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In a perfect capital market, as explained Modigliani and Miller (MM) theory the choice of fund is unimportant cost to raise the fund is equal. If a company chooses to have an all equity capital structure it would just be the same as a company that have a debt and equity mixed. In this approach there are some assumption made that there is no effect of tax, that there is no cost that are involved in raising the funds. And information technology is available at the same time both to the firm and the investors. This kind of scenario is explained
Market debt to equity ratio
This is the proportion of debt book value and the market book value of equity
= market debt to equity ratio=total liabilities/(total liabilities +market value of equity )
Value of equity = $30*2500,000= $75,000,000
total liability= $6,000,000
therefore= 6,000000/ (75000000+6000000) = 7.41%
b) cost of levered equity based on the market debt to Equity ratio
based on the market debt to equity ratio
cost of levered equity = 0.12+0.0741(0.175-0.12)
Current weighted average cost of capital (WACC)
In a perfect market
(Damodaran, A., 2012)
Therefore in a perfect capital markets, a firm’s WACC is independent of its capital structure and is equal to its unlevered equity cost of capital
D where the company issues $ 1 billion in stock to repurchase debt
Value of equity = $30*2500,000= $75,000,000 + $1,000,000,000
total liability= $6,000,000 =
therefore= 6,000000/ (75000000+6000000) = 7.41%
Since D = 0, rWACC =rWACC=rE
Rwacc = (E/(E+D))rE=
Rwacc =(E/(E+D) *rE = E/E*0.12= 12%
In this the cost of equity is equal to the unlevered equity under the market condition
We can conclude in this approach where there is no debt that all the finances raised can just be used for the business instead of situation where a company have to make plan to repay loan and interest.
Impact of issuing $ 5 billion in new debt (held in perpetuity) this are debt that have no maturity date but interest will be paid on them indefinitely so no risk where a company have to make a plan to repay back the debt. When the proceeds raised are used to purchase stock it means that the company reduces the control that would rather be held by the shareholders, also interest
being an allowable tax expenses it saves the company a lot of money that would rather have been paid to the tax man, so eventually leads to increase in retained earnings. The biggest disadvantage of this is that when interest is too high it becomes a concern to the shareholders and this reduces the price of share in the market, also it may lead to bankruptcy because the interest required may not be raised or the profit earning may not be sufficient to cover the debt
Re$ 5b = 0.12+(3931m/3931m) *(0.12-0.03) (1-0.4) = 17.4%
When the mostly you are financed by debt only it raises the cost of capital. This risk of this kind is high even when a company is in a position to repay its debts. This is mostly affected by the traditional approach theory
In this company aim at having the lowest weighted average cost of capital and the highest value of the firm. This approach uses debt to increase the value of the firm.in this method it explains that there will be that optimal point where the mix between debt and equity will be that the cost of capital will be the lowest and the value of the firm the highest. But after reaching this level any increase in debt will push the value of the firm down.
Modigliani -miller approach
In this method value of the firm in the market and cost of capital are independent. And instead it depends on what the firm will earn in the future. This suggest that the company value will grow or decline depending on the profit the company is making. This approach assumes that there are no taxes, there are no transaction cost that are involved when raising debt or equity finances and that information is available at the same time to the investors and also the company as well so making borrowing cost remain the same. This means if an investor chooses to buy shares in a company only financed by equity only or buy shares in a firm where it has a mix of debt and equity it would cost the same
Pecking order theory
In this method a hierarchy is followed in choosing the sources of fund in this approach internal financing I in the first place and when it is not enough that is when other external finances can be explored. The next in line is debt as first external source of fund. Debt is utilized up to the optimal level where if it is increased it would be costlier for the business. And the last option is issue of equity to raise funds
This is the money that is required to do a project. These includes the money that is required to purchase the product, its transportation and fixing charges and finally the additional working capital that may be required as a result of the new equipment.
Initial cost of investment = $275,000+ $25,000+$12,000= $312,000
So, the initial investment cost is $ 312,000
Terminal cash flow is the amount of money that you are able to salvage after you dispose an item
So, the terminal cash flow in Year 6 is
= salvage value + working capital = $ 60,000 *.65+$12000+53250= 104250
By Scott B., Eugene F. Brigham (2015) CFIN4
In this we will consider the salvage value of the asset and from calculation the depreciation on asset reduces the asset to zero, so we will consider all the amount sold as gain and in this we will charge tax on it. Another thing we will consider is the working capital because the machinery will no longer be in use the working capital that was initially invested will be recovered and finally the cashflow gain at that year
Working capital here is the fixed cost that is used in the running of the new machine that has been brought. Working capital is treated as a part of initial investment cost. And when the machine will be disposed that money will be saved so a part of the terminal cashflow
At rate of return of 14% we will calculate if the project is to be invested in
The npv value = 1+(r/r
Tax on income = 55,000 less depreciation 50,000 then tax on remaining amount of 5,000= remaining amount = 5000*(1-.35)= 3250
Add back depreciation = 53250
Pv for 5 years at a rate of 14$ = (1+r)-n/r
NPV= -$312,000+($55,000-50000) *.65) +50000+ = -312000+53250*3.433+104250*.456
=-312,000+182,807.25+47,538 =- 81655
Please clarify how you got the numbers highlighted above
The project has a negative NPV value so the project should not be undertaken above because
Flight record ltd can increase the value of NPV in the project if debt loan was taken this is because interest on debt is an allowable tax expense. For example, in the question above if the interest per month is $30,000 there will be an saving in tax that was supposed to be paid of (30,000*.35) $10,500 that would have ended up as tax paid if the money was got through equity financing
To support you answer, please show time line to show the initial investment , cash in from the project over the six years, cash out (interest) on yearly basis then calculate the NPV which should be positive.
Financial leverage is important in the production of financial forecast and also in the control process of the firm this is because from the results got one is able to know the direction the compare is going and an accurate forecast can be made based on that information also control can also be introduced like in areas where it is established there is an increase in business risk measures can be undertaken now to avoid problems in the future.
There are different types of leverage
Also called trading on equity this involves using if debt to finance investments.it consist of a comparison between the earning before interest and tax and earning per share. When you have debt the business I s expected to pay loan amount and also interest on a regularly basis as per debt terms until it is fully paid. Advantage of this form of finance is the fact that the interest on loan is an allowable tax deduction so more money go to the shareholders. The disadvantage of this is that when debt financing is high it increases the business risk and the business may eventually become bankrupt. Fixed charge bearing fund is directly proportional to degree of financial leverage and vice-versa. Financial leverage high in the debt finance is higher compared to equity form of finance (Trisha, 2018)
It concerns investment decisions of the firm. It deals with fixed cost expenses in the income statement. The fixed cost unlike other variable cost does it remains constant so whether there is production or not you have to incur these expenses. This expense is used to meaure effects of changes in sales on Earning before both interest and tax. The higher the size of fixed cost the higher the degree of operating expenses. Change in sales size is directly proportional to profit of a firm because of its utilization of the fixed assets. (Trisha, 2018)
Both financial and operating leverage are about fixed charges and when they are combined, one can be able to calculate the whole risk of a business. This risk is of not being able to cover all the fixed cost expenses. If these fixed expenses are high it means the combined leverage will be high.
Working capital leverage
This is the ability to test the effect of changes in the current assets
Therefore, as the business risk increases so does the profit
Therefore, financial leverage is so important in the making of a financial forecast. There is because using the financial ratio you can be able to predict accurately the future of the business. And because with financial leverage you can be able also to plan to avoid business risk. When current leverage is calculated at it shows sign that business risk will increase measures are taken to avoid situation that may put the business in a position that will not be able to meet its fixed cost. Also, decision can be made to get debt loan if financial leverage is low because the debt does not dilute the share which otherwise would reduce if other shares were to be issued. Also, the gain of the business can be raised. Using leverage decision making can be made that will see the profitability of the business increase in the future.
Financial planning is crucial for a business to survive this is because of the following reasons,
When you plan you are able to use the available resources in the best way possible so for any given product it is well funded so no under or overproduction so optimum is achieved and it so given a company the muscle to compete with other businesses. (samiksha, 2018)
Business depending on its stage the most appropriate business structure is in terms of source of financing it. The structure is chosen to ensure the business grows and survives (BlueShore, 2018)
The available resources are allocated to the most profitable project so maximizing the owner’s wealth. When the best is chosen it will easily penetrate the market and this will ensure that the business growths.
Planning helps in control by comparing the actual results and what had been predicted and help to correct where there is a negative variance to ensure improvement in the future.
By studying the business trend one as able to make decision that will avoid some circumstances that might affect the profitability of the business.
Corporate life cycle influences the type of funding available for company. There are various stages in the life of a company (Jaafar and Abdul, 2018)
This is the stage where the business is just idea that is being developed, research is being done on how the business can be established, best location for the business, potential customers and just a basic structure of what the business will be like, in this stage business they either start or they idea if not actualized the business may not start in this stage it is hard to access any debt finance because your business is just an idea one can only get finances from own savings friends and family members who maybe willing to partner with you to take the business to the next level (Petch, 2018)
The start up stage
In this stage the business is in the process of being established in the stage the owners introduce new services, new products or even existing products with new technology or new way of doing things involved. This stage marketing is high because the business wants to penetrate the market, the sales are low at this stage but due to intensive marketing the sales increase with time. At this stage it is the most risk part of business cycle as considered by financial institution, this is because there is no past record that this business has and if their products are not accepted in the market it means that business will fail. So most financial institution cannot fund business at this stage (Neil P. 2018). At this stage the business mostly makes losses because of the new services or product introduced they are yet to be accepted in the market. At this stage much of the money that is earned is reinvested back in the business and also to fund new projects this is to ensure that the business survives in the other stages of business. (Ömer F., Semra K.2018
Different business cycles (Petch, N. (2018)
At this stage business start getting growing in a fast way. As sales increases there rises a need for more funds this is to meet the needed demand and also to other markets, like in other cities. The business needs to produce more products or expand their services and also the business be planning to move to a large area, this is necessary for future of the business (Synerion, 2018). In this because the business is established it is less risky so a business can have access to debt funds from financial institution so money that is so required to maybe move to bigger space venture into new market, can be got from financial institution because they are confident that they have a capacity to repay the loan acquired. increase production it can be got from financial institution This ensures that supply meet demand (Neil P. 2018). Another aspect of the business growth is strategy that will see the business always grow even in long term. This stage of growth is where you have products, you have bigger space you, you have expanded your services but still there are untapped market so you penetrate to new markets. In this stage of growth mostly it is funded internally by the money already saved (Ömer F., Semra K.2018). the other form of growth is diversification where a business ventures into new business, new products. This requires a lot of capital. Which can be got from the financial institution. And lastly growth can be achieved by acquisition thus immediately increasing customers and the market area. (Synerion, 2018)
The other life cycle ismaturitystage
At this stage the business is at its climax, and growth rate is low. All the financial needs are raised internally. In this stage even, assets of the business have grown tremendously and production at this stage is at the highest capacity because economies of scale has been achieved. Because of high competition and new entry of similar business. market share steadily decreases.at this stage it is easy to access debt finance because at this stage business risk has been fully eliminated.
Lastly it is the Decline stage
Competition at this stage is very high and market share sharply reduces. At this stage production is not fully utilized and because of these issues sales greatly reduces and profitability also reduces. At this stage a company can reinvest by applying new technologies developing new products and move be on the growth and maturity path again. With all these negative issues facing the business, the firm is less risky compared to introduction stage because the firm has a wide investment in asset. (Ömer F., Semra K.2018).
There three types of business finances
The first one is the one that is provided by your personal savings, friends and family members. The benefit of this kind of finance is mostly it is interest free so you can grow your business without pressure to repay loan or interest on loan.
The other type of finance is debt finance, this includes short term loans loan term loan debentures, overdrafts and others. These types of finances have the advantage that after you repay the loan the provides of the debt finance will not be part of the owners of the business.
The other type of finance is equity finance where shareholders contribute money and instead of receiving back their money in the future they become part of the ownership of the business. (Virginia 2018)
Financial structure is the mix of both debt and equity finance that is undertaken by a business to optimize on shareholders wealth
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