Cost of Capital Models

This report analyzes the cost of capital models and its impact on angel investor funding for a healthcare facility. It discusses the tax benefits of debt financing, computes the after-tax WACC, and evaluates the viability of the investment. It also suggests changes in the capital structure to meet the angel investor's ROI requirements.

COST OF CAPITAL MODELS
THE ANGEL INVESTOR
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COST OF CAPITAL MODELS
Introduction
An entrepreneur is seeking an investment of $ 100,000 for funding a diagnostic machine
purchase for a healthcare facility. The proposed capital structure for the funding would be 60%
debt while the remaining 40% through equity. The entrepreneur has approached an angel
investor for making investment in the project. The minimum ROI expected by the angel investor
is 8%. The objective of the given report is to carry out an analysis of the given situation to
determine whether the angel investor is likely to provide the funding or not considering the cost
of capital.
Analysis
The various aspects in regards to the given scenario are discussed below.
Tax Benefits related to Debt Financing
One of the key advantages of debt financing is the related tax benefit. This arises
primarily on account of interest expense which is paid on the debt and thereby is an operating
expenses which tends to lower the taxable income. This results in lower tax outflow for the
company and part of the incremental tax expenses is compensated through tax savings.
After Tax WACC Computation
Cost of equity is given as 15%
Cost of debt is given as 10%
Post tax cost of debt = 10%(1-0.35) = 6.5%
Weight of equity = 40%
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COST OF CAPITAL MODELS
Weight of debt =60%
Hence, after tax WACC = 0.4*15 + 0.6*6.5% = 9.90%
Viability of Investment
It is known that the angel investor expects a ROI of 8% on the investment. However,
considering that the post tax WACC tends to exceed ROI, hence it may be concluded that the
project is currently not feasible as the desired ROI would not be met (Damodaran, 2015).
Requisite changes in capital structure
It is evident from the above analysis that there is a need to lower the post WACC so as to
ensure that the desired ROI for the angel investor is derived (Lasher, 2016). The proposal would
be financially viable for the angel investor when the post tax WACC is 8% or lower. Let the
proposed debt be x% weightage which would imply that equity level would have (1- x%)
weightage.
Thus, 15%*x + (1-x)*6.5 = 8
Solving the above, we get x = 82.3%
As a result, in order to ensure that the investment criterion of the angel investor is met, the debt
contribution should be raised to 82.3% from the proposed value of 60% in the proposal.
Capital Structure Desired
As an angel investor, I would expect a lower weightage of debt and a higher contribution
of equity. This is particularly important from the perspective of bankruptcy and distribution of
the proceeds of the asset liquidation. The claim of the debtors of the company is superior to that
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COST OF CAPITAL MODELS
of equity shareholders owing to which any liquidation claims would be first used to settle the
outstanding debt obligations. Only if any proceeds are remaining after the settlement of the debt
claims would be distributed amongst the equity shareholders (Brealey, Myers & Allen, 2014).
Thus, a lower weightage of debt would leave some hope for some proceeds for the shareholders.
Conclusion
Based on the above analysis, it is apparent that in the present form the current proposal
would not be able to meet the ROI requirements of the angel investor considering that post tax
WACC exceeds the ROI. In order to ensure that the ROI requirements of the angel investor are
met, the debt weightage for the given proposal would have to be increased to 82.3% from the
current level of 60%. However, the angel investor may not be comfortable with such a high level
of debt considering that in case of bankruptcy the claim on asset is higher for debt holders in
comparison to equity holders.
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COST OF CAPITAL MODELS
References
Brealey, R. A., Myers, S. C., & Allen, F. (2014). Principles of corporate finance (2nd ed.). New
York: McGraw-Hill Inc.
Damodaran, A. (2015). Applied corporate finance: A user’s manual (3rd ed.). New York: Wiley,
John & Sons.
Lasher, W. R., (2016) Practical Financial Management (5thed.). London: South- Western
College Publisher
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