EXTERNAL FUNDING AND WACC
Equity Shares This is a common long – term source of financing for the big companies. However, this form of financing is not available to all firms due to the legislations governing it. One of the key features that governs equity financing is ‘sharing of ownership rights’, which means that the existing shareholders’ privileges have to be diluted to some extent. The firm acquires Initial Public Offerings (IPOs) hence selling rights to possess shares with the exchange of money (Lonergan, 2007). The form of returns which is in bonus shares or dividends offered to its shareholders is not tax deductible therefore making it more costly compared to debt finance (Maheshwari and Mittal, 2017). Liquidity risk – for investments that are illiquid, investors get an illiquidity premium so as to compensate the stockholder for holding their investment for longer periods of time.
c. Interest rate risk – The interest rates for debentures is fixed. Therefore, investors face exposure to the opportunity cost that if interest rates were to increase, they can get better rates of return. Term loan This is a long – term form of financing. Since they last over a long period of time, term loans have low interest rates as compared to short – term loans. The interest rates of this loans are fixed. Therefore they do not vary up to the maturity date. b. With the use of term loans, a company is able to concentrate its finances on other projects since the loan is providing for the huge investments of the firm. Also, it ensures a benefit on interest charges as compared to undertaking of a loan with a fixed interest rate.
Disadvantages involved with a bank overdraft include the risk of seizing of inventory or collaterals such as shares upon failing to meet payments. Also, a reduction on the limit or a withdrawal of the limit happens if the firms’ financials show poor performance. Higher interest rates are incurred if a company withdraws an overdraft that is higher that the limit allocated. Venture capital. It is therefore essential to analyze the costs associated against the benefits of each source of financing. Some of the factors to consider upon choosing a source of financing and one that is most suitable for the company include: 1. Cost The cost of obtaining financing and its effect on the income plays a critical role in the decision making process.
Such costs include brokers’ fee and interest rates. The aim of choosing the right source of financing is to minimize costs associated with the financing as well as maximization of wealth of shareholders. Examples of short term financing include overdrafts and supplier credit. An important factor to consider when choosing financing is flexibility. Suppose interest rates are forecasted to be lower in the future, a firm’s management may opt for short term financing until the stipulated future time. Other long term sources of financing penalize early payments therefore short term financing sources are more preferred since there are no penalties on early payments and also offer lower interest rates. Short term financing on the other hand have to be reviewed on a consistent basis which is a demerit if the firm faces financial stagnancy and has a shortage of funds.
Startup businesses are considered to be highly risky in terms of failing in the foreseeable future and also the lack of financial records as compared to a company that has been existing. For startups, to secure a loan, a guarantor or a letter of guarantee is required. Risky businesses have lenders imposing high returns as a compensation fee. The profits and level of reserves Current businesses today prefer to relocate big percentages of their yearly profits into special reserves. This refers to holding profits in the form of funds. It is a ratio that analyses a firms financing costs and the assets attained through the comparison of equity structure and debt (Murphy, 2018). The board of the firm uses the WACC to determine whether they should acquire financing in the form of equity or debt to finance its new projects.
The ratio averages the cost of borrowing funds from sources of financing such as common stock, bonds, long – term debt and bonds (Murphy, 2018). A high WACC represents a higher level of risk associated with the firms operations. A high WACC compared to the actual returns signifies that the firm may be losing value and investors can get better returns in another market. The profits made by the firm are to be shared among the shareholders or reinvested back into the business in the form of retained earnings. An investor’s preference is influenced by a firm’s dividend policy through the dividend puzzle. The capital structure policy A firm will have the best capital structure if it is able to effectively control its capital structure.
If the firm acquires financing in the form of debt, it will consequentially increase its total cost of debt. On the other hand, if the firm manages to secure financing in the form of equity, it increases its overall costs of equity. Some of the factors on the other hand cannot be controlled by the firm. Such factors are: 1. Tax rates The cost of capital is decreased if tax rates increase. This is because an increase in tax rates decreases a firms cost of debt. Still, a firms cost of debt will be increased if tax rates increase. A company should therefore critically analyze the market conditions so as to correctly calculate its cost of capital. It is the primary goal of companies to maximize its shareholders equity.
To obtain this, the firm should seek to reduce its WACC. This is achievable through having debt as part of the capital structure. This is because debt is cheaper compared to equity whilst evading the effects of minimal gearing which means WACC can be decreased further or the effect of too much gearing which means that the company could go bankrupt or incur extra costs such as tax exhaustion or agency costs. An example is in the payments to vendors which improves the company’s credit rating. Another reason is that external financing will enable the firm to major into financial projects with high positive growth of which they cannot finance on their own. References Bank, T. International Debt Statistics 2013. Washington: World Bank Publications, p.
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