IV. Qualitative and Ethical Considerations of Financial Analysis A. The cost of

Question

IV. Qualitative and Ethical Considerations of Financial Analysis A. The cost of capital may change when there are incremental capital requirements obtained from different sources, resulting in changes in capital structure. What qualitative considerations are important for a company seeking to raise capital? Answer this by considering the effect of leverage in your response. Specifically, what expected effects will additional leverage have on a company’s decision to accept investment projects? As the cost of capital increases or decreases, are managers more or less likely to accept capital projects? What is the effect on shareholder wealth when managers accept projects based upon fluctuations in cost of capital? Should shareholders be concerned about the ethics of managers’ selection process?

Explanation / Answer

Capital Structure is the combination of debt and equity securities that comprise a firm's financing of its assets. Each source of capital (debt and equity) involves cost. Capital structure should combine various sources into an optimum capital mix, involving the least average cost of capital and in this way helping in maximising of returns.

The following qualitative considerations are important for a company seeking to raise capital:-

1) Company should adopt that capital structure which minimises the risks such as business risks, management risks, interest rate risks, purchasing power risks etc. These risks are minimized by making suitable adjustments in the components of capital structure (debt and equity).

2) The capital structure should be designed as to preserve the the control of equity sharholders and to prevent the erosion of control from their voting rights.

3) A proper balance between fixed assets and the liquid assets should be maintained so as to ensure proper liquidity in the company.

4) There must be flexibility in order to make necessary changes in the capital structure as and when required.

Impact of Leverage:-

In capital structure decisions, the leverage (Operating and financial leverage) plays a very vital role. Operating leverage on the one side raises the operating profits, but on the other side it raises business risk too. Financial leverage quite prove dangerous when the cost of debt is more than the overall return of funds. More financial leverage results in more financial risks. Thus, increase in leverage results in increase in returns as well as risks too.

Managers are more likely to accept the capital projects when the cost of capital decreases. The shareholders wealth will maximize in long-run if managers spend their time and efforts in accepting projects based upon fluctuations in cost of capital. Thus, accepting the projects at the time when cost of capital decreases.

Yes, definitely, Shareholders should be concerned about the ethics of managers’ selection process as will have the ultimate impact on the Shareholders wealth.

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