Assignment 1: Discussion—Finance Organization And Lon 784406

Assignment 1: Discussion—Finance Organization and Long-Term Planning

Considering Genesis Energy’s aggressive growth plan, Sensible Essential Consulting suggested that its client should broaden the scope of financing beyond short-term loans and consider long-term financing options. These options would greatly enhance the ability of the operations management team to fund the capital investments and growth in operating expenses. One option is selling more equity in the company. A public stock offering might be a possibility; however, a company as young and small as Genesis Energy might be hard to value. Sensible Essential Consulting believes that another private investor might require preferred stock dividends in order to mitigate some of the financial risk.

Another option is a long-term bank loan. Acting as the finance expert for Sensible Essential Consulting, respond to the following: Determine the cost of debt and equity for Genesis Energy and its weighted average cost of capital. Go to and look under SEC filings. Use a US publicly traded company, such as Apple, Google, DuPont, etc. Identify the sources of long-term financing for Genesis Energy.

Analyze the potential costs and benefits of each option. Explain how relative risk (from the investor’s perspective) impacts the cost of capital for Genesis Energy. Determine the cost of debt and equity for Genesis Energy and its weighted average cost of capital. Calculate the required rate of return for Genesis Energy using the capital asset pricing model (CAPM). What is the required return for Genesis Energy shareholders?

Paper For Above instruction

Genesis Energy, an emerging player in the energy sector, faces the crucial decision of securing long-term financing to sustain its aggressive growth trajectory. The two primary options—issuing equity or obtaining long-term debt—necessitate a comprehensive evaluation of their respective costs, benefits, and implications on the company’s capital structure. This paper examines the intricacies of these financing methods, computes the associated costs of capital, and discusses how risk factors influence investor expectations.

Sources of Long-Term Financing for Genesis Energy

As a privately-held entity or a young company, Genesis Energy is likely to explore various sources of long-term financing. Equity financing, particularly through private placements or public offerings, provides capital without immediate repayment obligations but dilutes ownership. Given the company's size and valuation challenges, a private placement with institutional investors might be preferable. Alternatively, long-term bank loans or bonds are traditional debt sources, offering predictable repayment schedules but imposing fixed interest obligations.

Publicly traded companies like Apple or Google obtain long-term financing through a mix of equity and debt. Apple leverages a diverse capital structure, issuing bonds at attractive rates due to its high credit rating (Apple Inc., 2023). Similarly, Google’s parent, Alphabet, raises funds through bonds, favoring low-interest rates driven by market conditions (Alphabet Inc., 2023). While Genesis Energy may not access the same scale or creditworthiness, understanding these sources provides insights into typical financing avenues.

Cost of Debt and Equity

The cost of debt (Kd) for Genesis Energy depends on the interest rate it can secure from lenders, which is influenced by its credit risk and prevailing market rates. Assuming Genesis can secure a long-term loan at an interest rate of 6%, its after-tax cost of debt can be calculated as:

Kd = Interest Rate × (1 - Tax Rate)

Assuming a corporate tax rate of 21% (Tax Cuts and Jobs Act, 2017), the after-tax cost of debt is:

0.06 × (1 - 0.21) = 0.0474 or 4.74%

The cost of equity (Ke) is more complex to determine since it reflects investor expectations for return considering the risks. Using the Capital Asset Pricing Model (CAPM), the formula is:

Ke = Rf + β (Rm - Rf)

Where Rf is the risk-free rate, β is the stock’s beta, and Rm - Rf is the market risk premium. Assuming a current 10-year U.S. Treasury yield (Rf) of 3%, a beta for Genesis Energy of 1.2 (reflecting higher volatility relative to the market), and a market risk premium (Rm - Rf) of 6%, the calculation becomes:

Ke = 0.03 + 1.2 × 0.06 = 0.03 + 0.072 = 0.102 or 10.2%

This rate represents the expected return shareholders require given the company's risk profile.

Weighted Average Cost of Capital (WACC)

WACC combines the costs of debt and equity based on their proportions in the firm’s capital structure. If Genesis Energy considers an equity-debt ratio of 50:50, the WACC is calculated as:

WACC = (E/V) × Ke + (D/V) × Kd × (1 - Tax Rate)

Where E/V and D/V are the proportion of equity and debt in total financing, respectively. Substituting the values:

WACC = 0.5 × 10.2% + 0.5 × 4.74% = 5.1% + 2.37% = 7.47%

This WACC indicates the minimum return Genesis must earn on its investments to satisfy both debt holders and equity shareholders.

Risk and Cost of Capital

The risk profile from an investor's perspective significantly affects the cost of capital. Higher perceived risk—due to smaller size, market volatility, or sector-specific risks—elevates the required rate of return (Ehrhardt & Brigham, 2017). Investors demand a premium for bearing additional uncertainty, which is reflected in a higher beta or a higher required return, thus increasing the firm's WACC. Conversely, a stable, highly-rated company can negotiate lower borrowing costs and attract equity investors at lower expectations.

Benefits and Drawbacks of Financing Options

Issuing equity provides substantial flexibility and does not require fixed repayments, beneficial for a young firm with uncertain cash flows. However, it results in ownership dilution and potentially higher aggregate cost of capital if the market perceives the issuance as risky (Brealey, Myers, & Allen, 2020). On the other hand, long-term debt offers predictable payments and potential tax advantages, but increases financial risk, especially if the firm’s revenues are volatile. Excessive leverage can lead to insolvency if cash flows decline (Hillier, Grinblatt, & Titman, 2011).

Conclusion

Ultimately, Genesis Energy must weigh the trade-offs between dilution and financial risk. A balanced capital structure, considering the company's growth prospects and risk appetite, can optimize the WACC. By carefully evaluating the costs of debt and equity, and factoring in investor risk perceptions, Genesis can strategically choose financing avenues that support its long-term growth objectives while maintaining financial stability.

References

  • Apple Inc. (2023). _Annual report_. https://investor.apple.com
  • Alphabet Inc. (2023). _Annual report_. https://abc.xyz/investor
  • Ehrhardt, M. C., & Brigham, E. F. (2017). _Financial management: Theory & practice_ (15th ed.). Cengage Learning.
  • Brealey, R. A., Myers, S. C., & Allen, F. (2020). _Principles of corporate finance_ (13th ed.). McGraw-Hill Education.
  • Hillier, D., Grinblatt, M., & Titman, S. (2011). _Financial markets and corporate strategy_. McGraw-Hill.
  • Tax Cuts and Jobs Act, Pub. L. No. 115-97, 131 Stat. 2054 (2017).
  • Damodaran, A. (2012). _Investment valuation: Tools and techniques for determining the value of any asset_. Wiley.
  • Ross, S. A., Westerfield, R. W., & Jaffe, J. (2019). _Corporate finance_. McGraw-Hill Education.
  • Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. _The American Economic Review_, 48(3), 261-297.
  • Jensen, M. C. (1986). Agency costs of free cash flow, corporate finance, and takeovers. _American Economic Review_, 76(2), 323-329.

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