There are some ambiguous questions in topic tests that i need help with understanding.
The first one regards corporate finance.
Which of the following situations is the least likely reason why the marginal cost of capital schedule for a company rises as additional funds are rased?
A. The cost of additional funds from various sources rises as higher levels of financing are achieved.
B. The company deviates from its target capital structure because of the economies of scales associated with flotation costs and market conditions.
C. The comapny seeks to issue less senior debt becasue it violates the debt insurrence test of an existing debt covenant.
I chose B and is incorrect.
The answer is as following:
The WACC does not necessarily increase as more funds are being raised. Higher amounts of funding would not change the WACC if everythign were in proportion to the old target capital structure - it is the changes in relative proportions of sources of funding that could make a difference because of interest deductibility and financial risk.
By reading the answer I still dont know which answer is correct lol. Can someone help me with this?
The second question also regards corporate finance.
The effective annualized cost (%) of a banker’s acceptance that has an all-inclusive annual rate of 5.25% for a one-month loan of $2000000 is closest to:
A. 5.27%
B. 5.54%
C. 5.38%
The answer is A and it uses the formula ‘interest/net proceeds*12’. I thought the formula used instead should be ‘annual rate/12’^12-1? Why is the answer the first case?
Question 1: A, because, as the explanation states, raising more funds alone does not increase WACC. Think about it this way, your current capital structure is 60% debt and 40% equity. If you want to raise $100 and you decide to raise $60 through debt and $40 through equity, you raised more funds, but your WACC did not change because the weight of debt and equity are still in proportion. However, if you raised funds through debt and equity that do not match your current capital structure, then your WACC will be different.
Even if the firm maintained it’s existing capital structure, would raising additional debt capital not increase the firm’s cost of debt as a result of increased financial risk? I understand that the firm’s capacity to pay and available collateral (and the other 2 Cs) are examined to determine their creditworthiness, which is tied to their cost of debt. After raising capital, I’m guessing growth of firm’s operations, revenue, profitability, etc. won’t be immediate—it will take time for projects to generate profit. Wouldn’t this mean the firm’s is temporarily less creditworthy after taking on additional debt (and equity), raising their Kd? I don’t even know what I’m asking anymore. I guess, would a firm with a capital structure of $10M debt and $10M equity have the same cost of debt as a firm with $10B debt and $10B equity, all else proportionate (rev, exp, etc.)?
To be honest, I made exactly the same choice and was confused. To me, there must be a certain point beyond which the cost of debt surely must increase with an increase in the notional amount of the debt. Isn’t that the point of the marginal cost of schedule? Once the debt amount goes beyond a certain threshold, the cost of debt changes?