Strategic and Financial Decision Making Essay Example | Topics and Well Written Essays - 2000 words

Strategic and Financial Decision Making - Essay Example The cost of financing through equity is more than that of debt. The bond holders are paid fixed rate of interest every year, hence they bear no risk. The equity shareholders do not receive any fixed income every year; it is dependent on the profits of the company. Hence, there is a risk involved in holding equity shares as compared to debt capital. Therefore the equity shareholders require more return as compensation to the extra risk borne by them. On the factors discussed above, debt financing would seem more attractive as compared to equity financing. But decision cannot be made solely on the cost factor. One also has to look into the risk involved in different sources of financing. Since there is a fixed obligation every year towards interest payment, it is considered to be more risky than financing through equity on which no risk is involved. Thus, a company has to decide upon the level of debt on the basis of the risk it can undertake. Eugene, Houston (2007:1).The following ste ps involved in decision making process are: Existing capital structure: One has to evaluate the existing capital structure. In case the company has too much debt already it is not advisable to issue more debt. It can also maintain the existing debt equity ratio or change the ratio. Dividend payout policy: The dividend payout ratio should be decided be the firm, so as to maintain the same every year. This is because fluctuating dividend payout ratio would reduce the confidence of the shareholders towards the company. Effect of return: The company has to analyze the effect on return because of the cost of capital. It has to ensure that it is able to earn the desire level of return of the investors. Effect of return: In order to reduce the cost of the capital a firm might take debt equity mix. However, it should first analyze the risk involved in using debt as a source of capital. Effect on cost of capital: The effect of desired level of debt and equity on the cost of capital of the company should be evaluated. Excess debt can lead to increase in cost of capital after a certain point of time because of the high risk involved. These decisions should be based after careful study of the market. The risk appetite, the required rate of return of the shareholders, the effect on market value of the shares due to change in the capital structure of the company should be studied. Hence, these factors have to be taken into consideration in order to arrive at a sound decision. b) The investment proposal involves an initial investment of 3,000,000 along with cost of forecasting of 100,000. The proposal is expected to be financed at the existing debt-equity ratio of 2:3. It is assumed that the return required by equity investors is 10.5% (real). Therefore nominal return (inflation adjusted) expected would be 10.5% + 5% (inflation) that is 15.5%. The rate of interest payable on corporate bonds (debt) is 6% p.a. We have to now compute the weighted average cost of capital