Capital structure decision and cost of capital

There are many advantages and disadvantages of debt capital. This will also depend on the type of debt capital, in normal practice long debt capital is considered to be a source longterm capital. But to some companies they may finance long term assets using short term and medium term debt depending on the nature of their business. The advantages of the sources of capital is detailed below; (a) Long-term debt This is a form of loan capital that is payable on long basis. This includes; (i) Debentures: Is a written acknowledge of a debt by a company containing provisions

of interest and the terms of repayment of principal. This can be secured, unsecured, irredeemable, or redeemable. Secured debt will carry charge on one or more specific assets or all assets of the company such that on default of repayment of interested principal, the debenture holder will appoint receive to administer the assets until the interest is paid eventually they can sale the asset to repay the principal. Redeemable debt is where the principal is repayable at a specified future date whereas irredeemable is the opposite. (ii) Preference share: Is a form of financing whereby shareholders are paid a fixed rate of

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dividend after creditors but before ordinary shareholders. This can be Cumulative preference shares where shareholders are paid a fixed amount of dividends and arrears accumulate. Non- cumulative where they receive a fixed rate of dividend but arrears does not accumulate. Advantages (i) Cheap – because is less risky, debenture holders can accept a lower rate of return. (ii) Cost is limited to the stipulated interest repayment. (iii)There is no dilution of control where debt is offered since no voting rights. Disadvantages (i) Interest is a compulsory default will mean selling the company securities or the

company will go under receivership. (ii) It is limited since the shareholders are concerned that a geared company can not pay its interest and still pay its dividend and raise the rate of return that they require from the company to compensate for this risk. (iii) Provision must be made for the repayment of debt with fixed maturity rate. (iv) If the general interest rates fall, fixed rate interest payments may prove to be a burden. (b) Short and Medium Term Financing Short -term is a form of financing whose period of repayment is up to one year. Medium – term is a form of financing from one year to seven years.

This form of financing is best when the finance raised is to meet a specific current requirement, which is not expected to continue indefinitely. Advantages (i) They are risky since they can be paid on demand or within the stated period and normally the duration is short whereas others can be terminated any period depending on the financial position of the company for example bank overdrafts and loans. (ii) During winding up of the company, they are given last priority since they are not secured. (iii) They have no voting rights in the company’s general control.

(iv) Flexibility – they can be sued as required for instance bank overdrafts can be sued so long as the company does not exceed the required limit. In addition, credit period can be extended depending on the goods or services supplied. (v) Liable – any company can easily access this facility so long as it meets the requirements. (vi) Not expensive – interest rates are usually above the base rate and are tax deductible. Disadvantages (i) Risky since they are legally repayable on demand or within a certain stated period depending on the financial position of the company.

(ii) Security is usually required by way of fixed or floating charges on assets or sometimes in private companies by personal guarantees from owners. (iii) Interest costs vary with bank base rates. 2. The effect of debt capital on cost of equity According to Modigliani-Miller the expected present value of a firm’s future operating income is independent of the leverage ratio of debt to firm value. Using the therefore, the use of debt capital brings the cost of overall cost capital to come down to the level that is considered optimal. This is because debt capital introduces to interest saving thus

increasing the retained earnings for the fir. This will eventually translate to increase in the share capital of firm providing funds to be utilized within when financing any capital investment project. The cost of capital V=B+S and cost of capital = EBIT V 3. The optimal capital structure is that mixtures of capital, that is debt and equity, which at the maximum debt the company can get without affecting the future continuity and the cost of capital is minimized. The main objective at the optimal capital structure is maximize the shareholders wealth and at this point, the liquidity and the risky of

technical default should be is avoided. 4. Incorporated Company’s capital structure and its cost of capital Before one determines the cost of raising new capital. He should be able to estimate the cost of overall cost of capital. Company F (ASSUMPTIONS) Source Book Value Market Value Proportions Cost (%) Product Short term debt Long term debt 6,471,000 6,485,000 0. 2857 5. 8(1-. 34) 1. 0937 700,000 1,715,000 0. 0756 4. 8(1-. 34) 0. 2395 11,515,000 14,500,000 0. 6387 11. 8 7. 5367 Equity 22,700,000 1. 0000 8. 8699 Company C (ASSUMPTIONS) Source Book Value Market Value Proportions Cost (%) Product

Short term debt Long term debt 2,500,000 2,200,000 0. 0550 5. 8(1-. 34) 7,800,000 7,800,000 0. 1950 4. 8(1-. 34) 21,000,500 30,000,000 0. 75 10. 2 7. 65 Equity 40,000,000 1. 0000 8. 8994 Company H (ASSUMPTIONS) Source Book Value Market Value Proportions Cost (%) Product Short term debt Long term debt 8,000,000 8,000,000 0. 181 5. 8(1-. 34) 11,000,000 11,200,000 0. 2534 4. 8(1-. 34) 20,000,000 25,000,000 0. 5656 12. 3 6. 9569 Equity 44,200,000 1. 0000 8. 4526 Assumption that the after tax cost of new debt as shown above is 5. 8% for the short-term debt and 4. 8%.


Carlson S; (1969) International Financial Decisions; North Holland Pub;

Gapenski l, Brigham E; (1994) Financial Management: Theory and Practice; Dryden Press.

Luecke R; (2002) Finance for Managers; Harvard Business School Press;

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