O’Grady Apparel Case Study 4 Integrative Case 6

O’GRADY APPAREL CASE STUDY 4 Integrative Case 6 O’Grady Apparel Company Name of student Name of paper Professor’s name Date Due Answer

Calculate the after-tax cost for each source of financing under respective ranges, and analyze how changing the capital structure affects the weighted average cost of capital (WACC).

Paper For Above instruction

In the strategic financial management of O’Grady Apparel, understanding the intricacies of financing costs and capital structure is essential to optimize the firm's value and ensure sustainable growth. This paper analyzes the calculation of respective after-tax costs for various sources of financing within specified ranges, assesses the impact of shifting capital structure on WACC, and evaluates the implications of increased leverage, balancing the benefits against heightened financial risks.

Initially, the focus is on calculating the after-tax cost of debt, preferred stock, and common equity based on provided data. For long-term debt in the range of $0 to $700,000, the pre-tax interest cost is established at 12.5%, with the after-tax cost computed as 12.5% x (1 - 0.4) = 7.5%. For debts exceeding $700,000, the interest rate increases to 18%, resulting in an after-tax rate of 18% x (1 - 0.4) = 10.8%. These figures reflect the firm's exposure to different debt levels and their respective costs, considering the corporate tax shield advantage that debt provides.

Preferred stock, with an initial rate of 17%, incurs a flotation cost, and after adjusting for flotation cost (say, approximately 3.9%), the effective cost becomes about 17.94%. The calculation considers the dividend rate relative to net issuance costs, which affect the effective cost burden on the firm. For common equity, the cost is derived from dividend valuation models, considering growth rates. For ranges up to $1,300,000 in equity, it’s estimated at around 23.8%, and for larger capital amounts exceeding that threshold, the cost increases to approximately 26%, reflecting the higher risk and required return demanded by investors due to increased equity financing.

The assignment then shifts to analyzing the breakeven points. For debt, the breakeven at $1,400,000 (derived from dividing $700,000 by the debt proportion of 0.5) and for equity at $3,250,000 (from dividing $1,300,000 by the equity proportion). These points indicate thresholds where the composition of sources of capital would change, affecting the overall cost structure.

Next, the calculations incorporate the weighted average cost of capital (WACC) across different ranges of total financing. When total financing falls below $1,400,000, the WACC is calculated using specified weights and costs, resulting in a value around 21.39%. As financing exceeds $1,400,000 but remains below $3,250,000, the WACC adjusts accordingly, reflecting the changing proportions and costs of debt and equity. Beyond $3,250,000, the WACC slightly decreases due to greater reliance on cheaper sources of debt, but at the expense of increased financial leverage risk.

In examining the impact of shifting to a more leveraged capital structure—namely, increasing debt while keeping the cost of each financing source constant—it becomes apparent that WACC tends to decrease. This reduction results from the tax deductibility of interest, which lowers the firm's overall cost of capital. However, heightened leverage also brings augmented financial risk, potentially increasing the likelihood of financial distress during downturns. The optimal capital structure balances these benefits and risks, aiming for a minimal WACC without excessively exposing the firm to solvency issues. The calculated WACC for the new structure, with 50% long-term debt, 10% preferred stock, and 40% common equity, is lower than that of the original, indicating improved cost efficiency.

However, the increased leverage amplifies the firm's financial risk profile, notably through higher debt service obligations and potential adverse effects on credit ratings. Consequently, management must weigh the advantages of reduced WACC against the increased probability of financial distress, especially in volatile markets or during economic downturns. Integrating qualitative analysis with quantitative metrics, optimal capital structure decisions should focus on aligning leverage levels with the firm’s risk appetite, operational stability, and long-term strategic goals.

In sum, the calculation of cost components and the analysis of shifting leverage highlight the delicate balance firms like O’Grady Apparel must maintain. By strategically managing debt and equity proportions, the company can achieve a more efficient capital structure—minimizing WACC while maintaining financial flexibility. Such careful financial structuring enhances shareholder value and positions the firm to capitalize on growth opportunities without incurring unnecessary risk.

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