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MGM625-0903A-01 Applied Finance for Decision-Making - Phase 3 Discussion Board 2 - Essay Example

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Discuss the trade-offs between incremental IPO proceeds and debt financing. How would the companys balance sheet be impacted by debt financing rather than using cash? How…
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MGM625-0903A-01 Applied Finance for Decision-Making - Phase 3 Discussion Board 2
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Applied Finance for Decision Making Discuss with the head of strategic planning how using more debt can impact a firm’s capital structure. Discuss the trade-offs between incremental IPO proceeds and debt financing. How would the companys balance sheet be impacted by debt financing rather than using cash? How would the company’s return on equity be impacted by utilizing more debt?
The concept of weighted average cost of capital is very beneficial especially in terms of the development of the ideal capital structure. The weighted average cost of capital deals with the cost and the amount of debt and the equity of the company that is used to fund the operations. It has been noted that in most cases the debt carries costs which are much lower (Morgan, Redman Smith and Cooper, 2001). The main reasons behind this include, the ownership of the equity holders is not diluted, and higher rates of interest needed due to the higher levels of risk taken, and also the interest paid on the debts do qualify as business expenses. In theory it is good to use debt as a financing source for businesses. This is mainly because of the fact that the interest paid is generally tax deductible and it can be included as business expenses unlike the cost of equity.
2. Discuss the trade-offs between incremental IPO proceeds and debt financing.
There are two major ratios that can be affected by debt:
• Debt to Capital Ratio = Debt / (Debt + Equity)
This ratio reveals the solvency and the capital structure of the company. It is used as an indicator for the leveraging in terms of the debt and also provides for a better understanding of the amount owned and the amount owed. This gives a view of the amount the company can use for borrowing.
• Debt to Equity Ratio = Debt / Equity
This ratio on the other hand provides details to the extent the company are willing to fund operations with debt instead of equity.
There are also a few benefits of debt which include the tax benefits, and also inclusion of higher levels of discipline to the management. However, considering the cost of debt, it is seen that it includes, loss of future flexibility cost, agency cost and bankruptcy costs that can be levied on the companies (Samuels, Wilkes and Brayshaw, 2000).
Look at the balance sheet attached and discuss how the companys balance sheet would be impacted by debt financing rather than using cash?
The normal reaction would involve an increase in the Long term debts, which would also lead to an increase in the cash on the assets side of the book. This would in turn have a strong affect on the above mentioned ratios. Also the changes might not be appreciated by the creditors. Also the company might also face issues in terms of receiving loans from the banks as well.
How would the company’s return on equity be impacted by utilizing more debt?
Use of higher levels of debt financing when compared to the equity financing means the company would have higher financial leverage. It is noted that the interest payments to debtors is normally tax deductible unlike the dividend which is payable to the shareholders. Thus if the company has higher levels of debt then this would lead to higher return on equity (Drury, 2005). It is seen that if the amount of debt taken by the firm increases, the cost of debt will also increase as the creditors would demand for high risk premiums, thereby decreasing the return on equity. Also increase debt will create a positive contribution on the ROE of the firm only when it is higher than the Return on assets.
Bibliography
Drury, C., (2005), Management Accounting for Business, 3rd edn., Thomson Learning, London
Morgan, R. G., Redman A. Smith, M., and Cooper, W. D., (2001), Capital Budgeting Models: Theory vs. Practice, Accessed on 18th July 2009, retrieved from http://www.allbusiness.com/accounting/budget/840197-1.html
Samuels, J. M., Wilkes, F. M. and Brayshaw, R. E., (2000), Management of Company Finance, 6th edn, Thomson Learning, London Read More
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