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Long-term capital

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How does a company determine an optimum percentage allocation for long-term capital (debt and equity) it should maintain?

Explain the factors that detract from these amounts of debt and equity (or percent amounts) and the factors, which add to these amounts of debt and equity (or percent amounts)?

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Solution Summary

Almost 1300 words explain how optimum percentage allocation for long-term capital is maintained as well as factors that make this difficult.

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A firm's long-term success depends upon the firm's investments earning a sufficient rate of return. This sufficient or minimum rate of return necessary for a firm to succeed is called the cost of capital.

The cost of capital can also be viewed as the minimum rate of return required keeping investors satisfied. Thus it is used to know the rate of return expected by the investors. Thus cost of capital is used to evaluate the project. It is also know as discount rate.
hus it is used to know the rate of return expected by the investors.
Cost of capital (WACC)=
(Cost of Equity x Proportion of equity from capital)+ (Cost of debt x Proportion of debt from capital)+ (Cost of Preference share x Proportion of preference share from capital).
Equity includes retained earnings and the cost of R/E is taken at cost of equity. Cost of equity capital is the opportunity return from an investment with same risk as the company has. Cost of equity is usually defined with Capital asset pricing model (CAPM). The estimation of cost of debt is naturally more straightforward, since its cost is explicit. Cost of debt includes also the tax shield due to tax allowance on interest expenses. In case of preference shares, the dividend rate can be taken as the cost since it is the amount, which the company intends paying against preference shares. As is the case of debt the issue expenses or discount/premium on issue has also to be taken into account.

When investors are shopping for places in which to invest their funds, they have an opportunity cost. The firm, given its riskiness, must strive to earn the investor's opportunity cost. If the firm does not achieve the return investors expect (i.e. the investor's opportunity cost), investors will not invest in the firm's debt and equity. As a result, the firm's value (both their debt and equity) will decline. Hence firm's existing capital structure must be optimal to reduce the cost of capital and to increase the shareholder's wealth.

How can varying percentages of ...

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