Discussion And Response
Long- and Short-term Costs of Capital
Please respond to the following:
Why might the constant dividend growth model (CDGM) and capital asset pricing model (CAPM) produce different estimates of the cost of equity capital used in the weighted average cost of capital (WACC)? Describe the difference between permanent and temporary working capital. What are some factors an organization considers when it chooses the mix of long- and short-term capital to finance the organization’s activities?
Part 2 Respond
DGM assumes that there is a constant perpetuity in future dividend growth rate which is not the case because dividends change. Dividends paid by several companies to its shareholders depends on the decisions made by the top management not necessarily that they are paid basing on how past dividend payments were paid. The model in its assumption assumes that business operations, business risk and the cost of equity are constant in the future. In real sense, the future is always uncertain which renders this model unreliable. Business operations, its risks and general economic environments are always subject to change. In other times, the dividend growth model does not consider risk as a factor. The fact is that risk is implicit because the share price is always used to calculate the cost of equity. In reality, economic research has shown that the share price usually falls as risk increases which shows that risk will result to an increase in the cost of equity.
From the above explanation on dividend growth model, it’s true that the model does not consider risk to be explicit but on the other hand, Capital asset pricing model (CAPM) considers. All investors hold diversified portfolios and are expecting good returns from every portfolio. They therefore expect a return from the systematic risks that occurs. The cost of equity in the case of CAPM is the required rate of return. It is the sum of the risk premium which reflects the individual investor's systematic risk which the company encounters from the stock market. The CAPM therefore shows a clear reflection of how the cost of equity must be given the systematic risk of the company. CAPM is therefore the recommended model to measure risk and to be used when calculating the weighted average cost of capital (i.e. WACC).
Difference between permanent working capital and Temporary working capital
Permanent working capital defined as the minimum amount of current assets (i.e. finished goods, bank balance, raw materials etc.) that is required by a business enterprise to run its business operations without interference. So this is the type of working capital that is required to be monitored at all times because it is the core of every business whose purpose and aim is to make profit and ensure business continuity.
On the other hand, temporary working capital is the varying capital that is required as a result of fluctuations in business operations. In other terms, it is the other capital that is required to compliment the permanent working capital. This type of capital depends on the season. During off-seasons, they are not required as much as such.
Financing factors to consider:
*Repayment terms: It must be noted that longer loans attracts significant interest to be paid while shorter loans requires large amount of periodic payments.
*Interest rate: The interest should also be considered before making a decision because for example, venture capitals may not require periodic payments but the owners may need a large premium at the end all at once.
Financing requirements must also be looked into. Make sure that you discuss fully on the financial requirements. Some of the common requirements include credit score and interest coverage which needs a fully discussed agreements