Companies
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
Case study: Debt vs. Equity Holders
Companies obtain their funds from two sources: debt and equity. The providers of these funds are protected in different ways. Debt
holders have specific contracts with the company, and if the company defaults they have recourse ahead of shareholders.
Shareholders are the bearers of residual risk and in return for the uncertainty this creates, equity finance is more expensive than debt
finance- reflecting the risk premium and risk appetite of the shareholders. But, because the shareholders come last and it is not clear what they are entitled to, they operate in conditions of an incomplete contract.
Question:
If the shareholders’ position is not protected by a contract-unlike the provider of debt- how is it in fact made viable? Discuss.
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