After calculating weighted average cost of capital, I have realized that this company needs to think on ways of financing new projects if the current is the optimal capital structure. In my analysis, I found out that the capital makes no use of long-term sources of capital. This area needs to be exploited by the company. However before choosing a source of finance, the capital structure ought to be reviewed before raising funds
This report is based on a working weighted average cost of capital which is aimed at assisting the company identified their overall cost of capital that is required for projects. The report would help users to get an in- depth understanding of the company’s capital structure, financing policies, financial stability and the required rate of return for projects. For the management, their objective would be to raise funds that will assist in avoiding technical default. Its intended users are the management of the company and employees.
Incorporated Company’s capital structure and its cost of capital
Before one determines the cost of raising new capital. He should be able to estimate the overall cost of capital.
|Source||Book Value||Market Value||Proportions||Cost (%)||Product|
|Short term debt||6471||6471.0000||0.2859||7.8(1-.34)||1.4718|
|Long term debt||750||745.0000||0.0329||5.52(1-.34)||0.1199|
The book values used in this case is for year ending 30.9.2006. the market values adapted for the purpose of this analysis is of 25th July, 2007as at 10.23am.
The cost of new debt is the after tax interest cost of raising new debt. Assume that the after tax cost of new debt as shown above is 7.8% for the short-term debt and 5.52%.
The weighted average cost of capital is at times called overall cost of capital. This can be used as a discount rate to calculate the projects net present value, so long as the projects risk is equivalent to the firm’s existing assets and the firm intends to maintain its target capital structure.
For example if Apple inc. wants to finance a project using the capital structure and finance a project of $ 5 million. Therefore, the amount to be raised will be as follows
|Short term debt||0.2859||1,429,500|
|Long term debt||0.0329||164,500|
Analysis of capital structure as shown
Short and medium term financing
Short -term is a form of financing whose period of repayment is up to one year. Medium – term is a form of financing from one year to seven years. This form of financing is best when the finance raised is to meet a specific current requirement, which is not expected to continue indefinitely.
Examples of short-term finances are:
- Bank – overdrafts; These are usually provided by the clearing banks and present permission by the bank to write a cheque even though the Company has insufficient funds deposited in the account to meet the cheque’s amount. The company will use this facility up to the limit placed and interest is charged by the bank on amounts outstanding at any one time, and the bank may require repayment of an overdraft at any time.
- Bank loans;This is a formal agreement between the bank and the borrower, that the bank will lend a specific sum for a specific period. Interest is charged on the whole amount for the duration of the loan.
- Trade credit; This is a form of financing where by the company can acquire goods or is able to obtain goods or services from supplier without immediate payment on agreement that the company will pay at a later date. Credit periods vary from one industry to the other. But there are circumstances where longer periods of credit are offered depending on the types of goods or services supplied for instance where goods supplied require a long period to be converted into saleable products for example farming.
This is where funds are obtained by issuing shares to the public for subscription. It can also be obtained through rights issue. New share can be issued by private negotiations, placing, or offer for sale or by rights issue. This company uses this souce of capital in large amounts.
When calculating the cost of its capital you will not take into account the tax element. this is because their returns are paid after taxes.
Is a source of financing where by funds obtained can be repaid back after along period normally from eight years and above. The company pays interest and principal or dividend at stated or prescribed period.
Examples of this are;
- Debentures; Is a written acknowledge of a debt by a company containing provisions of interest and the terms of repayment of principal. This can be secured, unsecured, irredeemable, or redeemable. Secured debt will carry charge on one or more specific assets or all assets of the company such that on default of repayment of the interest principal, the debenture holder will appoint a receiver to administer the assets until the interest is paid and eventually they can sale the asset to repay the principal. When calculating the cost of capital you take into account the tax element.
- Preference shares; Is a form of financing whereby shareholders are paid a fixed rate of dividend after creditors but before ordinary shareholders. This can be Cumulative preference shares where shareholders are paid a fixed amount of dividends and arrears accumulate; non-cumulative where they receive a fixed rate of dividend but arrears do not accumulate.
In order to achieve better results in the new projects, the company will need to review its capital structure policy. Currently they are not using the less costly source of capital adequately. This would considerably improve the profitability and liquidity of the company. They also have to review their policy on capital management and keep optimal levels of various items of current assets. This has the effect of maximizing their wealth.
Carlson S; (1969) International Financial Decisions; North Holland Pub.
Gapenski l, Brigham E; (1994) Financial Management: Theory and Practice; Dryden Press.
Luecke R; (2002) Finance for Managers; Harvard Business School Press.
Apple inc. financial statements. Web.
Financial Statements of Apple Inc. 2006.