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Cost of capital (Essay Sample)

The background readings of this Module provide plenty of information regarding both the issue of the capital structure decision and the concept of the weighted average cost of capital. Consider three companies: Ford, Disney, and Electronic Arts. Reflect on the nature of the business of these three companies. You are recommended to also get to the web site of one company in each of these categories. You might also check what the beta of each of these companies is. Based on the readings of the Module, and upon reviewing the nature of the operations of the companies including the nature of their customers and products, what would you recommend should the capital structure (total liabilities or debt and equity proportions) be for each of the three companies? Note that you are not asked to provide specific numbers, just 'low debt ratio', 'medium debt ratio' or 'high debt ratio'. (Do not quote the actual company's capital structure or their debt-to-equity ratios as per their balance sheet.) Write a five page paper explaining your recommendations for each of these three companies. Consider the nature of their business, the riskiness of the company, and the advantages and disadvantages of debt over equity financing in your answers. Case Assignment Expectations In the grading of your assignment, you will be assessed on the following items: 1. The use of multiple references beyond just the links mentioned above. Those links are just to get you started, but your ability to do your own research beyond these two articles will be assessed. 2. Your ability to focus the paper from beginning to end on the precise assignment questions. Remember that the assignment question is not to provide the firm's actual capital structure, but rather your recommendation as to whether or not the firm should have a high, medium, or low debt ratio. 3. Your paper should be at least five pages in lengths. 4. Your paper should include proper referencing, both with a bibliography and references within your text. source..
Cost of Capital
For any company to operate, it needs assets which signify the wealth of the company. These assets when used by the company produce the returns that determine the overall profitability of a company. A company will thus look to determine the most cost effective method of acquiring assets such that the returns are more than the costs. This way the company is able to replace the assets when they wear off and give a decent financial return to the owners of the company.
Thus a company will be driven by factors including the cost of and the benefits that accrue to a capital structure in determining the ideal capital structure. This will also depend on the industry the company plays in, the management affinity to a particular capital financing avenue and the overall ability of the company to generate income from the capital employed.
When faced with the choice of determining the ideal capital structure of an organization, management will either take the decision to have a low debt ratio, a medium debt ratio of a high debt ratio. However, it is worth to note that the level of debt ratio is highly subjective and human driven. This means that for two managers operating in the same industry, having company’s with similar operation dynamics, a debt ratio of 20% could be viewed by one as low and another as high.
Ford motor company produces cars and trucks. As such the nature of its operations requires heavy investment in production equipments. These equipments have to be versatile and easily adoptable to changing times. Using this alone as a basis of determining the capital leverage of a company then Ford motors would ideally require to be highly leveraged. This is on the assumption that motor production does not change every so often. This is to mean there is relative stability in terms of designs and production processes. However in its operations, it has incorporated a credit component which offers financing facilities both to retail consumers as well as dealers within the Ford distribution chain. With this mind, Ford Motors needs a high debt ratio. Given that in its operations it is not exposed to extremely fluid environments as is the case of operations in the internet industries, coupled with the relatively high incidence of certainty of operations, a high debt ratio is ideal for Ford Motors. As such, given its equity base, Ford Motors can finance most of its operations on debt capital. This allows for a more long term projection and emphasis when securing debt financing.
It is imperative in the other hand to make sure that the interest on the debt is lower that the Ford Motors ability to generate income from its operations. The high debt ratio offers to Ford Motors some unique advantages in its operations. Given its long and stable history in relation to revenues, earnings and cash flow, ...
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