“The use of debt to fund the firm (called leveraging) carries with it benefits as well as risks” (Hickman et all., 2013, Chap 8, Overview, para. 4). In the short term, leverage lowers the weighted average cost of capital due to the typically lower required rates of return on debt as compared to equity. In the long run, debt requires interest payments and the principal must be repaid. A firm that cannot repay its debt faces default risk and/or bankruptcy. The risks due to excessive leverage are known as financial risks. Thus, as a firm considers using debt or equity to fund its business, it must consider both the benefits of debt and the financial risks of too much debt. In this discussion, you will evaluate a real-world scenario and consider the implications of the debt financing decision for the firm.
Prepare:
Prior to beginning work on this discussion forum,
- Complete the the Week 5 – Learning Activity: Understanding Cost of Capital.
- Read Chapter 10 in Essentials of finance
- Read Chapter 8: Section 8.1: Perfect Capital Markets in Essentials of finance
- Watch the following video: https://www.youtube.com/watch?v=tUT-eJR5ZOY
After watching the video, answer the following questions in your post:
Did Alex Clark initially fund the business with equity or debt?
Initially, Clark’s chocolate business is very small. Compared to publicly traded companies, would Clark’s required rate of return on equity be higher or lower than the “average” required rate of return on equity for small cap companies of 15%? Explain your answer.
After the business was established and Bon Bon Bon had primarily wholesale customers, Clark talked about expanding into a full-time retail location. Suppose that Clark considered buying a small building for the new, full-time retail location (rather than renting space). This is a good example of an investment project that a business must evaluate. Would the required rate of return for Clark’s building purchase be higher or lower than the overall chocolate company’s required rate of return? Explain your answer.
Should Clark use some bank debt to finance all or a portion of the potential retail building purchase?
Justify your answer by explaining how the weighted average cost of capital for the company would change if Clark uses bank debt to finance all or a portion of the building purchase.
What is the primary risk that Clark faces if she uses debt to finance the entire building purchase? For purposes of this discussion, assume that the debt would then comprise 95% of the company’s capital structure.
