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Advantages of ordinary share capital

Shareholders have the right to vote


Shareholders have the ability to elect the board of
directors
Shareholders are able to buy as many new stocks as
possible
Disadvantages of ordinary share
Share prices fluctuate a lot, which short term oriented
investors find very distressing.
Some companies go broke, and due to the occasional
dishonest auditor you won't be able to see it coming.
Therefore you need to diversify a lot, though this is easy
to do since you can buy small amounts of shares.
Shares require analysis and hard work if you are going to
do better than average.
Advantages of preference share capital
Preference shares has no interference with the
management of the company.
It makes the capital structure of a company to be flexible.
Preference share has nothing to do with companies in the
mortgage of its asset.
Disadvantages of preference share capital
It is a fixed burden on the company because company has
to pay dvident at fixed rate.
Company pays tax on the dividend also after paying for
preference.
Advantages of Bonds and Debentures
Debenture holders have no right to participate in
management.
Interest on debenture is deducted from the taxable income
of the company.
Increase in debenture also increases the interest or income
of share holders.
Disadvantages of Bonds and Debentures
 Debenture interest and capital repayment are obligatory
payments.
The protective covenants associated with a debenture
issue may be restrictive.
Debenture financing enhances the financial risk
associated with the firm.
Advantages of long term debt
The cost is limited and known and cheaper than the cost
of equity (because it is less risky to the investor who
therefore requires a lower required rate of return).
The interest is tax-deductible, unlike dividend payments,
which makes the cost even cheaper in comparison to
equity.
There is no dilution of control when debt is issued.
Disadvantages of long term debt
There is always the possibility of default if income is low.
The company must pay interest, even if it means taking
out additional debt to do so.
The cost of equity rises as more debt is used. The higher
leverage results in higher risk to shareholders who will
require a higher rate of return.
Advantages of leasing finance
Leasing better utilizes equipment; you lease and pay for
equipment only for the time you need it.
There is typically an option to buy equipment at end of
lease term.
You can keep upgrading; as new equipment becomes
available you can upgrade to the latest models each time
your lease ends.
Typically, it is easier to obtain lease financing than loans
from commercial lenders.
It offers potential tax benefits depending on how the lease
is structured.
Disadvantages of leasing finance
No ownership: The main disadvantage of leasing is that
you never own the product.
You have an obligation to continue making payments.
Typically, leases may not be terminated before the
original term is completed.
You have no equity until you decide to purchase the
equipment at the end of the lease term, at which point the
equipment has depreciated significantly.
Cost of capital
[WACC] weighted average cost of capital
Cost of debts:
cost of equity
cost of preference shares:
Weight Average Cost of Capital
The formula for the above measures= (Ke*E) + Ka(1-
t)*D/ E+
 (D) = is the cost of the use of equity capital, provided by
the shareholders, and investors.
(I) = is the cost of the use of debt capital provided by
capital lenders. The average between the rate of dividend
and the rate if interest, is the average cost of capital.
Cost of Debt
Cost of debt, rd(I-T) , is also used to calculate (WACC) .
Cost of debt is= interest rate on new debt- Tax savings
 = rd-rdT
 =rd(I-T)
E.g. if allied can borrow at an interest rate of 10% and its
marginal federal plus-state tax rate is 40%, its cost of debt will
be 6%.
Cost of debt is=rd I-T)=10%(1.0-0.4)
 =10% 0.6)
 =6.0%
Cost of preference share
cost of preference share = rp =DP/Pp
E.g allied sold some stock to a few large hedge fund, the
stock would have a $10.00 dividend per share and it will
be priced at $97.50 a share. Thereby allied cost of
preference stock would be $10.3%.
 Rp = $10.00/$97.50 = 10.3%
Cost of Capital
Minimum required return / cost of capital= that
particular
discount rate “k” that makes NPV = 0.
! The return generated by a security is the cost of that
security to the company that issued it.
cost of capital to the firm = reward to investors.
! The cost of capital depends primarily on the use of
funds, i.e.,
the risk of the CFs, not on the source.
Q risk of CFs (systematic risk)
Q company capital structure
Importance of cost of capital on capital
structure
Cost of capital helps in making decision as to
whether or not to invest in productive asset
such as plant, and machinery, coporate
acquisition, working capital, and the like.
Cost of capital is also used to maximize the
value of the existing share holder’ equity
investment.
Cost of capital helps to accomplish the ends
of net present value by accepting all project
that are expected to be positive.
 
Cost of capital helps to save high capital
value on financial decisions everyday. 
 
IMPORTANCE OF CAPITAL
STRUCTURE
 

It makes economic sense for the firm to strive


to minimize the cost of using financial capital.
It is the basic point on consideration a trial
capital structure, based on the market value
of the debt and equity.
It helps to reduce accumulation of long term
debt which affect the interest growth of an
organization. 
It helps to maximize a firm’s common stock
price.
Appraisal Technique
One of the most important steps in the capital
budgeting cycle is working out if the benefits
of investing large capital sums outweigh the
costs of these investments.
PAY BACK PERIOD
(a)  It is so popular because of its simplicity.
(b)  Payback takes account of the effect on
business profitability.
(c)  It is the most objective method.
INTEREST RATE
RETURN
(a)  The amount of time it takes staff to repay
their training costs.
(b)  The number of years to pay back an
original investment.
(c)  The level of interest that a project is able
to withstand.
NET PRESENT VALUE
Time value. It recognizes the time value of
money-a $ received today is worth more than
a $ received tomorrow.
Measure of true profitability. It uses all
cash flows occurring over the entire life of the
project in calculating its worth. Hence, it is a
measure of the project’s true profitability.
Value additively. The discounting process
facilitates measuring cash flows in terms of
present values that is in terms of equivalent,
current $.
Shareholder value. The net present value
(NPV) method is always consistent with the
objective of the shareholder value
maximization. This is the greatest virtue of
the method.
PROFITABILITY INDEX
Time value. It recognizes the time value of
money.
Value maximization. It is consistent with the
shareholder value maximization principle. A
project with profitability index grater than one
will have positive net present value (NPV) and
if accepted, it will increase shareholders
wealth.
Relative profitability. In the profitability index
(PI) method, since the present value of cash
inflows is divided by the initial cash outflow, it
is a relative measure of a project’s
profitability.