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Explain the effect default risk, inflation, interest rate risk and stock market volatility have on WACC

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Companies seek the lowest average rate of financing costs to capitalize the business. Common sources of financing are as follows:

- Common stock equity
- Preferred stock equity
- Bond debt

Explain how the following risks may affect these 3 sources of financing and the impact overall on weighted average cost of capital (WACC):

- Default risk
- Inflation
- Interest rate risk
- Stock and market volatility

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Solution Summary

This solution discusses sources of financing of a company, including common stock equity and preferred stock equity, as well as bond debt. The impact of risk factors on sources of finance is also provided. The solution is approximately 994 words.

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Sources of Financing

Source of financing can be divided into three categories that are traditional sources, ownership capital, and non-ownership capital. Some of common source of financing for a company are as below:

Common Stock Equity

Common stock equity is an ownership capital that is owned by shareholders of the company and it is used as source of financing. Common stock equity represents equity shares of the company that is useful to raise funds from the market. It is one of the cheapest sources of financing due to absence of interest expenses. By using common stock equity, the company can generate capital directly from individual and institutional investors by issuing shares in the market through initial public offering (IPO). This type of source of financing is commonly used to finance larger expenses such business expansion, new product development, and setting of new plant (Graham, Smart & Megginson, 2009). Along with this, lower risk is associated with common equity in the case of financing.

Preferred Stock Equity

It is also a type of source of financing that is used by the business organizations to raise funds from the market. Preferred stock equity is like a cross between long term debt and common equity and it requires a fixed dividend payment to preferred shareholders. Preferred stock equity is similar to common stock in terms of rights of shareholders, but a preferred shareholder receives dividend before an ordinary shareholder. At present, most of companies use common stock equity to generate finance as compared to preferred stock equity due to lower cost of financing or capital (Smart & Megginson, 2008). The proceeds of preferred stock equity are used by the firms at start-up and growing stage to finance ...

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