Assets required for operation: $2,000
Case A – firm uses only equity financing
Case B – uses 30% debt with a 10% interest rate and 70% equity
Case C – firm uses 50% debt with a 12% interest rate and 50% equity
To compare the financing options for a firm, let's calculate the amount of equity and debt for each case and see how the different proportions and interest rates affect the financing cost.
Case A: Firm uses only equity financing
In this case, the firm is using 100% equity to finance its operations. Therefore, the entire $2,000 is considered equity.
Case B: Firm uses 30% debt with a 10% interest rate and 70% equity
In this case, the firm is using 30% debt and 70% equity. To calculate the amount of debt, multiply the total assets by the debt proportion:
Debt = 30% * $2,000 = $600
Equity = 70% * $2,000 = $1,400
Case C: Firm uses 50% debt with a 12% interest rate and 50% equity
Similarly, in this case, the firm is using 50% debt and 50% equity.
Debt = 50% * $2,000 = $1,000
Equity = 50% * $2,000 = $1,000
Now, let's determine the financing cost for each case.
Case A: There is no interest expense since the firm is using only equity financing.
Case B: The interest expense on debt can be calculated by multiplying the debt amount by the interest rate:
Interest Expense = $600 * 10% = $60
Case C: Similarly, calculate the interest expense for Case C:
Interest Expense = $1,000 * 12% = $120
By comparing the different financing options, we can see that for each case:
- Case A has no financing cost since it uses only equity.
- Case B has a financing cost of $60 due to the interest expense on the debt.
- Case C has a higher financing cost of $120 due to the higher interest rate on the debt.
This comparison helps assess the impact of different financing options on the firm's overall cost of funding.