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A company may raise debt financing either through bank loans or bond issues.
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A company may raise debt financing either through bank loans or bond issues. In both types of borrowing the interest rate may be either fixed or floating. If the rate is floating, then an index is used to determine the interest payments for each period.
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LIBOR stands for London Interbank Offered Rate.
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In bond issues if the interest rate is floating and not fixed, then it is called as an indexed bond. The index can be any economic indicator but mostly it is a price index, such as the inflation rate, the oil price or the gold price index.
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Apart from indexed bonds, companies may issue convertible or callable bonds. Convertible bonds give the bondholders the right of converting the bonds into common stocks of the company at a predetermined conversion rate.
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Working capital requirements should be financed with short-term funds through commercial paper issues, whereas fixed asset investments should be made with long-term borrowings such as corporate bond issues.
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The cost of equity is the return a company requires to decide if an investment meets capital return requirements.
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A firm uses cost of equity to assess the relative attractiveness of investments, including both internal projects and external acquisition opportunities.
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Common equity financing is raised either by issuing new shares or by retaining the net income earned. The former is external financing while the latter is an internal source.
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The CAPM estimates the required return of a stock investment in relation to its systematic risk which cannot be diversified away in a portfolio context.
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The starting point in calculating the required return is the estimation of the risk-free rate (krf). In real life, there is no totally riskless investment. However in any economy, the securities issued by the Treasury are free of default risk.
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Secondly, in CAPM applications the estimation of the market return, hence the market risk premium (MRP) which is the expected market return minus the risk-free rate is essential. Thirdly, the beta of the stock in question is determined. As a final step, after the estimation of all the parameters in the CAPM equation, the required return on the stock is computed, which is the cost of the common equity.
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The bond-yield-plus-risk-premium approach provides a practical but highly subjective solution to the estimation of the cost of equity. The approach is based upon adding up a risk premium over the firm’s bond yield.
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The WACC estimation should be based on the market values of the capital components since investors require to be compensated on the full amount of their investments at stake which is the current market value of the investment.
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In order to estimate the marginal cost of capital, firstly the amount of the additional new capital that raises the cost of capital is to be determined. Then the weighted average cost of capital is calculated at that amount of new capital raised.
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The net income approach advocates that a firm can boost its value by lowering its WACC, which is possible by increasing financial leverage in its capital structure. In this approach, it is assumed that the cost of debt is always less than the cost of equity and that the increase in the debt ratio does not lead to a change in the risk perception of the investors.
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Firms raise equity funds from their shareholders, who own a direct share of the net income and the net worth of the company. As shareholders hold residual claims on both the earnings and the assets of the business, they bear more risk than the creditors. Therefore, equity financing becomes more expensive than debt financing. Furthermore, as more debt is raised, the risk borne by the shareholder’s increases, leading to a higher cost of equity.
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There are many factor explainin it but the main factors are listed below: • Shifts in the demand for the products/ services of the company. Higher volatility of demand for the products/services of the firm escalates the business risk. • Fluctuations in thesales price dueto market volatility. Firms operating in markets with high output price variations are prone to higher business risk. • Changes in input costs. Uncertainty and excessive volatility in input costs raise the business risk. • The cost structure of the company, especially the level of the fixed costs in total costs which are measured by the degreeof-operating leverage (DOL). If the DOL is high, the firm will be exposed to higher business risk. • The ability to adapt cost-effective measures to changes in both the input costs and output prices. Some firms can quickly implement cost-effective processes to adjust to the fluctuations in input costs or output prices. This ability reduces the business risk faced by the company.
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The value of the firm is measured as the sum of the value of the firm’s equity and the value of the debt.
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Asymmetric information occurs when one party from a financial transaction has different information than the other.
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The model assumes that the cost of debt, the WACC and the value of the firm is irrespective of financial leverage. The value of the firm is its net operating income which is also independent of leverage, capitalized at the constant WACC. Therefore, the firm value will remain unchanged by the financing decisions under the assumption of no corporate taxes. The cost on the borrowings is a constant no matter the amount of debt capital. However, utilizing higher levels of financial leverage in the capital mix increases the risk borne by the shareholders. As a result, the cost of equity rises relative to the increase in leverage, but the rise in the cost of equity is offset by the lower cost on the borrowings. Hence, the WACC remains constant at all possible levels of leverage
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Each firm has unique features affecting its asset structure, risk appetite, and competitive strength. The firm age, size, and its legal status are among other elements that impact capital structure. Additionally, the performance of the company, its short and long-term solvency, its level of leverage determines its creditworthiness. Credit-worthy businesses can have easy access to available funds both in debt and equity. Thus, they will enjoy more flexibility in capital structure decisions.
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Financial leverage is an indicator of financial risk and occurs in case of borrowing. Financial risk is the additional risk borne by the stockholders when the company raises debt financing.
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Bankruptcy risk refers to the likelihood that a company will be unable to meet its debt obligations.
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Value of STU (levered firm)=$50,000+$60,000=$110,000 Value of LMN (unlevered firm)=$100,000 Value of LMN=Value of STU+$10,000=$100,000+ ($50,000*0.20) If you have 10% of the shares of LMN (unlevered firm), your shares will be worth: 0.10*$100,000=$10,000 and your share of the income will be: 0.10*$10,000=$1,000 If you have 10% of the shares of STU (levered firm), your shares will be worth: 0.10*($110,000-$50,000)= 0.10*$60,000=$6,000 and your share of the income will be: 0.10*($10,000-(0.06*$50,000))= 0.10*($10,000-$3,000)=$700
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