Respond To The Following Scenario With Your Thoughts

7501000 Wordsrespond To The Following Scenario With Your Thoughts

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. “We will need to determine the required return for our intended project so that we have a decision criteria defined for the project," she says.

“Do you have the information I need to describe capital structure and to calculate the weighted average cost of capital (WACC)?" you ask. “I do," she smiles. “We can determine the target WACC for Apix Printing Inc., given these assumptions," she says as she hands you a piece of paper that states: Weights of 40% debt and 60% common equity (no preferred equity); A 35% tax rate; Cost of debt is 8%; Beta of the company is 1.5; Risk-free rate is 2%; Return on the market is 11%.

“Great," you say. “Thanks. Be sure to indicate how these costs of capital might be used to determine the feasibility of the capital project," Mary says. “I want your recommendation about which is more appropriate to apply to project evaluation, too."

“One more thing," she says as she stands up to signal the end of the meeting. “You did a good job with the explanations that you provided Luke the other day. Would you have time to define marginal cost of capital for me so I can include it in my discussions with investors? You seem to have a knack for making things accessible to nonfinancial folks." “No problem," you say. “I’m glad my explanations are so useful!"

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. Please submit your assignment.

Paper For Above instruction

The capital structure of a company refers to the particular combination of debt and equity that it uses to finance its overall operations and growth. It represents the relative proportion of debt (borrowed funds) and equity (owner's funding) in the company’s capital makeup. A firm’s capital structure significantly influences its overall risk profile and cost of capital, impacting its valuation, competitive positioning, and decision-making regarding new projects or investments.

In the scenario of Apix Printing Inc., the proposed capital structure involves 40% debt and 60% equity. This mix indicates a leverage strategy where the company relies more heavily on equity rather than debt. The chosen structure aims to balance the benefits of debt, such as the tax shield, against the increased financial risk that higher leverage can bring. An optimal capital structure minimizes the company’s weighted average cost of capital (WACC), which is critical for evaluating the feasibility of new projects.

The weighted average cost of capital (WACC) is a metric used to measure a firm's average after-tax cost of capital from all sources, weighted proportionally. It essentially provides a hurdle rate that a project must beat to be considered worthwhile, accounting for the costs associated with both debt and equity financing.

Using the given assumptions, we can calculate WACC as follows:

WACC = (E/V x Re) + [(D/V x Rd) x (1 - Tc)]

Where:

E = market value of equity

D = market value of debt

V = E + D = total value of financing

Re = cost of equity

Rd = cost of debt

Tc = corporate tax rate

In the provided scenario:

E/V = 60% (equity weight)

D/V = 40% (debt weight)

Re = ? (to be calculated)

Rd = 8%

Tc = 35%

To compute Re, we apply the Capital Asset Pricing Model (CAPM):

Re = Rf + β (Rm - Rf)

Where:

Rf = risk-free rate = 2%

β = beta of the company = 1.5

Rm = expected market return = 11%

Plugging the values in:

Re = 2% + 1.5 x (11% - 2%) = 2% + 1.5 x 9% = 2% + 13.5% = 15.5%

Now, calculating WACC:

WACC = (0.60 x 15.5%) + (0.40 x 8% x (1 - 0.35))

= 9.3% + 0.40 x 8% x 0.65

= 9.3% + 2.08%

= 11.38%.

This figure of approximately 11.38% represents the company's average cost of capital from both debt and equity. It can be used as a critical benchmark or hurdle rate to assess whether proposed projects or investments are likely to generate returns exceeding this cost, thereby creating value for the company and its shareholders.

Application of WACC in Project Feasibility

The WACC serves as an essential discount rate in capital budgeting. When evaluating new projects, companies compute the net present value (NPV) of expected cash flows using the WACC as the discount rate. Projects with an expected return exceeding the WACC are considered value-adding and generally pursued. Conversely, projects with returns below the WACC may erode value and should be reconsidered. Thus, the WACC functions as a decision-making threshold, ensuring that only projects aligning with the company's cost of capital are undertaken.

Furthermore, WACC provides insight into the risk profile of the capital structure. A higher WACC indicates higher overall risk, potentially limiting the firm's capacity to finance new endeavors or leading to stricter project evaluation criteria. Conversely, a lower WACC suggests a more cost-effective capital structure, enabling the company to pursue more projects profitably.

Recommendation for Project Evaluation

In determining the most appropriate measure for project evaluation, the choice depends on the specific project’s risk profile and the company's capital structure. The Weighted Average Cost of Capital (WACC) is most suitable when projects are comparable in risk to the overall firm and financed similarly to the firm's existing capital structure. This is because WACC internally reflects the firm’s cost of capital, considering both debt and equity proportions, and hence provides a realistic hurdle rate for investment appraisal.

However, if a particular project’s risk profile diverges significantly from the overall company risk, a project-specific discount rate—such as the project's own tailored cost of capital—might be more appropriate. For projects with different risk levels, risk-adjusted discount rates or the marginal cost of capital could be better suited. Accordingly, when evaluating typical projects aligned with the firm's current risk and capital structure, WACC remains the most common and pragmatic choice.

Definition of Marginal Cost of Capital

The marginal cost of capital (MCC) is the cost incurred by a firm to raise an additional unit of financing, whether debt or equity. It represents the minimum required return that investors demand for providing further capital, considering current market conditions and the firm’s existing capital structure. As firms seek financing for new investments, their MCC usually increases with higher levels of capital—reflecting the rising difficulty and risk associated with raising additional funds.

The MCC plays an integral role in strategic financial management. It guides firms in deciding whether to undertake new investments by comparing the expected returns from projects against the MCC. When project returns exceed the MCC, it indicates that the endeavor is value-enhancing and financially justifiable. Conversely, if the expected project returns fall below MCC, it suggests that the project may diminish shareholder value and should be avoided or restructured.

In summary, understanding the capital structure and calculating metrics like WACC and MCC are vital tools for sound financial decision-making. They help in assessing project feasibility, optimizing capital allocation, and aligning investment strategies with shareholder value maximization.

References

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