The Capital Structure Decision and the Cost of Capital Essay Sample free essay sample

Advantages and Disadvantages of Debt funding Advantages The biggest advantage of debt funding is that it allows the laminitis to stay the proprietor without sharing the control with anyone else as it is the instance with equity funding. The proprietor can take determinations on his ain without holding to confer with or be influenced by anyone and therefore enjoys full authorization. The proprietor doesn’t have to portion the net incomes from operations with anyone and therefore can maintain it to himself or reinvest in the concern as it is to his ain advantage. There are no claims to the net incomes except for the installments owned to the debitor. The life of claims to the net incomes is limited till the loan is exhausted including the interested after that the full net incomes earned remain with the proprietor. in contrast to equity funding where net incomes are shared among the stockholders throughout the life of the concern. We will write a custom essay sample on The Capital Structure Decision and the Cost of Capital Essay Sample or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page As the company pays off its debt in clip it improves it recognition evaluation. which helps it to get fundss in future. as fiscal establishments prefer companies with high recognition evaluations to widen loans. The disposal of debts is easier as it does non necessitate you to execute complex processs. and fix certain studies sporadically to portion information with the stockholders. the lone disposal required is to refund the sum within the given clip restraints. The involvement disbursal is revenue enhancement deductible hence debt funding increases the net net incomes for the company. ( Ross. Westerfield. Jordan. and Jordan. 2003 ) Disadvantages The biggest disadvantage of debt funding is that it requires refunds at regular intervals which may turn out to be a hard duty for new companies as they may non hold regular hard currency flows and may default their payments and will subsequently hold to pay terrible punishments imposed through the contract. Not run intoing payments in clip will besides ache the company’s recognition evaluation and may do jobs for it to get funding in future. . ( Ross. Westerfield. Jordan. and Jordan. 2003 ) Lenders normally extend loans to established companies for their repute hence it is a job for newer companies to get loan and have to set heavy collaterals to acquire them. Interest is an disbursal that a company has to pay for the loan and it may do its interruption even point to lift and may make jobs at the clip of crisis where hard currency flows are few. The Affect of Debt funding on needed rate of return As explained by the Modigliani-Miller theorem the cost of equity additions with the addition in debt funding. This is due to a simple ground that company’s increased dependance on debt increases its exposure. because if the company is non able to run into the needed payments in clip it may hold to confront several effects including selling off of assets. hence the degree of hazard attached with puting in the company increases. For this ground the investors now requires a higher rate of return as compensation for the sum of hazard that he bears for puting in the company. ( Lacey and Chambers. 2007 ) As the revenue enhancements are included in this theoretical account the relationship between the hazard. debt and cost of capital remains the same but it raises superciliums at the company’s terminal as they witness that as debt additions replacing equity in the capital construction of a house the leaden norm of cost of capital ( WACC ) starts dropping as equity is eliminated and so is the cost attached to it and we end up accomplishing the optimum capital construction at a point where the capital construction of the house comprises 100 % of debt. This evidently holds true under the premises made for revenue enhancement payments that it will be most good for the company to wholly trust on debt for financing it undertakings. Optimum Capital Structure Capital construction refers to how a house has financed its assets. it comprises of two basic constituents debt and equity mixed in certain proportions. The optimum capital construction refers to such a mixture that maximizes the value of the house. ( Ghosh. 2007 ) There are two basic determiners of Optimal Capital Structure: The revenue enhancement deductibility advantage of debt funding acts as a major attractive force for fiscal directors to fund the assets through debt The hazard associated with higher debt to the steadfast acts as a neutralizer. hence keeping the directors to wholly trust on debt and affect equity alternatively Harmonizing to the Modigliani-Miller theorem the optimum capital construction for any steadfast comprises 100 % of debt but it is non applicable in the existent universe in fact no proper expression can be calculated for any company to compose its capital construction. It depends from company to company and from state of affairs to state of affairs. ( Lacey and Chambers. 2007 ) The Case For the nutrient supermarkets company I have chosen Wal-Mart. it one of the largest corporations in the universe in services industry. It focuses on supplying broad assortment of merchandises under one roof at the lowest possible monetary value. it targets an mean adult male with a center and lower category income while non burying the upper category every bit good. It operates all over United States and has shops in legion states every bit good. the focal point of its service is availability and monetary value hence net income borders remain low. The company can afford a high debt ratio because it has a uninterrupted hard currency flow. it increases with seasons such as the vacations but else remains consistent throughout. I recommend a high debt ratio because due to uninterrupted hard currency flows it has an increased ability to pay off its debt and hence minimising the hazard of defaulting the payments. while making so it required return on equity may increase but as the debt rep laces the equity the WACC decreases supplying an Optimum Capital construction that comprises of a higher proportion of debt. For the vesture company I have chosen Nike. it manufactures athleticss dress for both work forces and adult females. its operations are expanded all over the universe. Costss are minimized by outsourcing the fabrication to states offering inexpensive labour. it targets people involved in athleticss and promises high quality athleticss good. the merchandises offered are good priced and surely non inexpensive hence its mark market are people belonging to middle to upper categories of income. Since it is an dress company that offers exclusivity and quality it can put a high monetary value and can hold high net income borders but it can besides easy be affected by a alteration of gustatory sensation in people or loss of involvement in a peculiar athletics hence hard currency flows although high but are non that assuring. sing that the company should keep a average debt ratio as the hard currency flows will be maintained but will non be consistent still the company will be able to run int o its payments. hence the optimum capital construction for Nike should hold about equal proportions of debt and equity. ( Ghosh. 2007 ) Marriott International was my pick for Hospitality Company ; the company offers hotels at all monetary values from extremely priced suites to cheap motel suites. It attracts people who travel a batch. corporate clients and tourers. since cordial reception concern is greatly affected by the political and legion events the exposure remains high. hence the company should keep a low debt ratio sing the fact that hard currency flows are non that assuring and holding a high debt ratio will expose the company to unneeded hazard. So the optimum capital construction for Marriott International must largely consist of equity for funding. As debt is a direct index of the hazard for puting in a peculiar company hence based on my recommendations. the beta for Wal-Mart should be comparatively high. for Nike should be comparatively low and for Marriott should be comparatively lower. As all three companies are immense and have certain reputation attached to their names hence their beta should be and is comparatively low to the market. Mention: Ghosh. Arvin ( 2007 ) .Capital Structure and Firm Performance. Piscataway. New jersey: Transaction Publishers. Ross. Stephen A. . Westerfield. Randolph W. Jordan. Bradford D. A ; Jordan. Bradford ( 2003 ) .Necessities of Corporate Finance + Self Study CD-ROM + PowerWeb. McGraw-Hill/Irwin. Lacey. Nelson J. . A ; Chambers. Donald R. ( 2007 ) .Modern Corporate Finance: Theory A ; Practice. Hayden-McNeil Publication.