Share
Explore BrainMass

Lmitations of the various types of capital

Explain the limitations of the various types of capital? Why is there a need to have both short term and long term capital? Which do you consider to be more risky? Why or why not.

Solution Preview

Long term Financing Options available is a issue of capital structure. A firm's optimal capital structure is that mixture of debt and equity than minimizes its weighted average cost of capital (WACC). Since the after-tax cost of debt is lower than equity for many corporations, why not use debt only or mostly? It turns out that, while debt reduces a company's tax liability because interest payments are deductible expenses, increasing amounts of debt raise both the cost of equity capital and the interest rate on debt because of the increasing probability of bankruptcy. In other words, higher amounts of debt raise the financial risk of a company, and this risk is reflected on the cost of all the types of capital the company uses. As such, the relationship between financial leverage and WACC is not a straight line, but more of a U-shaped curve, with a minimum WACC between the extremes of debt utilization.

Equity Financing
Equity means sharing in the ownership. Thus this involves contribution by the owners of the organization. Equity can be raised either by private placement or by public.
(Pandey, I.M.)

Advantages of raising shares
1) Permanent Capital: It need not be paid back
2) Borrowing Base: It can be used to trade on equity
3) Dividend Payment Discretion: The payment of dividend is in the hands of management
4) No Mortgage
Unlike debt this does n't involve the mortgage. Thus assets are free of any encumbrance.
5) Wealth creation tool
This can be used to create wealth for employees and shareholders.

Disadvantages
1) Cost: It is more costly than debt
2) Earnings Dilution: It involves reduction in EPS.
3) Ownership Dilution: It involve sharing of ownership
4) Higher Opportunity cost
This has got the highest opportunity cost as it has the maximum risk
5) No tax shield
Unlike debt the payment of dividend has got no tax shield.

Debt Financing
This is raising money from the lenders. They pay interest to the lenders. The various option of debt is:
Bonds
It is a ...

Solution Summary

This explains the limitations of the various types of capital

$2.19