What is a capital?
Capital is the total of financial resources invested in the business. In terms of the sources, there are two types of capital: interest-bearing debt funds, such as loans, bonds, short-term notes, and interest-bearing payables to trade suppliers; and equity, such as common and preferred stock and the earnings retained in the business that add to stockholders’ share of the entities.
Weighted average cost of capital is the weighted average of the returns on investment or future dividends for the stockholders and interest rates on debt for the creditors. This average return should be used as the required return for investments, as mentioned earlier, because it represents the weighted average of the required returns of all the different debt creditors and equity investors. It also represents the weighted average of the costs that can be saved by the business if the resources or financial funds are returned to the creditors and investors instead of being used for investments within the business.
Capital structure is represented by the types of sources of capital funds invested in the business. A common measure of sources is the percentage of debt relative to equity that appears on a company’s balance sheet. Usually, the cost or required returns for the debt is much less than the equity, especially on an after-tax basis.
Thus, the total cost of capital declines when some debt funds from creditors are substituted for equity funds from investors. Yet as more debt is added, the business becomes riskier because of the higher amount of fixed payments that must be made to creditors, whether or not the business is generating adequate funds from earnings; and then the costs of both the debt and equity funds are increased to the point where the weighted average cost increases.
Some words about acquisitions.
Acquisitions, which are purchases of other businesses, are merely another type of capital budgeting investment for a business. Such purchases should be evaluated in the same manner as any other capital investment, as outlined earlier, to obtain the maximum positive net present value.
Price/earnings ratio is often used in making acquisitions as an abbreviated measure of valuation. This ratio is of the value or price of a business or its stock to its earnings. Yet the actual decision to make an acquisition is a capital budgeting decision; the resultant determination of price or net present value can then be described in relative terms to the earnings in the price/earnings ratio.
Date: 2015-01-29; view: 494