A Corporation has following capital structure. Debt 10 millions Equity 15 millions The company’s cost of debt is 10%. The risk free return is 7%, market risk premium is 5% and the beta of the company is 1.5. The tax rate is 35%. The company is in need of money of 10million.. The chairman of the company is of view to increase this amount through debt. Required: a) Should the firm make the change through debt? b) What if the company raise money through issuance of shares?
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
A Corporation has following capital structure.
Debt 10 millions
Equity 15 millions
The company’s cost of debt is 10%. The risk free return is 7%, market risk premium is 5% and the beta of the company is 1.5. The tax rate is 35%.
The company is in need of money of 10million.. The chairman of the company is of view to increase this amount through debt.
Required:
- a) Should the firm make the change through debt?
- b) What if the company raise money through issuance of shares?
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