Sterling Household Products Essay

MCI would be better to keep its capital structure of 55% debt. The cost of equity is high because raising more equity will dilute the value for existing shareholders. Due to the fact that MCI has a high leverage, it is not feasible to issue debt. Additionally, MCI has exhausted the line of credit from the banks and used convertible debentures frequently. MCI belongs to a competitive and regulatory industry. The high leverage will limit its potential to grow. In exhibit 8, MCI does not have a bond rating. The convertible bond allowed the company to raise capital and convert to equity later. The interest coverage ratio of AT&T is 3.6X whereas that of MCI is 4.2X. After increasing the market share, the company can obtain a bond rating by decreasing its financial leverage.

What risk-free rate and the risk premium did you use to calculate the cost of equity?

We would recommend the capital structure with 30% debt. This is because with 30% debt, they would be able to repurchase 19.8 million shares outstanding as well as save 37.8 million in taxes. EBIT is high in this company, and because of this, financial leverage will raise EPS and ROE. However, variability also increases as financial leverage increases, so the company would not want to take on too much debt and become very risky.

Nevertheless, the use of the Optimal Capital Structure (OCS) is the right techniques to be used in order to acquire the right combination of debt and equity that can maximize the

Cost of Equity = Risk free rate + (Market return – risk free rate) X beta

Cost of Equity is the return that stockholders require for a company. A company’s cost of equity represents the compensation that the market demands in exchange for owning the assets and bearing the risk of ownership. Based on capital markets the cost of equity varies in direct relation to the assumed risk in that specific market. The distinctive of the firm is the sensitivity to market risk (β) which depends on everything from management to its business and capital structure. Therefore past performances and present conditions have a direct effect on the overall value. Applying calculations at a divisional level allows specified markets to be analysis based on present market conditions for that service or product. The formula used to calculate Cost of Equity is:

Please refer to Appendix 2 for other considerations for cost of equity calculations. Most firms use the Capital Asset Pricing Model (CAPM) to determine the cost of equity. The components that make up the CAPM include: the risk free rate, the beta of the security, and the expected market return of the stock. These values are all based on forward-looking data. The model dictates that shareholders require a return equal to the return from a risk-free investment plus an equity risk premium for bearing extra risk. Refer to Appendix 1 for a full breakdown of the CAPM formula.

It was determined that the liquidation of $209 million in cash and marketable securities and the addition of $50 million in long-term would result in a capital structure which was reasonable and sustainable. Overall, tax expense would be lower, the value of the firm would increase and the riskiness of the company’s equity would edge just a touch higher.

3.3 Calculating the costs of equity by the earnings capitalization ratio, and its advantages & disadvantages i. Calculation (based on EXIHIBIT 1&4) According to the earnings capitalization model, we have cost of equity = E1 / P0 = 2.16 / 42.09 = 5.13%

2. Another method of deriving the cost of equity is by using the capital asset pricing model (CAPM). The underlying assumption of CAPM is that the market is pricing in the risk of the stock in relation to the risk of the market. This firm-specific risk is the cost of equity for the firm. The formula for CAPM is:

Part I. Estimating the cost of capital is challenging, because the cost of capital effectively puts a price on the risk of the project. If we know the risk, it would not be risk, it would be certainty. Inherently, then, there is a philosophical challenge with finding a good estimate of the firm's cost of capital. It is assumed, however, that the market view of the firm is a fairly accurate reflection of the company's risks. The main techniques for estimating the cost of capital, therefore, are market based. In general, these market based solutions are only used to determine the cost of equity with the scope of a broader weighted-average cost of capital equation.

However, unlike debt, equity does not need to be paid back if earnings decline. On the other hand, equity represents a claim on the future earnings of the company as a part owner. The cost of equity is complicated in the sense that the rate of return demanded by equity investors is not as clearly defined as it is by lenders. Theoretically, the cost of equity is approximated by the Capital Asset Pricing Model (CAPM) = Risk-free rate + (Company’s Beta x Risk Premium).

From the investors point of view, the cost of capital is the rate of return expected by those who invested funds in the business which includes interest payment and dividend commitments. (Book) It is the cost of company’s debt and equity. Cost of capital is based on the funds used. Many companies use a composition of both debt and equity to finance their business. For such

A firm's cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership. It is basically the return that stockholders require for a company. Cost of equity can be determined using the Capital Asset Pricing Model (CAPM).

Financial performance of firm and its value is greatly affected by the design of its capital structure. This issue is getting immense consideration after the MM,