You have recently joined a company, Felicia & Fred, as a financial analyst. The

Question

You have recently joined a company, Felicia & Fred, as a financial analyst. The company is headquartered in New England and manufactures unique fashion jewelry. It prides itself in the U.S. domestic production of these quality accessories, which are in high demand among its customers. The owners took the company public last year; hence, it is presently financed exclusively by equity. Despite the provision of equity capital, the company’s manufacturing capacity still falls short of achieving production adequate to suffice demand. The company plans to raise additional capital for further expansion of manufacturing facilities by customizing and refurbishing a large former mill building. Identify two considerations which the company should contemplate if new debt were incurred by reflecting on the following questions: What likely effect would the incurrence of debt have on the weighted average cost of capital? What likely effect would the incurrence of debt have on the acceptance of expansion projects?

Explanation / Answer

Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. Incurrence of debt will lower the weighted average cost of capital. Debt is used by many corporations and individuals as a method of making large purchases that they could not afford under normal circumstances. Debt is the least expensive source of financing the project when compared with equity or preference capital. Also servicing of debt (interest payment obligations on outstanding debt) enjoys tax shield and post tax cost of debt is considered for calculating weighted average cost of capital since cost of equity is post-tax. The level of interest rates will affect the cost of debt and, potentially, the cost of equity. Hence higher the proportion of debt in the overall capital structure lower is the weighted average cost of capital. However a very high proportion also increases the risk in the business as the considerable amount of profits earned by the organization will result into servicing of debt in the form of interest and repayment of principal.

What likely effect would the incurrence of debt have on the acceptance of expansion projects?

Expansion of project can be funded solely through equity or through a mix of debt and equity in order to take the advantage of tax shield and maximize profitability thereby maximizing return on equity. The minimum WACC is the level where stock price is maximized. While there is a tax benefit from debt, the risk to the equity can far outweigh the benefits

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