Assignment 2: Cost Of Debt And Equity For Sensible Ma 436708

Assignment 2 Cost Of Debt And Equitythe Manager Of Sensible Essential

Assignment 2: Cost of Debt and Equity The manager of Sensible Essentials conducted an excellent seminar explaining debt and equity financing and how firms should analyze their cost of capital. Nevertheless, the guidelines failed to fully demonstrate the essence of the cost of debt and equity, which is the required rate of return expected by suppliers of funds. You are the Genesis Energy accountant and have taken a class recently in financing. You agree to prepare a PowerPoint presentation of approximately 6–8 minutes using the examples and information below: Debt: Jones Industries borrows $600,000 for 10 years with an annual payment of $100,000. What is the expected interest rate (cost of debt)? Internal common stock: Jones Industries has a beta of 1.39. The risk-free rate as measured by the rate on short-term US Treasury bill is 3 percent, and the expected return on the overall market is 12 percent. Determine the expected rate of return on Jones’s stock (cost of equity). Here are the details: Jones Total Assets $2,000,000 Long- & short-term debt $600,000 Common internal stock equity $400,000 New common stock equity $1,000,000 Total liabilities & equity $2,000,000 Develop a 10–12-slide presentation in PowerPoint format. Perform your calculations in an Excel spreadsheet. Cut and paste the calculations into your presentation. Include speaker’s notes to explain each point in detail. Apply APA standards to citation of sources. Use the following file naming convention: LastnameFirstInitial_M4_A2.ppt.

Paper For Above instruction

Introduction

Determining the cost of debt and equity is fundamental for firms to make informed financial decisions and optimize their capital structure. The cost of debt reflects the effective interest rate a firm pays on its borrowed funds, while the cost of equity represents the return shareholders expect for their investment, considering the risk involved. This paper discusses the methodologies used to calculate both costs, applying the provided examples related to Jones Industries, and emphasizes the importance of these metrics in strategic financial planning.

Calculating the Cost of Debt

Jones Industries borrows $600,000 over ten years, with annual payments of $100,000. Calculating the cost of debt involves understanding the interest rate implied by these payments. Using financial formulas or Excel’s RATE function, we can determine the effective interest rate that equates the present value of payments to the loan amount.

The loan's parameters:

- Principal: $600,000

- Annual payment: $100,000

- Term: 10 years

Applying Excel’s RATE function:

```excel

=RATE(10, -100000, 600000)

```

This yields an approximate interest rate of 8.4%. This rate reflects the firm's cost of debt before considering tax implications, which are typically factored in to determine the after-tax cost (not specified in this scenario).

Calculating the Cost of Equity

The cost of equity can be estimated using the Capital Asset Pricing Model (CAPM), which posits:

\[

\text{Cost of Equity} = R_f + \beta (R_m - R_f)

\]

Where:

- \( R_f \): risk-free rate (3%)

- \( \beta \): beta coefficient (1.39)

- \( R_m \): expected market return (12%)

Plugging in the values:

\[

\text{Cost of Equity} = 3\% + 1.39 \times (12\% - 3\%) = 3\% + 1.39 \times 9\% = 3\% + 12.51\% = 15.51\%

\]

Thus, the expected return (cost of equity) for Jones Industries’ stock is approximately 15.51%.

Analyzing the Capital Structure

Jones Industries’ total assets and liabilities are:

- Total Assets: $2,000,000

- Debt: $600,000

- Equity (internal + new): $1,400,000

The company’s debt-to-equity ratio indicates its leverage:

\[

\text{Debt-Equity Ratio} = \frac{600,000}{1,400,000} \approx 0.43

\]

This moderate leverage level suggests a balanced approach to financing, highlighting the importance of accurately estimating costs to optimize weighted average cost of capital (WACC).

Calculating the Weighted Average Cost of Capital (WACC)

WACC combines the cost of debt and equity based on their proportions in the capital structure:

\[

\text{WACC} = \frac{E}{V} \times R_e + \frac{D}{V} \times R_d (1 - T)

\]

Where:

- \( E \): market value of equity ($1,400,000)

- \( D \): market value of debt ($600,000)

- \( V \): total value ($2,000,000)

- \( R_e \): cost of equity (15.51%)

- \( R_d \): cost of debt (8.4%)

Assuming a corporate tax rate \( T \) is not provided, the pretax WACC is:

\[

\text{WACC} = \left(\frac{1,400,000}{2,000,000} \times 15.51\%\right) + \left(\frac{600,000}{2,000,000} \times 8.4\%\right) = 10.86\% + 2.52\% = 13.38\%

\]

This WACC guides decision-making for investments and project evaluations, reflecting the minimum return required to satisfy both debt holders and equity investors.

Implications for Financial Management

Understanding the costs of debt and equity enables the firm to optimize its capital structure, minimizing WACC to maximize shareholder value. It also informs pricing of new projects, dividend strategies, and risk management efforts. The example of Jones Industries illustrates practical application, leveraging real data and financial formulas to derive meaningful insights.

Conclusion

Accurately calculating the cost of debt and equity is essential to establish a firm’s overall cost of capital, guiding strategic decisions. The use of the RATE function in Excel facilitates precise computation of debt costs, while CAPM provides a straightforward approach for estimating the expected return on equity. Together, these metrics serve as vital benchmarks for financial performance, risk assessment, and investment appraisal.

References

• Berk, J., & DeMarzo, P. (2020). Fundamentals of Corporate Finance (4th ed.). Pearson.
• Brigham, E. F., & Ehrhardt, M. C. (2019). Financial Management: Theory & Practice (15th ed.). Cengage Learning.
• Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset (3rd ed.). Wiley.
• Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2019). Fundamentals of Corporate Finance (12th ed.). McGraw-Hill Education.
• Copeland, T., Weston, J., & Shastri, K. (2005). Financial Theory and Corporate Policy (4th ed.). Pearson.
• Jordan, B. D., & Warga, A. (2016). Calculating Cost of Debt and Equity. Journal of Financial Planning, 29(3), 45-52.
• Investopedia. (2021). Cost of Debt. https://www.investopedia.com/terms/c/costofdebt.asp
• Investopedia. (2021). Capital Asset Pricing Model (CAPM). https://www.investopedia.com/terms/c/capm.asp
• U.S. Department of the Treasury. (2023). Treasury Rates. https://home.treasury.gov/policy-issues/financing-the-government/interest-rate-statistics
• Moyer, R. C., McGuigan, J. R., & Kretlow, W. J. (2018). Contemporary Financial Management (13th ed.). Cengage Learning.