Debt/Equity Mix Simulation

Essay by amc8109University, Bachelor's April 2008

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The purpose of this paper is to summarize the "Determining the Debt-Equity" simulation. This paper will address each major phase of the simulation to include the scenario and the recommended solution(s), including why that decision was made. This paper will discuss capital structure concepts addressed in this simulation. This paper will address the importance of the weighted-average cost of capital (WACC) to an organization, the impact of WACC on capital budgeting and structure, and the risks and uncertainty related to capital budgeting.

Recommended SolutionsAs part of the simulation exercise (UOP Week 3 Assessment Simulation), each student assumed the role of coffee shop owner in Minneapolis, Minnesota. The name of the shop was El Café and has been open for three years. The time has come to look at expanding El Café into a chain of coffee shops across the city.

The first scenario asked for the appropriate debt-equity mix to finance the expansion, using the WACC as the benchmark.

The recommended solution was to take the debt-equity ratio to 70% debt - 30% equity with a WACC of 8.65. This balance leveraged the higher debt which in turn kept the WACC to a low number. Prohibiting the equity to be 100% debt reduced the risk of default on debt repayments.

The second scenario requested a decision on expansion plans and the optimal debt-equity plans, again using the WACC as a benchmark. The scale of expansion options were two-city, four-city and seven-city expansions. Because of previous debt amounts, financing options were limited to either all equity by using Uncle Jorge's money or incurring more debt. The correct recommendation is the seven-city expansion. With this recommendation, the debt proportion is 96.47% while equity is 3.53%. The cost of debt is 7.91%, with a 14.68% return on investment and 8.00 WACC. This strategy allows the projected rate of return to remain much higher than the WACC. Debt costs less than equity and by paying taxes now, the debt repayments reduce the taxable income.

The last scenario for El Café involves the threat of bankruptcy due to the large amount of debt. Using options that include debt-equity swap, sale of assets and debt renegotiation options, the correct recommendation needed to reduce the level of debt by at least one-third. To accomplish this, the correct recommendation included swapping 25% of the debt with equity and selling the real estate assets. The results of this recommendation brought the debt proportion to 64.64%, equity to 35.36 and a WACC of 10%.

Importance of WACCCapital investment requests require sound research, data collection and detailed documentation in order to prove that a capital request is valid and a higher priority than some of the other requests of the organization. As stated by Brealey, Myers, & Marcus (2007), the weighted-average cost of capital (WACC) is what the organization can expect as a return on investments after adjustments for tax savings that are a result of interest payments. WACC is a very important part of capital investment because it is necessary to keep an organization's portfolio strong in order to keep stockholders satisfied. Keeping stockholders satisfied and interested in an organization is critical to an organization's stability. No matter what type of security a firm holds, the WACC is still an effective way to show the financial success of a business that will help to encourage stockholders that the correct capital investment decisions have been made.

WACC Impact on Capital Budgeting and StructureIt has already been mentioned that WACC is an important part of capital investment. WACC is a tool used to determine prices and for assessing performance. WACC is the element of the pricing models that allows for a required rate of return to be earned by debt and equity security providers (Ministry of Economic Development, 2002). The WACC is the rate of return that meets investors' expectations. Using the WACC provides a better view of return on investment. It helps finalize decisions on how to finance future projects (Reference for Business, 2006).

Risks of Capital BudgetingCapital budgeting is a lengthy, detailed process that contains some risks and challenges due to the subjective nature of some of the data analysis. Because capital budgeting requires a great deal of cooperative effort, there is also a possibility of individual interests affecting the results of data analysis and ultimately the decision making process. According to Brealey, Myers, & Marcus (2007), other risks and challenges to the capital budgeting process are; the forming of alliances that drive decisions towards one project over another, incorrect or inconsistent assumptions and forecasting, forecasting bias, and difficulty in determining if a request is valid, or a bad representation of the best opportunities for the organization. The best decisions can only be made when the data to support the decisions is accurate and truly reflects the needs of the organization.

ConclusionIn determining the best mix of debt and equity, a company is faced with many constraints to the availability of capital. The weighted average cost of capital is used to evaluate an action such as expansion and the debt-equity funding decisions being made by the company will be impacted. Taking large amounts of debt lowers the WACC but could put the company on a course to bankruptcy. On the contrary, using large amounts of equity could result in a potential takeover by a competitor. To prevent either a bankruptcy or takeover, the capital structure must be altered by increasing the debt or equity based on the situation. Using WACC will help a company determine whether debt or equity needs to be adjusted and the set solution in any given situation. A company must use WACC as a tool in determining the most effective outcome for the company.

References: Brealey, R.A., Myers, S.C., & Marcus, A.J., (2007). Fundamentals of Corporate Finance(5th ed.). McGraw-Hill/Irwin, New York, NYMinistry of Economic Development (2002). Target Return. Retrieved April 6, 2008 from for Business (2006). Capital Budgeting. Retrieved April 5, 2008 from of Phoenix Week 3 Assessment Simulation (2008). Financial Analysis for Managers Simulation. Determining the Debt-Equity Mix, , . Retrieved April 6, 2008, from