Report on Financing Wetsuits Private Limited Company.
Report on Financing Wetsuits Private Limited Company.
Equity Beta is a signal of the consequential risk that comes from ordinary shares returns. It is also referred to as levered beta. The difference between the equity and asset beta is that there’s a positive correlation with debt amount on the financial structure of the firm. The Wetsuits equity beta is derived from
Stock’s rate of return = (2 / 8) x 100 = 25%
Market rate of return = 12%
Beta is obtained by = (Stock rate of Return – Risk free Rate) / Market Rate of return – (Risk Free rate)
This gives (25-4) / (12-4). Equity beta is therefore 2.625.
With a cost of equity equal to summation of the risk free rate + predicted equity beta x (market risk premium), we get our cost of equity as 0.04 + 2.625(0.12-0.04) = 25%.
The firm’s cost of equity is representative of the redemption that a certain market makes demand of for holding the burden of ownership of an asset. It is likely that this high cost of equity is as a result of a very positive response of the share price to the market. Moreover, shareholders and the public as a whole at times when holding shares is such a risky undertaking.
The Weighted Average Cost of capital is a computation of a company’s cost of capital whereby the capital category is correspondingly weighted. It is given as:
{Percentage of financing that is equity X cost of equity} + {Percentage of financing that is debt X cost of debt}
This gives (2 /12 *0.25) + (10 /12/ *0.08) = 0.4833
The junior manager’s suggestion is rather sensible albeit not well substantiated. The use of covariance in evaluating stocks gives investors a perception on movement of two stocks. The forecast of movement in prices for the two portfolios is bound to be a positive considering that the market return and Wetsuits share return record an above average covariance level. Moreover, the standard deviation acts as a standard assessment of risk. Covariance calculations help investors and investment analysts determine the movement of two variables. A movement that is in the same direction is indicated as positive covariance whereas a counter movement is referred to as a negative covariance.
Prudent stock market analysis requires that investors embark on minimizing potent risks for an amount taken that bears the same return. In this regard, historical prices and the differences between stocks ‘A’ returns and its average return is calculated (Weaver & Weston 2008 p31). The director’s point of view is on minimizing the Weighted Average Cost of capital. Typically, this strategy is a high risk approach. Further, this procedure insinuates that a high percentage of financing of assets will be carried out through debts. Consequently, this strategy could lead to critical financial wreckage. The use of a mix depends entirely on operating cash flows of Wetsuits as well as the stability of these cash flows.
As with any company, a serious analysis of the economy supersedes all other factors while making economic projections. In this regard, economic indicators such as gross domestic product, the unemployment rate, and inflation rates are vital areas to interpret before making debt commitments. As in the case of Wetsuits, a high inflation rate would be a negative repercussion on their debt finance as they would end up paying more for what they borrowed. Correspondingly, the behavior of financial markets where equities outperform bonds by a substantial margin would be detrimental on the valuation of Wetsuits equity.
For most major business investments, use of debt finance is inevitable. However, even when engaging in debt financing, it is essential that companies focus also on measuring the efficiency of these debts (Baker 2005 p36). Principally, debt measurements will enable top management to assess how well a company optimizes financial leverage in furthering the business and enhancing profitability. Jack’s argument that reducing debt levels will give Wetsuit flexibility, therefore, does make financial sense in that this would help to keep over-leverage in check. However, Wetsuits would also record low debt levels as a strategy to keep acceptance ratios within acceptable limits. Consequently, the company would have a chance to continue making withdrawals.
Cost of capital refers to the cost of the funds engaged in business financing. In the long run, Wetsuits major objective in the cost of capital minimization will be to enjoy a justified adaptability over its production operations. Minimizing cost of capital can be done for various reasons. One, this is an avenue for reducing the working Capital required for the business operations. With sales increase, there is subsequent availability of capital for debt reduction and other projects (Fabozzi & Peterson 2003 p73). Moreover, minimizing cost of capital enables companies use bank debt in a more cautious manner. Minimizing costs is enormously effective as it will enable Wetsuits to use cash management services as a way of minimizing borrowings. The fundamental objective of businesses is to make profits. A balance of price and output is, therefore, required in order to determine where the highest returns can be obtained. Consequently, striking a balance between two will ultimately lead to increased sales and Wetsuits would be in a position to raise more capital.
Moreover, for firm maximization to be effective, use of the cheaper source of funds is a sound strategy. In this case, with the interest rates standing at 5% while that of bonds going at 8%, it is better to take the former. Also, Wetsuits should consider the 45% leverage in that taking debts that significantly reduce their leverage level would consequently reduce their efficiency. Financing an investment by retained earnings is undoubtedly the most preferred source of funds. Retained earnings refer to the profits that a business makes but keeps in the business for re-investment.
First, finances raised by retained earnings do not increase a company’s debt profile. Secondly, the organization enjoys control over its operations as it does not have to deal with the stringent rules from creditors and other external financers. Furthermore, use of retained earnings enables quicker expansion of businesses as profits earned are reinvested in the business expansion (Khan & Jain 2007 p57). For investors, remarkable market value gains imply that management can be entrusted by the investors to make good use of the retained capital.
Noel’s proposal to use short-term borrowing to invest in long term fixed assets is rather flawed. Ideally, long-term debts are best suited for making of term investments in fixed assets (Weaver & Weston 2008 p179). However, equating the loan term and the life of an asset is an essential principle that every investor should master. The implication of this strategy is that Wetsuits may reach a point where they have no money for working capital. On the other hand, Jack’s argument may be financially sound on the consideration that it is less risky since they are not under an obligation to pay back. Besides, the investors involved normally perceive the investment as long-term and, therefore, do not expect immediate repayment of the amount borrowed.
Essentially, equity entails the ownership claim in a company divided amongst the preferred and ordinary shareholders. The implied cost of stock issue is the required return on investments that the investors expect. The increase in price of stock, accelerated by growth in earnings per share added with the dividend payments gives the return on common stock (Khan & Jain 2007 p96). It is interesting to note that in as much as dividends are an enticement to stock buyers; they do not have any surety.
They may, therefore, change periodically. With this concept in mind, we can deduce that it is not an obligation for companies to pay dividends. Consequently, this implies that an equity is much safer than debt since these companies are not obliged by shareholders to pay them dividends and failure to do so does not amount to a default. This, therefore, explains Jack’s argument on why he thinks financing investments by equity is safer than financing by debt where interest is guaranteed and dividends are not. In the event they opt to finance by debt, it can reduce leverage by embarking on long term borrowing to cater for long term investments.
A careful consideration of the equity versus debt issue helps in determining the WACC. The weighted average cost of capital weighs each source of capital by the amount that is spent up. It is, however, based on various assumptions. The assumptions are that it is a market driven and a function of the investment and not the investor. Moreover, it’s assumed to be based on expected returns and measured in nominal terms. It is not measured by book value, rather, it is measured by market value (Baker 2005 p124). A company that seeks to operate efficiently will prioritize on minimizing its WACC so as to reduce the cost of financing its operations.
A proper analysis of the debt to equity ratio of the Wetsuits helps us obtain an overview of its capital structure and hence enables us to compare the risks and opportunities involved. If Wetsuits go ahead with the right’s issue, the Earning per share will automatically get halved (Bierman & Smidt 2003 p70). Consequently, the market price will reduce to half its earlier level to indicate a change in earnings per share. Therefore, the implication of this is that it dilutes earnings with respect to the bonus issue and hence affects the market price negatively.
REFERENCES
BAKER, H. K., & POWELL, G. E. (2005). Understanding Financial Management a Practical Guide. Oxford, Blackwell Pub. http://public.eblib.com/EBLPublic/PublicView.do?ptiID=243549
BIERMAN, H., & SMIDT, S. (2003). Financial management for decision making. Washington, D.C., Beard Books.
FABOZZI, F. J., & PETERSON, P. P. (2003). Financial Management and Analysis. New Jersey, John Wiley & Sons. http://public.eblib.com/EBLPublic/PublicView.do?ptiID=162787.
.KHAN, M. Y., & JAIN, P. K. (2007). Financial management. New Delhi, Tata McGraw-Hill.
WEAVER, S. C., & WESTON, J. F. (2008). Strategic financial management: applications of corporate finance. Mason, OH, Thomson/South-Western.
