Cost of Capital and Working Capital Management: Case of CMS Company (Math Problem Sample)

COST OF CAPITAL AND WORKING CAPITAL MANAGEMENT: CASE OF CMS COMPANY
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INTRODUCTION
Firms have widely made use of capital structure to ensure they are able to strike a balance between equity and debt financing. Firms that are in the high risky industries, have opted to use more of debt finance rather than equity financing (Peter et.al 2011). Research has shown that most firm fearing for liquidity and solvency problems, have opted to make use of equity financing.
Other firm have had high application of working capital management techniques through which they have been able to manage their businesses (Murray 2016). It has been reported that firms with proper working capital management systems have been able to sustain their business in the future. According to Murray (2016), different approaches used in working capital management have seen most firms improve their efficiency as well as their future sustainability.
The current analysis will thus make reference of CMS company to assess the cost of capital, the best weighted costs of capital that can be achieved, and evaluate working capital options.
Weighted average cost of capital (WACC)
Research has been conducted with respect to WACC and it has widely been referred to as the overall cost of capital that can be employed in a firm. It has been used as the overall to cover an average of the different cost of capital that can be developed (Murray 2016). Thus it has been calculated as a percentage cost of the different capital components. Therefore, it gets the market value weight attachment. It is thus given by:
W.A.C.C=
Where:
Ke, Kp and Kd = Percentage cost of equity, preference share capital and debt capital respectively. E, P and D = Market value of equity, preference share capital and debt capital respectively. Market value = Market price of a security x No. of securities. V = Total market value of the firm = E + P + D.
The cost of the different items is calculated using the Gordon model that has widely been used to determine the cost of different components. The assumption of the model is that there is zero growth associated with the model (Murray 2016). The results from the analysis attached in appendix 1 reveal that the cost of equity is 7.3%, the cost of preference shareholding is 15%, and the cost of debt is 5.6%. This is an indication that the firm make application of equity financing more than the debt financing.
The market value of equity was found to be 46,800. That of preference shares to be 0.40, and that of debt was 3,000. Again, this indicates that the value of equity is high above. Consequently, the firm is able to leap more for having made use of equity financing. This has an implication on the market price of the shares which could go up and thus attract a lot more investors to engage with the firm. The WACC was found to be 7.197% which is indicative of the rate the firm would be willing to pay if they were to acquire funds. In evaluation of projects, this would be the minimum rate of return that the firm would be willing to take for investing in a given project.
The company cost of capital would thus be 7.197%. This would be used in determination of whether investments are worth taking for the company. The use of the method ensures that a firm comes up with a cost of capital that is relative to its financing. However, the method has been criticised widely. This has mainly been on bases of its assumption that the business risk equals the project risk. In the world filled with a lot of uncertainty, the risk could be different which compromise the use of the method. In addition, it assumes that the cost structure is optimal without evaluation of performance indicators which may lead to a cost of capital that is inappropriate (Murray 2016). Also, it is based on past information and thus cannot be an appropriate measure to undertaking future proposals.
Cost of equity and debt compared
The cost of equity for the firm is 7.3% and that of debt is 5.6%. The cost of equity is thus higher than the cost of debt. This is an indication that the firm has high reliance on equity than it relies on debt. The cost of equity has been seen as the cost of raising capital through stock. While the cost of debt is the cost of raising capital through debt financing. Research has shown that the cost of debt should always be maintained lower (Michael and Phillip 2002). This is because its interest is tax deductible.
In addition, debts are taken and should be repaid back with an interest. The interest is the cost of being given the capital to use. However, in the case of equity, people make investments and in the case of ordinary shareholders, they earn returns from their investments in form of dividend. Therefore, for the debt capital, it must be repaid (Philip 2012). Consequently, firms should ensure it is maintained low in order to ensure they are able to repay when the debts fall due.
The other reason has been the examination of both terms. The cost of equity reflects ownership while the cost of debt makes a reflection of an obligation. For this reason, firms should ensure they lower their level of obligation. Therefore, issues a lot of shares to raise capital through stock. Research has shown that stock building leads to improved sustainability of a firm (Michael and Phillip 2002).
Also, the risk of having higher equity is lower than that of debt. Since shareholders reflect ownership, they do not have to be paid dividends (Michael and Phillip 2002). Thus they receive balances from the earning made by the firm. On the other side, debt capital has to be repaid and is a mandatory under the law. Thus firms opt to have higher equity to reduce their risks which is evident in CMS.
Financial managements and optimal capital structure
An optimal capital structure has widely been seen as a match in the different sources of financing. Including the equity funding as well as the debt funding. Firms have been asked to ensure they lay a balance between equity and debt financing to ensure they have sustained performance.
Financial management engages the art of controlling, managing, monitoring, planning, and directing. The functions are directed towards effective procurement and utilisation of funds. Therefore, firms have to decide on the sources of funds as well as the projects they should prioritize on (Franck and Usha 2004). This means that they have to set an optimal structure which would enhance their performance ability.
An optimal structure is influenced by availability of securities with firms having less securities relying more on debt. The structure is also influenced by the cost of the finance. Most firms opt for debt financing where its costs are set at low levels. In addition, competitiveness of the industry where the firm is located. Most firms in high risky industries, opt for high risky investments and thus take more of debt capital. Therefore since FM has been seen to make application of the most efficient means in optimal management of resources, then capital structure management become a core of operation (Franck and Usha 2004).
Working capital management
Factoring is a financing model that has been applied by a lot of firms in the recent past. A factoring company offers instant cash to firms. The factoring companies give cash to firms, and payment is in form of slow-paying invoices (Franck and Usha 2004). In most cases, the factoring company purchases the receivables of a firm, and receive payment once the debts are settled. In return, the company selling its receivables is able to acquire cash from the factor to settle its expenses.
Therefore, factoring has a wide range of advantages including; it is able to offer instant cash to the firms in need. Through the firm’s receivables, a firms is able to trade them for cash. In addition, a firm is able to manage its credits better. This is because, all receivables need to be settled to pay off cash given by the factor. Consequently, firms follow up for all debts reducing the number of bad debts (Michael and Phillip 2002). The financing is easy to acquire since it requires less formalities and only relies of receivables. Also, as the debtors increase, the financing can as well increase. Therefore, offers an effective way of acquiring funds within a short time. Therefore, it is a short-term financing solution and can be used by firms to settle their short-term liabilities, and recurring expenses.
There are a wide range of activities that can be undertaken by a factoring firm including; trucking, brokerage, and business management services, staffing, manufacturing, and wholesaling.
From the analysis attached in appendices 2, it is clear that the firm should take the factoring option as it lead to an overall increase in the amount they would be saving totalling to $467,416. The analysis showed that the factoring is financially acceptable to CMS. This is because it leads to an overall reduction in cost. From the analysis it is clear that bad debts would decrease, the days taken to collect credit would also reduce, and the total number of debtors would be reducing. Despite the associated costs of the factoring, the costs would be taken as the transaction costs of having the system in operation. Therefore, offer a better solution to the firm as it would be able to manage its receivables in relation to the number of debtors held, and the days taken to collection of the debts. This is in line with discusses implications of making use of a factoring.
Working capital management approaches
When making financing for the current assets, it has bee...