Every company in any business requires sources of fund to run the business. Two ways that companies can obtain funds are Debt Funding and Equity Funding.
Debt Funding
Debt funding is to borrow money from financial instructions and the companies must pay interest and load at some stage depending on payback scheme.
Short term borrowing can come from the following sources;
- overdraft
- commercial paper
Long term borrowing can come from the following sources;
- corporate bonds
- long term loans
- mortgages
Equity Funding
Equity often means an ownership interest in a business. The companies sell shares to equity investors as financial institutions, insurance companies, individual investors, etc and these equity investors become the owner of the companies (share holders). The equity investors expect to get regular dividends and a capital gain from the company’s growth. However, there will not guaranteed outcome of the future performance of the company to their share holders. If the company goes bankrupt, the ordinary share holders will be the last group of people who will get the money back.
Most of companies utilize a mix of debt and equity to run their businesses. This is known as the capital structure of the companies. Estimation of cost of capital of company requires combination of cost of debt and cost of equity and the method is known as “Weighted Average Cost of Capital” (WACC). WACC represents a minimum return for the selection of the discount rate to evaluate oil and gas project. The big number of WACC is not a good sign because it requires more return on investment on a project to justify the project start.
WACC is calculated by this formula;
The method for calculating WACC can be expressed in the following formula:
WACC = (E÷V) × Re + (D÷V) × Rd × (1-Tc)
Weighted Average Cost Of Capital (WACC)
Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm’s equity
D = market value of the firm’s debt
V = E + D = total market value of the firm’s financing (equity and debt)
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
Ref – http://www.investopedia.com/terms/w/wacc.asp
We will go through the calculations later.
Reference Book
Thomas Sowell (2007) Basic economics: A Common Sense Guide to the Economy, New York, New York, USA: Basic Books.