Question

Question 2.

(a) What are the two ways that companies can raise common equity? List them and explain each. (20 points)

(b) Based on the relationship between the Return on investment and Cost of capital, when should companies take or considers the project?

(c) List two types risks associated with projects

Answer 1

Answers-  

a)

The total amount raised through common shares as capital is known as common equity. Common shareholders are given preferrence after preferred shareholders and creditors. Common equity is recorded in the balance sheet.

Companies raise common equity by two methods:

Direct method: In the direct method, the issuance of equity shares is done in the open market. In Direct Listing Process, the business sells shares directly to the public without the help of any intermediaries like investment banks or securities firms. This proess does not involve any underwriters or other intermediaries, there are no new shares issued and there is no lockup period for the equity shares issued.

Indirect method: This method is done by reinvesting earnings that are not paid as dividends ie retained earnings.

b)

Return on investment (ROI) is a financial ratio used to calculate the benefit an investor will receive in relation to their investment cost.

It is calaulated by dividing net income by the original capital cost of the investment. The higher the ratio, the greater the benefit earned by investing.

The formulas for Return on Investment (ROI) are

ROI = Net Income / Cost of Investment

ROI = Investment Gain / Investment Base

One should consider the investment when the ROI is higher and if the Internal Rate of Return (IRR) is greater than or equal to the cost of capital, the company would accept the project as a good investment.

c)

The two risks associated with projects are

Cost risk

This is typically escalation of project costs due to poor cost estimating that needs to be funded and accuracy and scope creep which is when the project grows in complexity as clients add to the requirements.

Scheduling risk

There are a number of reasons why the project might not proceed in the way it was scheduled. These include unexpected delays due to natural factors, errors in estimation and delays in acquiring parts needed for project or funding delays.