Question

Provide an analysis of the the costs of using debt and equity financing (include definitions). Also evaluate the criteria used when making financing decisions.

Answer 1

Cost of common stock (r_s): r_s represents cost of common stock. This represents the rate of return which is expected by shareholders. Cost of equity means the price (includes dividend) a firm pays for equity capital.

Cost of debt (r_d): r_d represents cost of debt. Cost of debt is straight forward understanding about borrowing cost a firm bear. Equation: r_d = Outstanding loan x Rate of interest. Cost of debt is given tax impact. Cost of debt means the price (interest) a firm pays for borrowing debt.

Weight Average Cost of Capital (WACC): WACC represents Weighted Average Cost of Capital. In nutshell WACC helps us to reach to the composite cost of capital of the firm.

Equation: WACC = w_dr_d (1 – T) + w_psr_ps + w_s r_s (New notation; T = Tax rate, w_{d =} Size of debt or weight of debt, w_ps = Weight of preference share, r_ps = Cost of preference share, w_s = Weight of common equity. Debt is given tax impact because tax benefits are availed by firms by charging debt to profit and loss. Hence that impact is negated here.

Basically, above equation give the effect of cost of each capital component. Right from common equity or equity, preference share and debt.

Debt cost comprise of rate of interest and service charges laid by lender to borrower. Long term debt can be issued in form of bonds, long term loan form banks or financial institutions. Suppose the company is issuing debt of $10,000,000 then say, interest cost be 5%. hence the cost of debt will be $ 0.5 Million.

After-tax cost is a relevant debt cost.

WACC represents Weighted Average Cost of Capital.

Equation:

WACC = w_dr_d (1 – T) + w_psr_ps + w_s r_s

Notations:

w_s= Weight of equity,

r_s= Cost of equity share,

T = Tax rate,

w_{d =} Weight of debt,

r_d = Cost of debt

w_ps = Weight of preference share,

r_ps = Cost of preference share,

Debt in above formula is given tax impact because tax benefits are availed by firms by charging debt to profit and loss. Hence that impact is negated here.

Let’s demonstrate this,

1)      Profit Loss account of a firm with debt of 10 million @5% p.a and equity be 10 million @ 7%:

Gross profit = 1 million
Interest cost = 0.5 million
Profit before tax = 0.5 million
Tax @ 50% = 0.25 million

Therefore, PAT = 0.25 million (0.5*50% tax)

We can make observation here that tax portion is getting reduced only due to impact of interest cost. If there were no debt then tax would have been 0.5 million instead of 0.25 million.

This means bringing a debt in firm reduced the taxability and enhanced returns to equity. Higher debt doesn’t increase in the PAT numbers but it gives capacity to take more projects at lower cost. Lower cost is achieved due to bringing more debt in to a capital structure. Debt has two impacts 1) It can be charged in P&L where as equity cost is not charged before tax 2) Debt costing gives one more impact on P&L that it is a cost and tax in not charged on debt cost.

That is why WACC = w_dr_d (1 – T) + w_psr_ps + w_s r_s , equation takes leverage of lowering debt cost tune to tax impact. If debt cost is 5% and tax is 50% then debt attributes only 2.5% (5% x 50%) of the cost to WACC formula.

Financing decision is nothing but to make decision on right preposition of equity and debt. Financial decision is to maintain WACC at lowest so that equity holders benefit from low cost of capital. Higher the leverage (higher debt to equity) higher the surplus for equity. Higher leverage invites financing risk. The debt roll over or refinancing the debt becomes more challenging because at higher leverage debt is more and every time at maturity of debt the management have to plan efficient replacement of the debt i.e maintaining a desirable debt cost.