Mary Francis Has Just Returned To Her Office After Attending

Mary Francis Has Just Returned To Her Office After Attending Prelimina

Mary Francis has just returned to her office after attending preliminary discussions with investment bankers. Her last meeting regarding the intended capital structure of Apix went well, and she calls you into her office to discuss the next steps. For this assignment, complete the following: Describe capital structure. Determine the WACC given the above assumptions. Indicate how these might be useful to determine the feasibility of the capital project. Recommend which is more appropriate to apply to project evaluation. Define marginal cost of capital.

Paper For Above instruction

Introduction

Capital structure is a fundamental concept in corporate finance that pertains to the proportion of debt and equity financing a firm uses to fund its operations and growth. Determining an optimal capital structure is crucial because it influences the company's overall cost of capital and, consequently, its valuation and investment decisions. The weighted average cost of capital (WACC) is an essential metric used by firms to assess the cost of financing and is pivotal in evaluating the feasibility of proposed capital projects.

Understanding Capital Structure

Capital structure refers to the mix of debt and equity that a firm employs to finance its assets and operations. Equity includes common and preferred stock, representing ownership interests, while debt typically involves bonds and loans that require periodic interest payments and repayment of principal. A firm's choice of capital structure impacts its financial leverage, risk, and return profile. An optimal balance aims to minimize the company's cost of capital while maximizing shareholder value (Myers, 2001).

The appropriate capital structure depends on various factors such as industry norms, market conditions, the firm's operational risk, and tax considerations. Debt tends to be cheaper than equity due to tax deductibility of interest expenses, but excessive debt increases financial risk, potentially leading to financial distress.

Calculating WACC

The Weighted Average Cost of Capital (WACC) is a calculation of a firm's average cost to finance its assets, weighted by the proportion of each component in the firm's capital structure (Brealey, Myers, & Allen, 2019). It serves as a critical discount rate in capital budgeting, used to evaluate the net present value (NPV) of investment projects.

Given the assumptions provided from the previous discussions, let’s consider the typical components necessary for calculating WACC:

- Cost of debt (After-tax)

- Cost of equity

- Proportion of debt and equity in capital structure

Assuming the following:

- Debt-to-equity ratio: 1:1

- Cost of debt (before tax): 5%

- Corporate tax rate: 21%

- Cost of equity: 10%

The cost of debt after tax = 5% × (1 - 0.21) = 3.95%

The proportion of debt (D) and equity (E) based on the 1:1 ratio:

- D / (D + E) = 0.5

- E / (D + E) = 0.5

Calculating WACC:

WACC = (E / (E + D)) × Re + (D / (E + D)) × Rd × (1 - Tax Rate)

Plugging in the values:

WACC = 0.5 × 10% + 0.5 × 3.95% = 5% + 1.975% = approximately 6.98%

This indicates that the company's average cost of financing, considering the capital structure, is about 7%. This rate serves as a benchmark for assessing the viability of capital projects.

Utilization of WACC in Project Feasibility

The WACC is integral in capital budgeting decisions because it reflects the opportunity cost of capital for the firm. When evaluating new projects, organizations compare the expected internal rate of return (IRR) of the project to the WACC. Projects with an IRR exceeding the WACC are likely to add value and are considered feasible, while those with IRRs below WACC may diminish firm value.

In the case of Apix, understanding the firm's WACC aids in determining whether the anticipated cash flows from the capital project justify the investment costs. It ensures that the project’s return exceeds the minimum acceptable rate, incorporating the risk profile of the firm and the market conditions.

Recommendation: Which Capital Measure for Project Evaluation

For project evaluation, it is more appropriate to use the marginal cost of capital (MCC) rather than the average cost of capital (WACC). The MCC refers to the cost of obtaining additional financing and varies depending on the amount of capital already raised and the firm's existing financing structure (Horne & Wachowicz, 2008).

The MCC better reflects the true cost of financing incremental projects because firms often face different costs for raising new capital than the aggregate average, especially as they expand and their risk profile shifts. Using MCC allows firms to evaluate whether a new project’s return exceeds the specific cost of additional financing, leading to more accurate decision-making.

Moreover, a firm's marginal cost of capital typically increases as it issues more debt or equity due to market conditions and the risk premium demanded by investors. Therefore, applying the MCC enables more precise assessment of project viability, aligning with the incremental nature of capital investment decisions.

Conclusion

The capital structure of a firm plays a vital role in determining its overall cost of capital, which directly influences investment decisions. Calculating the WACC provides a useful benchmark for evaluating project feasibility, as it encapsulates the firm's average cost of financing across all sources. Nonetheless, for specific project evaluations—particularly when considering incremental capital needs—the marginal cost of capital offers a more precise measure, reflecting the true cost of additional financing. By appropriately applying these concepts, firms like Apix can make more informed decisions that enhance shareholder value and ensure sustainable growth.

References

  • Brealey, R. A., Myers, S. C., & Allen, F. (2019). Principles of Corporate Finance (13th ed.). McGraw-Hill Education.
  • Horne, J. C., & Wachowicz, J. M. (2008). Fundamentals of Financial Management (13th ed.). Pearson Education.
  • Myers, S. C. (2001). The Capital Structure Puzzle. Journal of Finance, 39(3), 575-592.
  • Damodaran, A. (2010). Applied Corporate Finance (3rd ed.). Wiley.
  • Ross, S. A., Westerfield, R. W., & Jaffe, J. (2013). Corporate Finance (10th ed.). McGraw-Hill Education.
  • Frazzini, A., & Pedersen, L. H. (2014). Betting Against Beta. Journal of Financial Economics, 111(3), 1-25.
  • Berger, P. G., & Ofek, E. (1995). Diversification’s Effect on Firm Value. Journal of Financial Economics, 37(1), 39-65.
  • Modigliani, F., & Miller, M. H. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment. 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.
  • Levy, H., & Sarnat, M. (1970). International Economy and International Capital Markets. MIT Press.

Related Assignments