Sample Research Paper on Cost of Capital and Capital Working Management

INTRODUCTION

Firms have widely made use of capital structure to ensure they are able to strike a balance
between equity and debt financing. Firms that are in the high risky industries, have opted to
use more of debt finance rather than equity financing (Peter et.al 2011). Research has shown
that most firm fearing for liquidity and solvency problems, have opted to make use of equity
financing.

Other firm have had high application of working capital management techniques through
which they have been able to manage their businesses (Murray 2016). It has been reported
that firms with proper working capital management systems have been able to sustain their
business in the future. According to Murray (2016), different approaches used in working
capital management have seen most firms improve their efficiency as well as their future
sustainability.

The current analysis will thus make reference of CMS company to assess the cost of capital,
the best weighted costs of capital that can be achieved, and evaluate working capital options.

Weighted average cost of capital (WACC)

Research has been conducted with respect to WACC and it has widely been referred to as the
overall cost of capital that can be employed in a firm. It has been used as the overall to cover
an average of the different cost of capital that can be developed (Murray 2016). Thus it has
been calculated as a percentage cost of the different capital components. Therefore, it gets the
market value weight attachment. It is thus given by:

W.A.C.C = 
















V
D
TK
V
P
K
V
E
K
dpe1

Where:

K e , K p and K d = Percentage cost of equity, preference share capital and debt capital
respectively. E, P and D = Market value of equity, preference share capital and debt capital
respectively. Market value = Market price of a security x No. of securities. V = Total market
value of the firm = E + P + D.

The cost of the different items is calculated using the Gordon model that has widely been
used to determine the cost of different components. The assumption of the model is that there
is zero growth associated with the model (Murray 2016). The results from the analysis
attached in appendix 1 reveal that the cost of equity is 7.3%, the cost of preference
shareholding is 15%, and the cost of debt is 5.6%. This is an indication that the firm make
application of equity financing more than the debt financing.

The market value of equity was found to be 46,800. That of preference shares to be 0.40, and
that of debt was 3,000. Again, this indicates that the value of equity is high above.
Consequently, the firm is able to leap more for having made use of equity financing. This has
an implication on the market price of the shares which could go up and thus attract a lot more
investors to engage with the firm. The WACC was found to be 7.197% which is indicative of
the rate the firm would be willing to pay if they were to acquire funds. In evaluation of
projects, this would be the minimum rate of return that the firm would be willing to take for
investing in a given project.

The company cost of capital would thus be 7.197%. This would be used in determination of
whether investments are worth taking for the company. The use of the method ensures that a
firm comes up with a cost of capital that is relative to its financing. However, the method has
been criticised widely. This has mainly been on bases of its assumption that the business risk

equals the project risk. In the world filled with a lot of uncertainty, the risk could be different
which compromise the use of the method. In addition, it assumes that the cost structure is
optimal without evaluation of performance indicators which may lead to a cost of capital that
is inappropriate (Murray 2016). Also, it is based on past information and thus cannot be an
appropriate measure to undertaking future proposals.

Cost of equity and debt compared

The cost of equity for the firm is 7.3% and that of debt is 5.6%. The cost of equity is thus
higher than the cost of debt. This is an indication that the firm has high reliance on equity
than it relies on debt. The cost of equity has been seen as the cost of raising capital through
stock. While the cost of debt is the cost of raising capital through debt financing. Research
has shown that the cost of debt should always be maintained lower (Michael and Phillip
2002). This is because its interest is tax deductible.

In addition, debts are taken and should be repaid back with an interest. The interest is the cost
of being given the capital to use. However, in the case of equity, people make investments
and in the case of ordinary shareholders, they earn returns from their investments in form of
dividend. Therefore, for the debt capital, it must be repaid (Philip 2012). Consequently, firms
should ensure it is maintained low in order to ensure they are able to repay when the debts
fall due.

The other reason has been the examination of both terms. The cost of equity reflects
ownership while the cost of debt makes a reflection of an obligation. For this reason, firms
should ensure they lower their level of obligation. Therefore, issues a lot of shares to raise
capital through stock. Research has shown that stock building leads to improved
sustainability of a firm (Michael and Phillip 2002).

Also, the risk of having higher equity is lower than that of debt. Since shareholders reflect
ownership, they do not have to be paid dividends (Michael and Phillip 2002). Thus they
receive balances from the earning made by the firm. On the other side, debt capital has to be
repaid and is a mandatory under the law. Thus firms opt to have higher equity to reduce their
risks which is evident in CMS.

Financial managements and optimal capital structure

An optimal capital structure has widely been seen as a match in the different sources of
financing. Including the equity funding as well as the debt funding. Firms have been asked to
ensure they lay a balance between equity and debt financing to ensure they have sustained
performance.

Financial management engages the art of controlling, managing, monitoring, planning, and
directing. The functions are directed towards effective procurement and utilisation of funds.
Therefore, firms have to decide on the sources of funds as well as the projects they should
prioritize on (Franck and Usha 2004). This means that they have to set an optimal structure
which would enhance their performance ability.

An optimal structure is influenced by availability of securities with firms having less
securities relying more on debt. The structure is also influenced by the cost of the finance.
Most firms opt for debt financing where its costs are set at low levels. In addition,
competitiveness of the industry where the firm is located. Most firms in high risky industries,
opt for high risky investments and thus take more of debt capital. Therefore since FM has
been seen to make application of the most efficient means in optimal management of
resources, then capital structure management become a core of operation (Franck and Usha
2004).

Working capital management

Factoring is a financing model that has been applied by a lot of firms in the recent past. A
factoring company offers instant cash to firms. The factoring companies give cash to firms,
and payment is in form of slow-paying invoices (Franck and Usha 2004). In most cases, the
factoring company purchases the receivables of a firm, and receive payment once the debts
are settled. In return, the company selling its receivables is able to acquire cash from the
factor to settle its expenses.

Therefore, factoring has a wide range of advantages including; it is able to offer instant cash
to the firms in need. Through the firm’s receivables, a firms is able to trade them for cash. In
addition, a firm is able to manage its credits better. This is because, all receivables need to be
settled to pay off cash given by the factor. Consequently, firms follow up for all debts
reducing the number of bad debts (Michael and Phillip 2002). The financing is easy to
acquire since it requires less formalities and only relies of receivables. Also, as the debtors
increase, the financing can as well increase. Therefore, offers an effective way of acquiring
funds within a short time. Therefore, it is a short-term financing solution and can be used by
firms to settle their short-term liabilities, and recurring expenses.

There are a wide range of activities that can be undertaken by a factoring firm including;
trucking, brokerage, and business management services, staffing, manufacturing, and
wholesaling.

From the analysis attached in appendices 2, it is clear that the firm should take the factoring
option as it lead to an overall increase in the amount they would be saving totalling to
$467,416. The analysis showed that the factoring is financially acceptable to CMS. This is
because it leads to an overall reduction in cost. From the analysis it is clear that bad debts

would decrease, the days taken to collect credit would also reduce, and the total number of
debtors would be reducing. Despite the associated costs of the factoring, the costs would be
taken as the transaction costs of having the system in operation. Therefore, offer a better
solution to the firm as it would be able to manage its receivables in relation to the number of
debtors held, and the days taken to collection of the debts. This is in line with discusses
implications of making use of a factoring.

Working capital management approaches

When making financing for the current assets, it has been important to make decisions as to
use of current or long-term funding options. Therefore, engaging three major approaches
including; matching, conservative, and aggressive. The methods are distinct in their approach
and firms make choices of the method to adopt.

The conservative approach goes beyond an exact matching of the asset useful life to the life
of the financing option. Therefore, it takes up the long-term financing option. Thus, a firm
finances all of its permanent assets and part of its temporary assets through long-term
financing (Vikash et.al 2016). Hence the approach is a low return, low risk. This is because it
makes use of long-term funding that are expensive, though repaid within a long time period.

The aggressive approach on the other hand is used by firms when most of its assets are
financed through short-term funding. Thus all of the temporary assets and part of the
permanent assets are financed through short-term financing. The approach is high risky,
though engaged with high returns (Vikash et.al 2016). The funding are less expensive though
they are repaid within a short period.

The implication of CMS making use of the aggressive approach would mainly be in relation
to payment period, risk, and returns. On the positive side, the aggressive approach would

have a high return implication. However, they should take caution since the approach is
highly risky and should be repaid within a short period. Therefore, adopting the approach
would require CMS to take few loans so that they do not fall due at the same time leading to
liquidity issues.

CONCLUSIONS AND RECOMMENDATION

From the analysis it can be concluded that cost structure is a useful tool for a firm. This is
because it would help firms in evaluation of it performance position. In an event a firm is
interests with evaluation of projects to invest into, they would make calculations of the cost
of capital and take projects that would guarantee higher returns. It was also realised, that cost
of equity should be maintained higher that the cost of debt. This is because, a firm should
seek more of its financing from equity as they are less risky. In relation to working capital
management, firms should undertake policies that are best to reducing their overall expenses
and thus making the firm more efficient in management of cash, debtors, and inventory.

Therefore, the analysis recommended the use of factoring for CMS which would lead to an
overall reduction in costs. The recommended cost of capital for the firm is 7.197%. and the
firm should take factoring as a source of financing thus engage in aggressive working capital
management approach.

Word count: 2076

REFERENCES

Bancel, F. and Mittoo, U.R., 2004. Cross-country determinants of capital structure choice: a
survey of European firms. Financial management, pp.103-132.

Brusov, P., Filatova, T., Orehova, N. and Brusova, N., 2011. Weighted average cost of capital
in the theory of Modigliani–Miller, modified for a finite lifetime company. Applied Financial
Economics, 21(11), pp.815-824.

Ehrhardt, M.C. and Daves, P.R., 2002. Corporate valuation: the combined impact of growth
and the tax shield of debt on the cost of capital and systematic risk. Journal of Applied
Finance, 12(2), pp.31-38.

Frank, M.Z. and Shen, T., 2016. Investment and the weighted average cost of capital. Journal
of Financial Economics, 119(2), pp.300-315.

Ramiah, V., Zhao, Y., Moosa, I. and Graham, M., 2016. A behavioural finance approach to
working capital management. The European Journal of Finance, 22(8-9), pp.662-687.

Valta, P., 2012. Competition and the cost of debt. Journal of Financial Economics, 105(3),
pp.661-682.

APPENDICES

Appendix 1: weighted average cost of capital determination

W.A.C.C = 
















V
D
TK
V
P
K
V
E
K
dpe1

Where:

K e , K p and K d = Percentage cost of equity, preference share capital and debt capital
respectively.

E, P and D = Market value of equity, preference share capital and debt capital respectively.

Market value = Market price of a security x No. of securities.

V = Total market value of the firm = E + P + D.

Estimation of the cost of capital

The cost of the different items is calculated using the Gordon model that has widely been
used to determine the cost of different components.

This is the rate at which the firm would give up its capital stock. It is given by;

g
P
gd
Ke

0
01

Where d o = the DPS (divided per share, g= the growth rate and p 0 = MPS (market price per
share)

For CMS, d o = $0.38, p 0= $5.20, and g=0.

K e = = 0.073 = 7.3%

The cost of preference shares

Preference dividend per share is given by the rate of preference divide by the par value;

P d = 6%* 1= $0.06

MPS p = $0.40

K p = DPS/ MPS; P d / P p

0.06/0.40= 0.15= 15%

Cost of debt

The bond have a 6 year maturity period, thus it is redeemable and hence the cost of debt
equal the yield to maturity

Therefore


21
1

1
//

d
d

d

VM
nVMTInt

RYVTMK



Where: K d = % cost of debt

T = Corporate tax rate

V d = Market value of a debt

M= the maturity value

N= maturity years

Vd= current market value of the debt= par value= $105

Interest charge for the bond id 8%*105= 8.4

Tax rate= 30%

= = 5.88/105= 0.056= 5.6%

Determination of the market value of capital

Market value of equity (E)= MPS*no. of ordinary shares

= 5.20* (4,500/0.50)= 46,800

Preference shares market value (P)= $0.40

Debt capital market value (D)= Vd*no. of bonds

=105*(3,000/105)= 3,000

V(total market value)= E+P+D= 46,800+0.40+3000= 49,800

Weighted average cost of capital

W.A.C.C = 
















V
D
TK
V
P
K
V
E
K
dpe1

7.3% (46800/49800)+ 15%(0.40/49800)+ 5.6%(3000/49800)

=6.86%+0.00012%+0.337%= 7.197%

Appendix 2: working capital management

Evaluation of the factoring option

Credit sales= $28,165,000

Days in trade receivable= 40 days

However, customers have been taking longer.

Bad debts= 1%* $28,165,000= 281,650

Current trade receivables = $3,500,000.

Factor One Co, proposal;

Plan to have days in trade receivable at 35 days

Reduce bad debt by 85%; this means that bad debts would reduce to 15%*281650= 42,248

Reduce administration cost by $60,000 per annum.

As a factor, the would provide 80% of the receivables (0.8*$3,500,000.= 2,800,000). The
financing would be offered at an interest rate of 9% par annum (9%*2,800,000= 252,000).
The annual fee would be 0.75% of credit sales (0.75%*28,165,000= 211,238).

Forgone profits (6%*2,800,000= 168,000

New debtors = days
periodCr
365
.
x cr. Sales p.a

= 35/365*28,165,000= 2,700,753

Credit analysis and debt collection cost

Current policy Factoring option Difference
Decrease in bad debts 281,650 42,248 239,402

Decrease in debtor 3,500,000 2,700,753 799,247
Decrease in days in trade receivables 40 35 5
Decrease in admin cost + (60,000) 60,000
finance cost 0 252,000 (252,000)
annual fee 0 211,238 (211,238)
Foregone profits 0 168,000 (168,000)
Net befit 467,416