Purdue MT 480M6 - Cost of Capital Models

INCORPORATE THE COMBINED ATTRIBUTES OF DEBT AND EQUITY GIVEN A COST OF CAPITAL MODEL 1 MT480M6 Cost of Capital Models Incorporate the Combined Attributes of Debt and Equity Given a Cost of Capital Model Purdue Global University Introduction Business have different ways of accessing capital to finance their operational activities. Debt financing is one of the most common ways of raising capital to finance business operations because it is a cheaper option. Debt financing involves the acquisition of debt from private and public institutions to supplement already existing revenue streams. The business negotiates repayment terms, which influences its credit worthiness. The sale of equity is another alternative of acquiring capital for funding operations in a business. The business sells shares and stocks to shareholders and invests the capital acquired in viable projects to generate profits and value for stakeholder investments. The weighted average cost of capital (WACC) is a financial ratio that determines the cost of acquiring capital through debt and sale of equity. The after-tax weighted average cost of capital (AT-WACC) influences investor decisions by determining the cost of acquiring financing. Investors prefer committing their resources in firms that have a low after-tax weighted average cost of capital (AT-WACC) because such businesses have low risk of loan default and a higher probability of offering a high rate of return on investment. A business with low after-tax weighted average cost of capital (AT-WACC) suggests that it has high operational costs, weak risk-mitigation measures, ineffective financial management policies, and unviable investment opportunities. A low after-tax weighted average cost of capital (AT-WACC) is preferable for investing, owing to a high rate of return of investment and low risk on investment.INCORPORATE THE COMBINED ATTRIBUTES OF DEBT AND EQUITY GIVEN A COST OF CAPITAL MODEL 2 Explain the tax benefits of debt financing Debt financing in business involves the use of business credit cards, business loans, and cash advances, among others. Debt financing has many tax benefits, which include - Tax deductions on loan repayments - Low interest rates - Ownership benefit - Better financial planning - Enhancement of the business credit worthiness - Cheaper business financing option The first benefit of debt financing is that loan repayments are tax-deductible (Cole & Sokolyk, 2018). By adopting the debt financing option, the business considers payments to repay the loan as expenses, which implies that that they should include tax costs. Therefore, the business saves on its much-needed resources and utilizes the additional funds in meaningful and viable investment projects. Further, including taxation on loan repayments also lowers the business’ tax obligations at the end of its accounting period. As a result, the business increases its profitability and attractiveness to investors. Increased shareholding increase the business’ capital outlay and generates sufficient funding for research, innovation, and marketing. The second benefit of debt financing is that tax deductions on loan repayments can lower interest rates. Low interest rates translate to a decrease in spending on loan repayments, which enables the business to save its resources. Further, low interest rates also enable the business toINCORPORATE THE COMBINED ATTRIBUTES OF DEBT AND EQUITY GIVEN A COST OF CAPITAL MODEL 3 increase its capital outlay by increasing credit from financial institutions. Lowering interest rates also enables the business to cushion investor resources from financial loss emanating from volatile macroeconomic policies, unforeseen business risks, and an unfavorable business environment. The third benefit of debt financing is that the business’ proprietor enjoys ownership of the credit facility. Therefore, the business owner decides how to manage the resources and develop modalities of loan repayment. Ownership of the funds also enables the business owner to make decisions that contribute to the profitability of the firm by exercising managerial control. Ownership also enables the business to negotiate with the financial institution regarding loan repayment terms. Fourth, debt financing enables the business to develop effective financial plans (Nukala & Rao, 2021). The business can hire competent, skilled, and experienced employees to implement its plans. After assigning all employees roles based on their expertise, the business can allocate sufficient resources to different departments and teams to facilitate the implementation of the plans. The business can also develop timelines and schedules to enable timely completion of the objectives. The business can also establish a robust monitoring and evaluation program to assess its success and effectiveness. The results of the evaluation will influence better decision-making and strategy formulation to achieve the business’ financial objectives. The fifth benefit of debt financing is that it enhances the credit worthiness of the business. Enhanced credit worthiness implies that the business can access additional credit easilyINCORPORATE THE COMBINED ATTRIBUTES OF DEBT AND EQUITY GIVEN A COST OF CAPITAL MODEL 4 and conveniently. Further, a good rapport between the business and the financial institution also assists in negotiations aimed at improving loan repayment terms. Improved credit worthiness also enhances attractiveness of the business to investors and firms operating in the same industry. Sixth, debt financing is a cheaper financing option compared to other alternatives such as sale of equity and retained earnings. Therefore, tax obligations are also simpler and convenient, implying that the business may incorporate technology in loan repayment. Calculate the AT-WACC with a 60% debt and 40% equity financing structure The weighted average cost of capital (WACC) refers to the cost of financing a business through capital and debt (Murphy, 2018). Capital financing of a business comprise sale of equity and debt financing. It is the purgative of the business to choose the most cost-effective capital financing method by conducting a cost-benefit analysis. The formula of weighted average cost of capital (WACC) is: (Weight of stock*Cost of stock) + (Weight of debt* After-tax cost of debt) In this case, the after-tax cost of debt is given by the formula: Interest rate of debt * (1-tax rate)