Running head: FINANCE AND ACCOUNTING 1
Finance and Accounting
Capital Structure
Capital structure refers to how a firm uses different sources of funds to finance its operations and investments. A company may use debt or equity to finance its operations and investments. The mix or proportions of debt and equity in a company is what capital structure entails. Each source of debt has its advantages and disadvantages. They also have their different costs. For instance, debt attracts interest costs while equity attracts dividend payments. Where interest rates are low, equity would be a more expensive source of finance. On the other hand, equity does not require repayment when earnings drop ( Pratt, and Grabowski, 2008).
WACC
WACC = +
Where:
Re = Cost of equity
Rd = Cost of Debt
E = Market value of the company’s equity
D = Market value of the company’s debt
V = E + D = total value of the company’s financing
Tc = corporate tax rate
WACC = 0.6 × Re + 0.4 × 0.08 × (1 – 0.35)
Re = Rf + β(Rm – Rf)
Re = 0.02 + 1.5(0.11 – 0.02)
Re = 0.02 + 0.135
Re = 0.155
WACC = 0.6 × 0.155 + 0.4 × 0.08 × 0.65
= 0.1138
= 11.38%
WACC serves as the discount rate with which a company calculates the net present value of its projects. It represents the company’s opportunity cost and is important in assessing investment opportunities in different projects ( Grabowski, Nunes, Harrington, and Duff & Phelps, 2017). In determining the viability of a capital project, the company would compare the internal rate of return of the project with the WACC. A project would therefore be feasible if its IRR is greater than the WACC. The WACC is also necessary in determining the net present value of projects. A feasible project would have a positive NPV. In project evaluation, the net present value is more appropriate in evaluating projects. That is because it considers all cash flows throughout the project’s life.
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Marginal Cost of Capital
The marginal cost of capital refers to the amount it would cost to raise one dollar of capital. It is the cost of raising an extra unit of capital in a firm ( Pratt, and Grabowski, 2010). Marginal cost of capital comes into play when a firm issues new stock. It normally occurs when the firm depletes its retained earnings and requires more funds for its operations and projects.
References
Grabowski, R.J., Nunes, C., Harrington, J.P. and Duff & Phelps. (2017). 2017 Valuation Handbook - U.S. Guide to Cost of Capital (Wiley Finance) 1st Ed .New Jersey: Wiley.
Pratt, S.P., & Grabowski, R.J. (2008). Cost of Capital 3rd Ed . New Jersey: Wiley.
Pratt, S.P., & Grabowski, R.J. (2010). Cost of Capital: Workbook and Technical Supplement . New Jersey: Wiley.
