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genesis_presentation.pptxCost Debt and Equity
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Introduction
Information about the cost of common stock( equity) and debt will assist Genesis management in identifying viable projects by comparing cost of financing and the expected returns.
Cost of finance is important when determining the firm’s capital structure
Cost of finance helps to determine the best project to invest in when faced with multiple investment decisions.
Shareholders expect firm's shares to grow with a higher rate than the cost of equity.
Business’ cost of capital is defined as the opportunity cost of making a specific investment decision.
Genesis Energy management should focus on minimizing the cost of capital in order to increase the company value.
Debt Financing Cost
Cost of financing Genesis by debt is the rate that the firm should pay to its creditors.
Cost of debt is calculated before taking tax into account
| Table 1: Debt financing | |||||||
| Debt financing cost is calculated using the Present Value interest Factor of Annuity (PVIF) formula | |||||||
| PVIFA=(1-(1+i)^-t)/i | where i= rate and t=years of repayment | ||||||
| PVIFA=(1-(1+i)^-10)/i | |||||||
| 6.01477274 | |||||||
| Cost of Debt= | 10.50% |
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Cost of debt financing
Genesis debt financing cost is the interest expense paid on a regular basis.
Borrowing $600,000for 10 years with an annual payment of $100,000the cost of debt is 10.50% annually.
The importance of calculating the cost of debt is to determine the tax savings that Genesis will receive from claiming interest paid as business expenditure.
The cost of debt is important in determining the viability of an investment .
It is important to compare debt financing cost and of equity cost of financing in order to determine the cheaper and effective method of financing.
The cost of equity is the same as the expected rate of return that Genesis could earn from investing in a different project with the same risk.
Cost of common stock(Equity)
Equity financing cost is the required rate of return by firm’s shareholders.
It can also be defined as the cost that Genesis Energy Company is required to pay to its shareholders
A firm’s cost of common stock is computed using the CAPM.
CAPM relies on past data to predict future.
The CAPM rate can be used to discount future cash flows to determine their fair value.
The cash flow fair value is then compared with the market value.
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Cost of common stock(equity)
Genesis Energy’s cost of common stock (equity) is computed using the CAPM (Simon, 2012).
Cost of common stock (equity)_=Rf+ Market Beta x ( expected market rate of return-Rf), where Rf = US short-term treasury bills (Risk -free)
The beta represent the sensitivity of Genesis stocks’ return to the market return
Cost of equity=3%+1.39(12%-3%)=15.51%
CAPM suggests that unsystematic risk should be ignored because the firm can reduce it through diversification
The systematic (market) risk cannot be reduced through diversification because if affects all projects.
Cost of Common stock (Equity)
A beta of more than 1.0 means than the Genesis’ risk is greater than the market risk
A beta of less than 1.0 shows that a firm’s risk is less than the market risk (Peavler, 2016).
A firm’s cost of common stock is mostly above the cost of liabilities because interest expense is a tax-deductible expense(Simon, 2012).
The firm can use the cost of equity to compare with the returns from other investments to identify the most viable investment option.
One limitation of equity financing is that it is not tax deductible like debt financing.
Genesis management should select the least expensive method of financing between the debts and equity.
WACC
| Calculating WACC | |||||
| Equity/debt | Rate | Weight | |||
| Genesis total debt | $600,000 | 10.50% | 0.3 | 3.15% | |
| Common stock | $1,400,000 | 15.51% | 0.7 | 10.86% | |
| Equity and liabilities | $2,000,000 | 1.0 | 14.01% | ||
| Weighted average cost of capital =14.01% |
WACC
First step in computing the WACC is to determine the proportion of debt and equity in the firm’s capital.
Then weights of debt and equity are multiplied with the expected cost of debt and equity respectively.
Genesis’ cost of debt is shown in table 1 and the cost financing through equity is computed using the CAPM model
The cost of debt/equity is multiplied by its respective weight.
After multiplication in the previous step, WACC is arrived at by adding up the debt and equity proportions(Besley $ Brigham, 2014).
Genesis WACC is 14.01%.
WACC
This means that the firms cost of financing its operations through equity and debt is 14.01%
Genesis should consider investing in projects with an expected rate of returns greater than 14.01%
Investing in investments with a lower rate than the cost of capital will put the firm into financial risk.
The management should evaluate investment projects to determine the expected rate of return in order to compare with the cost of capital (Besley $ Brigham, 2014).
It is important to consider the cost of debt or equity as a source of capital in order to chose the cheapest method of financing
WACC is also used to evaluate a business capital structure , this can assist the management to wo work towards improving the firm’s capital structure.
Conclusion
The firm should consider its cost of debt and equity before obtaining fund for operations or buying an asset
After the determining the weighted –average cost of capital , Genesis management should adjust it to account for the specific risk profile.
Cost of financing should never exceed the expected returns.
The management should maintain a suitable capital mix in order to increase the value of the firm.
Reference
Peavler, R. (2016). Cost of Capital for a Business. The Balance, 1-2.
Scott Besley, E. F. (2014). CFIN4. New Jersey: Cengage Learning.
Simon, A. (2012). CAPM vs Behavioral Finance: Risk and return: Does behavioral finance provide better explanations than the CAPM? Munich: GRIN Verlag.
