Unit 5 - Evaluating Performance

Unit 5 - Evaluating Performance

Introduction

Acme, a US MNE, has recently proposed to develop a production facility overseas. This facility will cost $500 million which will be financed by external sources in the United States. With several sources of finance available, determining the best source involves balancing the risk and the cost of capital in order to gain the best advantage. The project may be financed by either one source or multiple sources in order to diversify the risk. Acquiring finances from different sources allows the firm to acquire more finance at better rates.

Capital Structures

The capital structures of firms are composed of equity and debt. The objective of the firm is to reduce its Weighted Average Cost of Capital (WACC). Minimizing the WACC is not always the best solution as the firm will also have to analyze the risks associated with each source of finance and its availability to the firm. Debt is usually preferred by firms as the after-tax cost of debt is quite cheap and usually cheaper than the cost of equity (Brigham & Ehrhardt, 2008). Although the cost of debt is usually less, the interest and principal has to be paid on maturity. On the other hand, if the financial position of the company is not good during a certain year, it is not binding on the company to pay dividend to its shareholders. A detailed description of the two sources of finance is mentioned below. Therefore, while determining the source of finance, the weighted average cost of capital needs to be determined.

International Operations

The differences in the cost of capital and the rate of return from the project can affect the profitability and operations if the firm if the return is less. Before deciding to invest in this project, Acme needs to anticipate its profitability. The financial management includes the all the costs associated with the project. The objective should be to choose the source of finance with the lowest costs and lowest risks. This is not an easy task since risks and costs of capital are inversely related. The cost of debt financing is lower compared to equity since equity financing involves several formalities. It is not advisable for firms to just one source of finance in order to reduce the cost and risk. By finding the optimum level of all the sources of finance, the company can ensure it takes advantage of the tax savings caused by the portfolio and at the same time reduce risks by employing equity financing. The proper balance between the two sources is vital for the company to survive (Sources of finance, n.d.).

Debt Financing

There are several types of debt Acme can acquire in order to finance its projects. The following are the different types of debt financing.

Loans

Loans may be long term and short term. Firms can get loans from banks based on their reputation and financial position. These loans usually have a high interest rate because the investor has to face a risk since there are chances that ...