Introduction to finance fundamentals

Calculate Touring Enterprises' weighted average cost of capital (WACC).

Work as follows: first, compute the after-tax cost of debt, then compute the cost of equity.

WACC = E/V x Re + D/V x Rd x (1 - Tc)

Re = cost of equity

Rd = cost of debt

E = market value of the firm's equity

D = market value of the firm's debt

V = E + D = firm value

E/V = percentage of financing that is equity

D/V = percentage of financing that is debt

Tc = corporate tax rate

Cost of equity 5%

Cost of debt 10%

Total Equity- 7 million

Total debt- 18 million

Total 25 million

Determine the weightings of debt and equity in the capital structure.

Equity -28% (7 divided by 25)

Debt- 72%

Using your answers to the above questions, calculate the WACC

WACC = E/V x Re + D/V x Rd x (1 - Tc )

(7/25) x 5% + (18/25) x 10% x (1- .35)= 6.08%

If Touring Enterprises were to increase the percentage of debt in its capital structure, what would happen to the WACC?

The WACC would decline as debt financing is cheaper overall than equity financing. Furthermore, equity finances a large portion of the company. By increasing the cheaper debt financings, the overall WACC is lower as the equity portion declines.

Identify and explain the benefits and risks of debt financing.

Debt financing allows the business to have more control. The business does not have investors or partners to answer to. The business owns all the profit you make. If the company finances the business using debt, the interest you repay on your loan is tax-deductible. This means that small businesses are shielded, in some respects, from certain taxes and lowers your tax liability every year. Your interest is usually based on the prime interest rate. The lender from whom the company borrows money from does not share in the profits. In the instance of the above example, the company is more than double financed through debt than through equity. The company, although it pays a larger percentage to bond holders, is maintaining the ownership claim to earnings of the business.

Disadvantages of Debt Financing

The disadvantages of borrowing money for a small business may be great. You may have large loan payments at precisely the time you need funds for start-up costs. If you don't make loan payments on time to credit cards or commercial banks, you can ruin your credit rating and make borrowing in the future difficult or impossible. If you don't make your loan payments on time to family and friends you can strain those relationships. For a new business, commercial banks may require you to pledge your personal assets before they will give you a loan. If your business goes under, you will lose your personal assets. Any time you use debt financing, you are running the risk of bankruptcy. The more debt financing you uses, the higher the risk of bankruptcy. Such is the case in the above example. The company is largely financed through debt. In the event of adverse economic situations, the company may be unable to make timely interest payments.

If the Fed decides to raise interest rates next year, what effect would rising rates have upon the following?

Consumer financing for big-ticket items such as autos and homes

Higher interest rates could affect demand for big tick items such as homes and autos. For one, higher interest rates could make borrowing more expensive for consumers. This could potentially allocate consumers as loans are not as affordable. Monthly payments would also increase due to an increase in interest rates. This ultimately will affect how much debt consumers actually take on. This presents interesting challenges for financing companies who must balance the ability of the consumer to pay with the over interest income that would be gained from the loan. With higher interest rates, companies may also need to set aside higher capital reserves in the event that a default occurs. Provisions for loans losses could ultimately hinder company earnings and profit. As such, the increase risk of default could further increase the cost of financing big-ticket items such as homes and autos. For example, the future value of a $1,000 loan, for 5 years at a rate of 5% would cost an individual consumer $1,276.28. The same loan at a 10% rate would cost the consumer $1,610 over the same period. This $400 difference can be monumental for individuals who are experiencing stagnant wage growth. For example, the median household income is $48,000, which has only increased with inflation. However, as interest rates rise, they will undoubtedly outpace inflation leaving consumers strained.

The present and future values of annuities

The present value of annuities will decline due in part to the discount factor being higher. Because interest rates have risen, investors must now discount future cash flows with a higher interest rate. This will ultimately lower the present value of annuities as they are now worth less due to higher interest rates. Conversely the future value of annuities will actually be higher due in part to the increase in the discount factor. Rising interest rates will also affect the value of annuities. For example, an annuity paying $100 a year for 10 years at an interest rate of 5% would cost an investor $216.53. The same annuity with rising interest rates of 7% would cost an investor $116.34. This is approximately a $100 difference due to a 2% change in interest rates. As such, the present value decreases as the interest rate increase. Likewise the future value of these annuities interest rates would be $1,447 and $1,610. 51 respectively.

NPV calculation

Stocks and bonds do carry interest-rate risk: if general interest duties rise, the price of the bond will decline, at least until it approaches maturity. The price of the bond is equal to the NPV of the payments you'll receive. If you think interest rates are going to rise, you will want to use a higher discount rate to calculate the price you are willing to pay for the bond. Higher discount rates reduce NPV, making the bond less attractive. A higher interest rate also makes money overall more expensive. The cost of lending and borrowing will increase as a result of higher interest rates. This ultimately will alter the discount factor used to price securities, making them more expensive than they otherwise were under a low interest rate environment. Investors will subsequently change their behavior as a dollar now is worth much more under a high interest rate environment than it is today. For example the NPV of a project that is expected to generate $100 dollars of earnings for 10 years at a cost of $1,000 and an interest rate of 5% would be 55.077. The same project with an 8% interest rate would be 48.1872. As such the 5% project should be undertaken

Corporate earnings

Higher rates can reduce a company's value by raising borrowing costs for the company itself and for prospective customers. If a company relies in whole or in part on debt financing, higher rates will directly increase costs and reduce earnings.