IBM is an AAA rated agency which shows a low risk that it will default on its payments. This risk associated with a company is incorporated in the price that its bonds will sell for in the market. For example if a company is facing financial problems or its products are losing demand, its rating will go down, this means according to the supply-demand phenomenon demand for its bonds will decrease. This decreased demand will drive the prices down. Lower prices as compared to the par value (which is usually 1000) will drive the yield to maturity up thus increasing the rate of return on the bond and compensating lenders for the extra risk they took by investing. Another important issue of debt financing is the tax benefit gained. This can be easily shown by the following equation. The debt of a firm pays a periodical interest payment. This interest payment unlike the return on equity ends up in income statement under the head of finance cost. The finance cost of debt is deducted from the earnings thus lower the total taxable income of the company therefore giving a tax benefit. Companies often use this technique to remain in lower tax brackets. Common Stock Each firm has two options in raising capital through common stock; it can either issue new common stock or retain its earnings. The issue of common stock for a public corporation is a complex process requiring approval from shareholders (usually in an annual general meeting AMG). This gives room for a company to distribute dividends among shareholders. Shareholders can however gain from their holding in two ways; either through capital gains or distribution of dividends by the firm. Capital gains can occur if a firm retains it’s earning. The retained earnings are however not free of cost. They have an opportunity cost for the shareholders. This opportunity cost is equivalent to the rate of return that investors could have earned by investing funds in an alternate mode of investment. Therefore a firm cannot retain its earning until its earning more than the required rate of investors. Therefore if a firm cannot earn more than what its stockholder require () than it must distribute its earning as dividends. Preferred Stock Companies are increasingly using preferred stock as means of financing, their volume is still however much lower than common stock and debt financing. This form of financing does not give a tax benefit like debt financing therefore when calculating () tax benefit is not incorporated into payments. Preferred stock as the name implies have a preference over ‘right of earnings’ of common shareholders. Their claim however is still inferior to lenders. Preferred stock unlike common stock are usually issued with a maturity date and fixed rate of return. Firms usually do not defer on their preferred dividend payments, because according to law it renders them incapable to distribute dividends to shareholders. Optimal Debt-Equity level Many investors believe that it doesn’t matter which capital component is employed as far as they give a good rate. This however is not true, as the cost of each depends on percentage in which it has been employed. Both debt and equity have their pros and cons. Advantages and disadvantage Debt financing always results in repayment of the principal amount whereas equity financing does not usually require the return of principal amount. Moreover interest payments on debt force a firm to make regular out flows of cash which can be a menace in recessions and force companies to take loans to make interest payments on their previous loans. Dividends however are not compulsory to be paid every period and companies can reduce outflows by not paying them. Raising debt usually requires firms to pledge collateral as a guarantee that it will make payments. This greatly limits the amount of loans that a company can take. In equity financing no collateral is needed because shareholders become owners of the company and share its risk. Payments of interest however do give the firm a tax benefit as compared to equity. Conclusion There is in fact no right recipe for debt and equity as we can determine from the arguments provided. Both types of financing have their pros and cons. For a long time it was a general perception that a 40-60 mix was the ideal solution. This however is not true as each situation is different. For example a firm which has most of their operations on cash can afford to make period interest payments as they are cash rich. Firms with long receivable cycles and high risk might have a lot of potential but would have high risk of doing business as well. This would mean that banks would want high rate of returns; therefore are not suitable. When talking about optimal mix we must also understand the constraints that a firm might face in procuring funds. Startup for example might not be able to attain funds through debt and therefore their only source of funds might be equity. The mix can be estimated once the business model and long term goals of organization are clear. Organizations that offer long term growth are perfect for equity financing; this is because they need to retain their immediate cash flows to use in expansion and growth. Firms with business models that do not require continuous capital expansion can spare their immediate cash for interest payments and should therefore rely more on debt financing. References Resnick, Bruce. International Financial Management. Singapore. McGraw-Hill, (2004) Madura, Jeff. International Financial Management. New York. (2007) Daves, Phillips and Brigham, Eugene. Intermediate Financial Management. McGraw-Hill, (2005) Debt financing,E-notes. Cited on (6-12-2999) (http://www.enotes.com/small-business-encyclopedia/debt-financing) Debt vs. Equity. Venture Capital Focus magazine. Cited on (6-12-2999) (http://www.dynamic-equity.com/vcmag03.htm) Read More