Debt/Equity Mix
Debt for a company is realized through different financing costs to the company, including stocks. The cost of debt is measured by the interest that is paid to bondholders. A company has to take into account the current rates of interest when determining the cost of debt. This can be done by calculating the yield to maturity, as well as the tax rate. This can be computed as follows, where T equals the tax (percentage):
Kd (Cost of debt) - Y (Yield) (1 -T) (Block & Hirt, 2005).
The cost of preferred stocks is similar to the cost of debt, except that there is no maturity date for preferred stocks. Common stock must also be figured into the debt of a company. The demands of the current and future stockholders must be taken into account when figuring common stock, as new purchasers of common stock affect the equity in a company (Block & Hirt, 2005).
Common stock equity capital contributes to the retained earnings of the company, or how much money the company keeps for them. Unlike previous common stocks, new common stock, like preferred stock, takes into account selling cost. To determine which source of financing is best, one must look at the debt-equity mix. The average cost of capital, when plotted on a graph, produces a u-shaped curve (Block & Hirt, 2005).
Based on the curve, most companies would like to find themselves in the middle of such a curve as this equates a relatively healthy mix of debt to equity. A higher debt will lead to a higher cost for sources of financing because of the increase in financial risk (Block & Hirt, 2005).
The rate of debt to equity will also affect a company's dividend policy or “the decision to pay dividends”. Higher equity may lead to a greater payment of dividends. Payment of dividends may show that the company has good potential for growth, which may drive up stock prices, but also may signify a lack of viable investment opportunities, which would negatively affect stock...
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