Cost Of Capital: This Assignment Will Assess Competency

Cost Of Capital this Assignment Will Assess The Competency

Christopher William, president of William Industries which produces widgets, has hired you to determine its cost of debt and the cost of equity capital. The stock currently sells for $25 per share and the dividend will be $5. Christopher argues that it will cost us $5 per share to use the stockholders' money this year, therefore, the cost of equity is equal to 20%. Furthermore, Christopher believes that the cost of debt is 25%. This is based upon the most recent financial statements which show that William Industries has total liabilities of $10 million and will face total interest expenses for the year of $2.5 million. Christopher argues that the company should increase its use of equity financing because debt costs 25% while equity only costs 20% and thus, equity is cheaper. Is Christopher’s analysis of the cost of equity, debt, and decision to increase the use of equity financing over debt financing accurate? Defend your answers in a 600 to 850-word report. You MUST use Word Format, APA Style with references and in-text citations.

Paper For Above instruction

Understanding the precise calculation and implications of a company's cost of capital is imperative for strategic financial decision-making. In this context, Christopher William's assertions regarding William Industries' cost of equity and debt warrant thorough analysis to ascertain their accuracy and the feasibility of shifting towards more equity financing. Proper evaluation involves analyzing each component—cost of equity and debt—using recognized financial theories and methods, and assessing the broader implications of such shifts on shareholder wealth.

Analysis of Cost of Equity

Christopher’s assertion that the cost of equity is 20%, derived from the dividend discount model (DDM), is based on the dividend payout and current stock price. The formula for the cost of equity (Ke) in the DDM approach is expressed as:

Ke = (Dividend / Price) + Growth Rate

In this case, with a dividend of $5 and a stock price of $25, the dividend yield is 20%. However, this assumes that dividends will grow at a rate of zero. If dividends are expected to grow, incorporating the growth rate reformulates the calculation: Ke = (Dividend / Price) + g. Given no information about dividend growth, assuming zero growth, the cost of equity is 20%. However, this simplification overlooks potential future growth, which could reduce the actual cost of equity (Brealey, Myers, & Allen, 2017). Furthermore, the assertion by Christopher aligns with the Capital Asset Pricing Model (CAPM), which considers systematic risk—though no beta or market risk premiums are specified here.

Analysis of Cost of Debt

Christopher reports the cost of debt as 25%, based on interest expenses of $2.5 million on liabilities of $10 million. The calculation used is:

Cost of Debt = Interest Expenses / Total Liabilities = $2.5 million / $10 million = 25%

This is a straightforward approach, but it lacks consideration of the effective interest rate after tax effects. Since interest expense is tax-deductible, the after-tax cost of debt is calculated as:

After-Tax Cost of Debt = Cost of Debt × (1 - Tax Rate)

Assuming a corporate tax rate of 21% (aligned with U.S. federal rates), the after-tax cost of debt becomes:

0.25 × (1 - 0.21) = 0.1975 or 19.75%

This indicates that from a tax perspective, debt might be less expensive than initially suggested. It also emphasizes that a higher debt burden might be more tax-efficient, contrary to Christopher's belief that debt is less costly than equity (Brigham & Ehrhardt, 2017).

Comparison of Debt and Equity Costs and its Implications

Christopher criticizes the notion that debt costs 25% and equity costs 20%, implying that debt is more expensive. However, standard capital structure theory suggests that debt is typically cheaper than equity because debt carries less risk and has tax advantages. The cost of equity accounts for the risk premium demanded by shareholders for bearing residual risk; therefore, it generally exceeds the cost of debt (Modigliani & Miller, 1958). Thus, the assumption that equity is cheaper than debt, based solely on their respective interest and dividend costs, ignores this risk-risk premium differential.

Should William Industries Increase Equity Financing?

Considering the above, Christopher's recommendation to increase equity issuance due to lower costs is flawed. While the rationale assumes that reducing debt might decrease financial risk, it neglects the possibility that a higher debt-to-equity ratio can leverage tax benefits and lower the overall weighted average cost of capital (WACC). Reducing debt to achieve a lower WACC depends on the cost of debt after taxes and the company's risk profile (Brealey et al., 2017).

Moreover, increasing equity financing may dilute existing shareholder value and could be less desirable if the company's projections favor debt financing for its tax advantages. An optimal capital structure balances debt and equity to minimize WACC and maximize shareholder wealth (Myers, 2001). Therefore, simply replacing debt with equity without considering these factors may not be a beneficial strategy.

Conclusion

In conclusion, Christopher's analysis of the costs involved is overly simplistic and overlooks critical financial principles. The claim that equity is cheaper than debt ignores risk premiums, tax advantages, and the current debt levels. Meanwhile, the calculated cost of equity appears reasonable based on available data but warrants further examination considering potential growth and market conditions. The company should employ comprehensive capital structure analysis, involving WACC calculation, risk assessment, and strategic objectives, before deciding on financing strategies. Ultimately, a balanced approach that optimizes leverage and shareholder wealth should guide William Industries’ future financial decisions.

References

• Brealey, R. A., Myers, S. C., & Allen, F. (2017). Principles of Corporate Finance (12th ed.). McGraw-Hill Education.
• Brigham, E. F., & Ehrhardt, M. C. (2017). Financial Management: Theory & Practice (15th ed.). Cengage Learning.
• 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.
• Myers, S. C. (2001). Capital Structure. Journal of Economic Perspectives, 15(2), 81-102.
• 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.
• Lintner, J. (1956). Distribution of Incomes of Corporations among Dividends, Retained Earnings, and Taxes. The American Economic Review, 46(2), 97–113.
• Fama, E. F., & French, K. R. (1993). Common Risk Factors in the Return on Stocks and Bonds. Journal of Financial Economics, 33(1), 3-56.
• Brealey, R. A., & Myers, S. C. (2003). Principles of Corporate Finance (7th ed.). McGraw-Hill/Irwin.
• Chen, L., & Zhao, W. (2014). Optimal Capital Structure with Risk of Bankruptcy: Evidence from Chinese Listed Firms. Journal of Business Economics and Management, 15(2), 251-270.