Capital Structure Decision and Cost of Capital Coursework

Advantages and Disadvantages of Debt Capital

There are many forms of debt finance each with its advantages and disadvantages. They are briefly highlighted below

Long-term debt

Is a source of financing whereby funds obtained can be repaid back after along period normally from eight years and above. The company pays interest and principal or dividend at stated or prescribed period. Examples of this are;

• Debentures: Is a written acknowledge of a debt by a company containing provisions of interest and the terms of repayment of principal. This can be secured, unsecured, irredeemable, or redeemable. Secured debt will carry charge on one or more specific assets or all assets of the company such that on default of repayment of interested principal, the debenture holder will appoint receive to administer the assets until the interest is paid and eventually they can sale the asset to repay the principal. Redeemable debt is where the principal is repayable at a specified future date whereas irredeemable is the opposite.
• Preference share: Is a form of financing whereby shareholders are paid a fixed rate of dividend after creditors but before ordinary shareholders. This can be Cumulative preference shares where shareholders are paid a fixed amount of dividends and arrears accumulate;

Non-cumulative where they receive a fixed rate of dividend but arrears do not accumulate.

Advantages

• Cheap – because it is less risky, debenture holders can accept a lower rate of return.
• Cost is limited to the stipulated interest repayment.
• There is no dilution of control where debt is offered since no voting rights.

Disadvantages

1. Interest is a compulsory default will mean selling the company securities or the company will go under receivership.
2. It is limited since the shareholders are concerned that a geared company can not pay its interest and still pay its dividend and raise the rate of return that they require from the company to compensate for this risk.
3. Provision must be made for the repayment of debt with fixed maturity rate.
4. If the general interest rates fall, fixed rate interest payments may prove to be a burden.

Short and Medium Term Financing

Short -term is a form of financing whose period of repayment is up to one year.

Medium – term is a form of financing from one year to seven years. This form of financing is best when the finance raised is to meet a specific current requirement, which is not expected to continue indefinitely. Examples of short-term finances are:

• Bank – overdrafts: These are usually provided by the clearing banks and presents permission by the bank to write a cheque even though the Company has insufficient funds deposited in the account to meet the cheque’s amount. The company will use this facility up to the limit placed and interest is charged by the bank on amounts outstanding at any one time, and the bank may require repayment of an overdraft at any time.
• Bank loans: This is a formal agreement between the bank and the borrower, that the bank will lend a specific sum for a specific period. Interest is charged on the whole amount for the duration of the loan.
• Trade credit: This is a form of financing where by the company can acquire goods or is able to obtain goods or services from supplier without immediate payment on agreement that the company will pay at a later date. Credit periods vary from one industry to the other. However, there are circumstances where longer periods of credit are offered depending on the types of goods or services supplied for instance, where goods supplied require a long period to be converted into saleable products for example farming.

Advantages

1. They are risky since they can be paid on demand or within the stated period and normally the duration is short whereas others can be terminated any period depending on the financial position of the company for example bank overdrafts and loans.
2. During winding up of the company, they are given last priority since they are not secured.
3. They have no voting rights in the company’s general control.
4. Flexibility – they can be sued as required for instance bank overdrafts can be sued so long as the company does not exceed the required limit. In addition, credit period can be extended depending on the goods or services supplied.
5. Liable – any company can easily access this facility so long as it meets the requirements.
6. Not expensive – interest rates are usually above the base rate and are tax deductible.

Disadvantages

1. Risky since they are legally repayable on demand or within a certain stated period depending on the financial position of the company.
2. Security is usually required by way of fixed or floating charges on assets or sometimes in private companies by personal guarantees from owners.
3. Interest costs vary with bank base rates.

Effects of debt capital

The use of debt capital brings the cost of overall capital to come down. Let me take an example of a company that does not use debt capital and calculate it cost of capita. Assume they want to raise 699,300/-. Then 100,000 will come from retained earnings. the cost of retained earnings is 14.3% , cost of equity is 14.8%, cost of debt is 5% and cost of preferred stock is 6%

WACC = w_dr_d(1-T) + w_pr_p + w_ker_ke WACC= 0X 5%( 1-0.4) + 0 X 6.1% + 599,300/699,300 X 14.8% + 100,000/699,300 X 14.3% = 14.7%

Now assume preferred stock and debt will have equal share and they are 50% of the total capital and the tax rate is 40%

WACC= 0.25 X 5 %( 1-0.4) + 0.25 X 6.1% + 249650/699,300 X 14.8% + 100,000/699,300 X 14.3% = 9.6%

From the theoretical case, we realize that when debt capital is introduced the cost of overall capital comes down.

Optimal cost of capital

Optimal cost of capital is the mixture of capital, that is debt and equity, which at the maximum debt the company can get without affecting the future continuity. At this point, the liquidity and the risky of technical default is avoided. At this point, the cost of capital is low but not very low and the interest payable is not very much.

I have chosen Home Depot (chain store), Hilton (hospitality) and ACME (clothing). For the chain store, they sell goods on cash basis. I will advise them to choose high debt for both long-term debt and short term. This will ensure the company does not risk liquidation and the annual financial commitment is not very high. The asset beta for this company should be low because the nature of business is not very risky.

The hospitality industry; I will advice them to have low debt for short debt and long term. Most of their activities depend on season and too much credit can be very risky for them.

This will ensure the company does not risk liquidation and the annual financial commitment is not very high. The operating beta for this company is expected to be medium as the business is not very risk.

The clothing industry; I will advice them to have medium debt for short debt and long term. Most of their activities depend on season and their sales will depend on the performance of the economy. This will ensure the company does not risk liquidation and the annual financial commitment is not very high. This company is likely to have a high operating beta.