Question

Explain the concept of a weighted average cost of capital and a minimum cost level of leverage. Contrast the equilibrium theory and pecking order theory approaches to explaining a firm’s capital structure. How applicable are these theories to agricultural finance?

Answer 1

WACC weighted average cost of capital is the minimum rate of return required to create value for the firm.investors of equity, debt, preference share except have sufficient reasons to continue investing in the firm if it unse auraton equal to or more than wscc.it can be calculated using a simple formula just like all the other concepts it also has a certain advantages and limitations.

The main advantage of using WACC for evaluation of project is its simplicity. The same rate can be used for all the projects which will obviate all the individual projectwise different calculation.

The main limitation of using WACC is that it does not take into consideration the flotation cost of raising the marginal capital for new projects. Another problem with w ACC is its impractical assumption of the same capital makes which is very difficult to maintain.

A leverage ratio is any one of the several financial measurement that look at how much capital comes in the form of dept loan or assesses the ability of a company to meet its financial obligations.

Operating leverage is a measure of how much dept a company uses to finance its ongoing operations.

Companies with high operating leverage must cover a larger amount of a fixed cost each month regardless of whether they sell and units of product.

Low operating leverage companies may have high cost that vary directly with their sales but have lower fixed cost to cover each month.

The pecking order theory of capital structure is one of the most influential theories of corporate finance. The purpose of this study is to explore the most important factor on the forms capital structure by pecking order theory.

The result indicated the determinants of capital structure are profitability and growth rate the profitability negatively affect on capital structure it implies that forms prefer to use their earnings to finance business activities and thus use less debt capital. Growth rate positively effect to capital structure.The greater growth opportunity will have more capital structure to finance the growth. Equivalence theory of capital structure of bank and forms develops.The Liquidity quality serviceso bank deposits make deposits a cheaper sources of funding than equity.

Historically the agriculture sector has been of vital importance to society.The sector has since like many other witnessed modernizing changes that affect its operation and requirement of capital agricultural sector has witnessed was structural changes in recent year the trend is fear and bigger from that can utilise economy of scale it is illustrated by the fact that during last recent years the total number of agriculture farms have stood up for the bigger change and while cultivated area virtually unchanged.