Assignment 2: Cost Of Debt And Equity For Sensible Ma 854503
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
Understanding the cost of capital is vital for firms like Jones Industries to make informed financing decisions. The cost of debt reflects the effective interest rate a company pays on its borrowings, while the cost of equity represents the return required by shareholders for their investment. This paper discusses the calculation of both the cost of debt and the cost of equity based on provided financial data, illustrating their importance in capital structure management.
Cost of Debt Calculation
Jones Industries borrowed $600,000 for a 10-year term with annual payments of $100,000. To determine the expected interest rate, we can model this as a loan amortization where the annual payment covers both interest and principal repayment. Using financial formulas or Excel's RATE function, the interest rate can be derived.
Performing the calculation in Excel:
- Principal (PV): $600,000
- Number of periods (nper): 10
- Payment (pmt): $100,000 (annual payment)
Applying the RATE function:
- =RATE(10, -100000, 600000)
This yields an approximate annual interest rate of about 8.55%. This rate is the firm's effective cost of debt, reflecting the true cost of borrowing considering the repayment schedule.
Cost of Equity Calculation
Jones Industries' beta of 1.39 indicates its stock is more volatile than the market. Using the Capital Asset Pricing Model (CAPM):
Cost of Equity = Risk-Free Rate + Beta × (Market Return - Risk-Free Rate)
Substituting the provided values:
- Risk-Free Rate = 3%
- Market Return = 12%
- Beta = 1.39
Calculation:
- 0.03 + 1.39 × (0.12 - 0.03) = 0.03 + 1.39 × 0.09 = 0.03 + 0.1251 = 0.1551 or 15.51%
Thus, the expected rate of return required by shareholders (cost of equity) is approximately 15.51%.
Financial Structure and Its Implications
Jones Industries’ total assets and capital structure reveal that:
- Total Assets = $2,000,000
- Debt (Long and Short-term) = $600,000
- Common Internal Stock Equity = $400,000
- New Equity Issue = $1,000,000
The weighted average cost of capital (WACC) can be calculated to assess overall cost:
- WACC = (E/V) × Re + (D/V) × Rd × (1 - Tc)
Where:
- E = Market value of equity, including new equity
- D = Market value of debt
- V = E + D
- Re = Cost of equity
- Rd = Cost of debt
- Tc = Corporate tax rate (not provided here)
Assuming a corporate tax rate (e.g., 21%), the WACC provides an integrated view of the cost of capital, crucial for investment decision-making.
Significance of Cost of Capital in Financial Decisions
Knowing the precise costs enables firms like Jones Industries to:
- Evaluate the feasibility of new projects by comparing expected project returns to WACC
- Optimize capital structure to minimize overall cost of capital
- Make informed financing decisions between debt and equity sources
A higher cost of debt or equity indicates increased risk, affecting the firm's valuation and strategic options.
Conclusion
Accurately assessing the cost of debt and equity informs effective capital structure decisions and enhances firm valuation. The calculated cost of debt for Jones Industries of approximately 8.55% reflects the true interest expense on borrowed funds, while the cost of equity at roughly 15.51% indicates the return shareholders require given the company's risk profile. Integrating these components into WACC calculations helps firms like Jones make optimal financial decisions aligned with their strategic goals.
References
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