The cost of capital may change when there are incremental capital requirements o

Question

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 companys 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 processes?

Explanation / Answer

(a)

Weighted average cost of capital (WACC) = Proportion of debt x Cost of debt + Proportion of equity x cost of equity.

The existing WACC depends on the proportion and cost of debt & equity that the firm has raised till date. But a new project requires additional financing, which changes the costs of funds. If more debt (leverage) is added to the firm's capital structure, two effects take place: One, interest on debt being tax-deductible unlike equity dividend, cost of debt is typically lower than cost of equity and this lowers WACC. On the other hand, as more and more leverage is added to capital structure, lenders start become cautious about further lending, since default risk of debt repayment rises with higher leverage. Therefore, after a threshold debt level, lenders may require higher return, which raises the cost of debt. Higher cost of debt starts increasing the WACC.

Therefore, net effect on WACC depends on both these factors.

(b)

As WACC increases (decreases), net present value of the proposed projects decrease (increase), making the project less (more) attractive. Therefore managers become discouraged (encouraged) to accept the project.

(c)

Acceptance of projects on basis of fluctuation of WACC is inherently risky. The project evaluation will yield different results with different WACC, rendering the analysis useless. It will have a negative effect on shareholder wealth.

(d)

Shareholders need not be concerned about managers' ethics in selecting projects as long as no principal-agent problem arises. But in presence of principal-agent problem, managers act to maximize their own self-interests even if they're detrimental to shareholder interests.

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