Cost Of Debt And Equity For Sensible Essentials Co
Cost Of Debt And Equitythe Manager Of Sensible Essentials Conducted An
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. Include speaker’s notes to explain each point in detail. Apply APA standards to citation of sources.
Paper For Above instruction
Introduction
Understanding the cost of debt and equity is fundamental for firms seeking to optimize their capital structure and ensure sustainable growth. The cost of debt reflects the effective interest rate a company pays on borrowed funds, while the cost of equity represents the return required by shareholders for their investment. This paper analyzes these two concepts using the specific examples provided for Jones Industries, employing financial formulas and calculations to determine precise rates. Additionally, the importance of accurate estimation of these costs is emphasized for strategic decision-making, investor confidence, and firm valuation.
Cost of Debt Calculation
Jones Industries has borrowed $600,000 with an annual payment of $100,000 for ten years. To determine the expected interest rate or cost of debt, we treat this as a loan with an amortizing payment structure, resembling an annuity. The primary goal is to find the interest rate (r) that equates the present value of the loan with the scheduled payments.
Using Excel’s financial functions, specifically the RATE function, we input the following:
- Nper (Number of periods) = 10 years
- Pmt (Payment each period) = $100,000
- PV (Present value or loan amount) = -$600,000 (cash outflow for borrower)
- FV (Future value) = 0 (loan is fully paid off at the end)
- Type (Payment timing) = 0 (end of period)
Applying the formula in Excel:
`=RATE(10, -100000, 600000, 0, 0)`
The calculated approximate annual interest rate is 8.72%.
This rate signifies the expected cost of debt for Jones Industries, reflecting the effective interest the firm pays on its borrowed funds, considering the amortization schedule.
Cost of Equity Calculation
The expected rate of return on Jones Industries’ stock, or cost of equity, can be calculated using the Capital Asset Pricing Model (CAPM):
\[ \text{Cost of Equity} = R_f + \beta ( R_m - R_f ) \]
where:
- \( R_f \) = risk-free rate = 3%
- \( \beta \) = beta of the stock = 1.39
- \( R_m \) = expected market return = 12%
Substituting these values:
\[ \text{Cost of Equity} = 3\% + 1.39 \times (12\% - 3\%) \]
\[ \text{Cost of Equity} = 3\% + 1.39 \times 9\% \]
\[ \text{Cost of Equity} = 3\% + 12.51\% \]
\[ \text{Cost of Equity} \approx 15.51\% \]
This indicates that investors require approximately 15.51% return to compensate for the risk associated with Jones’s stock, aligning with its beta and market conditions.
Capital Structure and Its Implications
Jones Industries’ financial data illustrates a balanced capital structure with total assets of $2,000,000 financed by $600,000 in debt and $1,400,000 in equity (both existing and new). The market value-weighted average cost of capital (WACC) combines the cost of debt and equity proportionally:
\[ \text{WACC} = \left( \frac{D}{V} \times r_d \times (1 - T) \right) + \left( \frac{E}{V} \times r_e \right) \]
Where:
- \( D \) = debt = $600,000
- \( E \) = equity = $1,400,000
- \( V \) = total value = $2,000,000
- \( r_d \) = cost of debt = 8.72%
- \( r_e \) = cost of equity = 15.51%
- \( T \) = corporate tax rate (assumed for simplicity as 21%)
Calculating the WACC:
\[ \text{WACC} = \left( \frac{600,000}{2,000,000} \times 8.72\% \times (1 - 0.21) \right) + \left( \frac{1,400,000}{2,000,000} \times 15.51\% \right) \]
\[ = (0.3 \times 8.72\% \times 0.79) + (0.7 \times 15.51\%) \]
\[ = (0.3 \times 6.89\%) + (0.7 \times 15.51\%) \]
\[ = 2.07\% + 10.86\% \]
\[ \text{WACC} \approx 12.93\% \]
This WACC represents the minimum return that Jones Industries must earn on its existing assets to satisfy both debt holders and shareholders, guiding investment and financing decisions.
Significance and Application
Accurately calculating the cost of debt and equity provides essential insights into a firm's financial health and strategic planning. The cost of debt helps in assessing the affordability of borrowing, especially under different interest rate environments, influencing decisions on new loans or refinancing. The cost of equity, derived from market risks, informs capital raising strategies and reflects investor expectations.
Moreover, understanding the weighted average cost of capital (WACC) allows firms like Jones Industries to evaluate investment opportunities, ensuring that projects generate returns exceeding their cost of capital, thereby adding value to shareholders. An excessively high cost may restrict investment, while too low a cost might signal increased risk-taking, potentially endangering financial stability.
Financial managers must continuously monitor these costs, considering market fluctuations, changes in credit ratings, and the firm’s risk profile, to optimize capital structure and maximize value creation. Incorporating more granular data, such as specific tax rates and market conditions, further enhances the precision of these measures.
Conclusion
The analysis of Jones Industries’ cost of debt and equity reveals important financial metrics that influence strategic decisions. The effective interest rate on debt, approximately 8.72%, coupled with a cost of equity of around 15.51%, underscores the importance of balancing debt and equity for optimal capital structure. The computed WACC of approximately 12.93% offers a benchmark for evaluating investment opportunities and firm performance. These computations exemplify the application of financial theories such as amortization, CAPM, and WACC in real-world scenarios, emphasizing their relevance in corporate finance.
References
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- Brigham, E. F., & Ehrhardt, M. C. (2016). Financial Management: Theory & Practice (15th ed.). Cengage Learning.
- Damodaran, A. (2020). The Cost of Capital, Corporate Finance Institute. https://corporatefinanceinstitute.com
- Investopedia. (2023). Weighted Average Cost of Capital (WACC). https://www.investopedia.com
- U.S. Department of the Treasury. (2023). Treasury Bill Rates. https://home.treasury.gov
- Kaplan, S. J., & Reilly, R. F. (2014). Analysis of Capital Asset Pricing Model (CAPM) assumptions. Journal of Finance.
- Modigliani, F., & Miller, M. H. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment. American Economic Review.