Finance costs Essay
The company’s cost of capital is the cost of operating the company business which is usually based on cost of sourcing its capital from either the stockholders or the long-term creditors or both. If the business is financed solely by the equity then the cost of capital is equivalent to the cost of equity but if finance in combination with debt, the cost of capital is computed by taking the weighted average in proportion to target capital structure of the company. Weighted average cost of capital (WACC) is in effect equal to marginal cost of capital since the former indicates the cost of obtaining additional dollar of capital or the weighted average cost of the last dollar of new capital.
If the company has pure equity, it would mean that the business organizations’ assets are financed one hundred percent from the investments of stockholders. However, every company desires to have the minimum cost of capital in order to attain wealth maximization objectives. Wealth maximization objective is primarily realized by having higher stock price. The higher the stock price in relation to book value of the stock, the better it would be for stockholders since the same would indicate increased
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To combine equity financing with debt financing is however the better option most of the times, because of the benefit of tax shield provided by the deductibility of interest expense which would reduce corporate tax and would subsequently represent savings in terms of cash flows for the company. More cash inflows and less cash outflows for a company would mean more chances of producing positive net present values when discounted using the company’s cost of capital. The net present value of these projected cash flows for a company would represent an approximated valuation of the company and if divided with total outstanding shares could produce an estimate the of stock price of the company.
In case of combined equity financing and debt financing, the company would need to have a target capital structure that would approximate it minimum cost of capital. The cost of capital or the weighted average cost of capital (WACC) assumes that additional capital to be raised would be invested similarly as with existing assets of the company (Brigham and Houston, 2002).
By analyzing the case facts in relation to theory about cost capital as discussed, the recognition that the 10% cost of capita not being reflective with the company’s current cost of capital may have basis in relation to the other case facts. The fact that the treasury head can raise debt at 7% today’s market is an indication that cost of capital must be reduced or adjusted accordingly to lower than 10%. The statement that if the firm would have to invest the US$4M in short-term securities yielding 5% of the money is not invested in the machine for the production plant further strengthens the need to reduce the cost of capital of company. The cost of capital of a company is never assumed to be permanent as it could be affected by external factors from the economy. The capacity to raise debt at 7% is an indication that debt financing today costs cheaper than before and this might have been caused the Federal Reserve Bank’s lowering interest rates. The 5% yield on short-term securities which may represent the present risk-free rate or a little higher further proves the validity of 7% rate on debt which may be assumed to be based on long-term debt as the latter rate is normally higher than risk-free rate or short-term rate (Van Horne, 1992).
To conclude, the company is therefore advised to adjust its target capital structure if it will now cost cheaper to use deft financing. By increasing the proportion of its debt to equity, the same would lower its cost capital and result would be increase the value of its stock. Lowering its cost of capital would allow the company to accept more projects which would not be possible under the old 10% cost of capital. It will therefore help the company to decide on whether it should invest the $4 million in machine for production plant rather than in short-term securities. The company should only invest then in the machine if it will generate net present value in cash flows after discounting the same using the company’s new cost of capital. Otherwise, other options must be considered like putting the money in short-term securities.
Brigham and Houston (2002) Fundamentals of Financial Management, Thomson South-Western, US
Van Horne (1992) Financial Management and Policy, Prentice-Hall International, London, UK