Businesses base capital budgeting decisions on a Weighted Average Cost of Capita

Question

Businesses base capital budgeting decisions on a Weighted Average Cost of Capital, including Debt, Retained Earnings, Common Shares and Preferred Stocks. The weights are based in turn on the percentage of each type of capital in the Balance Sheet of the business. Consider the following information on the cost of capital and the balance sheet of ABC Inc. Long Term Debt (Bonds) $250,000,000 Common Shares $125,000,000 Preferred Stock 7% $150,000,000 Retained Earnings $275,000,000 The after tax cost of Long Term Bonds is 4.5%, Based on the selling price of common shares, share holders are expecting 12% return on their investment. The Cost of Retained Earnings is 13.5%,. What weights would you assign to each type of capital?

Explanation / Answer

Definitions In a business, capital revenue refers to the money that a business takes in and uses to produce the goods or services that it sells for profit. Capital revenue comes from many sources, including sales of products, sales of other assets, investment income, bonds and loans. In the case of bonds and loans, capital revenue is a form of equity that has a corresponding debt with the same value. Debts, which are a major category of liability, refer to all of a business's financial obligations to lenders. Calculations Calculating the value of a business's debt as a percentage of capital revenue involves a simple formula: debt divided by capital revenue, with the result multiplied by 100 to produce a percentage. If a new small business owner takes out a loan to start the business, its debt may represent 100 percent of its capital revenue until the business can earn revenue from other sources. An established business is likely to have a much lower debt percentage, though the amount varies based on each company's financial capital needs and strategies. Significance Access to a steady stream of capital revenue is essential to doing business. A small business that has no debt, but also lacks capital revenue, won't have cash flow to pay its employees, purchase raw materials or market itself. Business debt is only a problem when it exceeds the company's ability to repay it or interferes with long-term financial plans. This is why debt as a percentage of capital revenue has limited value to a business, explaining only how much of the capital revenue for a given period of time compares to the total of past borrowing. Alternatives Businesses can acquire capital revenue from sources that don't create new debt. For example, selling stock gives ownership of the company to shareholders but doesn't create a debt that needs to be paid off in the future. Stock sales raise large amounts of capital for major business expansions. A small business also can measure its debt using metri

Related Questions

Navigate

• Browse (All)
• Browse B
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.