Unit 3 IP

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Colorado Technical University *

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Finance

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Jan 9, 2024

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Kevin Hemstreet Unit 3 Individual Project Colorado Technical University July 2, 2023

Capital Structure According to “Capital Structure Decisions: Which Factors are Reliably Important?” by Frank Murray finds that capital structure refers to the way a company finances its operations and investments by utilizing a combination of debt and equity. It represents the proportionate mix of different sources of funding that a company employs to support its activities. The key components of capital structure include debt, equity (common and preferred), and their respective proportions within the overall financing of the company. Debt refers to the borrowed funds that a company raises from various sources such as banks, financial institutions, or bondholders. It represents the company's obligations to repay the borrowed amount over a specified period, typically with interest. Debt holders have a legal claim on the company's assets and are entitled to interest payments and the return of principal. Equity, on the other hand, represents the ownership stake in the company held by shareholders. Equity can be further classified into common equity and preferred equity. Common equity refers to the ownership interest held by common shareholders, who bear the residual risk and enjoy the potential rewards of the company's performance. Preferred equity represents a class of shares with specific preferences, such as a fixed dividend payment or priority in receiving assets in case of liquidation. The proportions of debt and equity in the capital structure vary among companies and industries. The decision on the capital structure is influenced by several factors, including the company's risk appetite, cost of capital, availability of financing options, tax implications, and market conditions. Achieving an optimal capital structure is crucial for a company as it affects its financial stability, cost of capital, and ability to undertake new investments or expansions. Determining the WACC To determine the weighted average cost of capital (WACC) given the provided assumptions, we can use the formula: WACC = (E/V) * Ke + (D/V) * Kd * (1 - Tax Rate) where: E = Market value of equity V = Total market value of equity and debt Ke = Cost of equity D = Market value of debt Kd = Cost of debt Tax Rate = Corporate tax rate Using the given information: Weights: 40% debt and 60% common equity Tax rate: 35% Cost of debt: 8% Beta: 1.5 Risk-free rate: 2% Return on the market: 11% First, we need to determine the cost of equity (Ke). We can use the Capital Asset Pricing Model (CAPM) formula to calculate it: Ke = Risk-free rate + Beta * (Return on the market - Risk-free rate) Ke = 2% + 1.5 * (11% - 2%) = 2% + 1.5 * 9% = 2% + 13.5% = 15.5% Next, we can calculate the weighted average cost of capital (WACC):

WACC = (0.6 * 15.5%) + (0.4 * 8%) * (1 - 35%) = 9.3% + 2.08% * 0.65 = 9.3% + 1.352% = 10.652% Therefore, the WACC for Apex Printing Inc. is approximately 10.652%. Determining the Possibility of the Capital Project The weighted average cost of capital (WACC) is a valuable decision criterion for assessing the possibility of a capital project, as highlighted in the research study by Wang and Jin (2019). By comparing the project's expected return to the WACC, a determination can be made regarding the financial viability of the project. If the expected return surpasses the WACC, it indicates that the project has the potential to generate returns that exceed the cost of capital, thereby creating value for the company and its stakeholders. This finding aligns with the study's exploration of determining the optimal capital structure of BOT projects, specifically exemplified by the Tianjin Binhai New District Metro Z4 line project in China. Conversely, if the expected return falls short of the WACC, it implies that the project's potential returns may not meet the cost of capital requirements. In such instances, caution should be exercised, as the project may result in a negative impact on shareholder wealth or value destruction. The research by Wang and Jin (2019) further emphasizes the importance of analyzing the optimal capital structure of BOT projects to ensure the efficient allocation of resources and maximize project profitability. In summary, the research supports the notion that the WACC serves as a valuable criterion for evaluating the feasibility of capital projects. It offers insights into the alignment between the project's expected return and the cost of capital, allowing decision-makers to determine whether the project is financially viable. The study conducted by Wang and Jin (2019) contributes to the understanding of optimal capital structure determination in the context of BOT projects, providing a framework for decision-making and resource allocation to enhance project success. Cost of Capital is More Appropriate to Apply to Project Evaluation In evaluating the proposed capital project, it is recommended to primarily focus on the cost of capital components, specifically the cost of equity and the cost of debt, rather than the WACC alone. While the WACC provides an overall measure of the company's average cost of capital, it may not sufficiently capture the specific risk and return considerations associated with the project. The cost of debt signifies the interest rate the company pays on its lent funds. It reflects the fixed obligations and financial risk associated with the project. Analyzing the cost of debt allows for an assessment of the project's financial feasibility in terms of meeting interest payments and the impact of debt financing on the company's cash flow. While the cost of equity represents the return required by investors to hold shares in the company. It accounts for the project's risk and potential return on investment. Evaluating the cost

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of equity enables an understanding of the project's attractiveness to shareholders and its alignment with market expectations. The recommendation on whether to prioritize the cost of debt or the cost of equity depends on the specific characteristics of the project and the company's financial situation. If the project relies heavily on debt financing, such as in the case of infrastructure projects, the cost of debt becomes a critical factor to assess the project's financial viability and debt serviceability. Conversely, if the project offers significant growth potential or involves substantial equity investment, the cost of equity becomes more relevant as it reflects the return required by investors and the project's potential impact on shareholder value. It is important to consider both the cost of debt and the cost of equity in evaluating the proposed capital project. Assessing the project's risk profile, financial leverage, market conditions, and industry dynamics will provide insights into the appropriate weighting of these costs in project evaluation. By incorporating both the cost of debt and the cost of equity, a more comprehensive analysis can be conducted to make an informed decision on the project's feasibility and alignment with the company's financial goals and risk appetite. Defining Marginal Cost of Capital The thought of the marginal cost of capital (MCC) is closely related to the cost of raising additional funds for new investment opportunities. According to Stretcher, Funck, and Johnson (2017), the MCC refers to the incremental cost a company incurs to obtain one additional unit of capital for investment purposes. As a company raises more funds, the cost of acquiring additional capital may not remain constant but can vary. The MCC is significant in assessing the cost-effectiveness of raising additional capital for new investments. When evaluating potential projects, companies compare the expected return on the investment with the MCC. If the anticipated return exceeds the MCC, it recommends that the project is financially feasible and can produce returns higher than the cost of acquiring the funds. Conversely, if the expected return is lower than the MCC, it indicates that the project may not be cost-effective, as the cost of capital outweighs the anticipated returns. Additionally, understanding the MCC helps in evaluating the impact on the company's overall cost of capital. As outlined by Stretcher et al. (2017), changes in capital investment can lead to fluctuations in the company's cost of capital. By raising additional funds, the capital structure may shift, altering the proportion of debt and equity in the company's financing mix. This change in capital structure affects the overall cost of capital, as the costs associated with debt and equity financing differ. Therefore, assessing the MCC helps in understanding the impact on the weighted average cost of capital (WACC), which represents the average rate of return required by all capital providers. In summary, the MCC, as described by Stretcher, Funck, and Johnson (2017), refers to the incremental cost incurred to obtain additional capital for investment purposes. It is a crucial factor in assessing the cost-effectiveness of raising additional funds and comparing the expected return on investment. Furthermore, it assists in evaluating the impact on the company's overall

cost of capital by considering changes in the capital structure. By considering the non-constant nature of the MCC, companies can make more accurate financial decisions regarding capital investment and ensure efficient allocation of capital resources.

References Frank, M. Z., & Goyal, V. K. (2009). Capital structure decisions: Which factors are reliably important? Financial Management Association. doi:10.1111/j.1755-053X.2009.01026.x Stretcher, R., Funck, M., & Johnson, S. (2017). Capital investment and non-constant marginal cost of capital. Journal of Economics and Finance, 41 (1), 27-50. https://doi.org/10.1007/s12197-015-9329-3 Wang, Y., & Jin, X. (2019). Determine the optimal capital structure of BOT projects using interval numbers with the Tianjin Binhai New District Metro Z4 line in China as an example. [Determine the optimal capital structure of BOT projects] Engineering, Construction, and Architectural Management, 26 (7), 1348-1366. https://doi.org/10.1108/ECAM-07-2018-0259

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