Module 5 Homework: Credit Agreements, Liabilities, and Cost of Capital

This homework assignment addresses core finance concepts, beginning with a definition of loan covenants, specifically financial and reporting covenants, and their implications. It then categorizes liabilities as either current or long-term, using examples like accounts payable, notes payable, and mortgage loans. The assignment also explores the three components of the cost of capital: cost of debt, cost of preferred stock, and cost of common stock. It proceeds to calculate the after-tax cost of debt and the cost of issuing preferred stock, comparing the advantages and disadvantages of both methods of financing. Finally, the homework examines the reasons why a company might choose not to offer cash dividends and the potential impact on its business operations. The assignment is supported by references to financial resources.

Module Five Homework
Respond to each and then upload your responses.
1) Define at least two common credit agreement provisions (loan covenants).
A covenant is a guarantee in an agreement or such other official loan contract mentioning
about activities which will and will not performed. The two common credit agreement
provisions in relation to loan covenants are :
1. Financial covenants which contain limitations basis some particular balance sheet,
profit and loss account and cash flow statement. It needs the company to whom loan
is being extended to maintain a minimum level of liquidity during the tenure of the
loan.
2. Reporting and disclosure covenants which requires the borrower to maintain a
minimal leel of interaction with the bank from whom loan is being taken. They are
required to present their financial statements on a periodic basis so as to comply with
the provisions of the loan agreement (The Receivables Exchange 2011).
2) Classify the following as long term or current liabilities: Accounts Payable,
Accrued Liabilities, Note Payable with total balance due in 5 years, Mortgage Loan
with payments made monthly over 5 years.
Accounts payable and Accrued Liabilities are current liabilities since these are to be met
within a span of 12 months and note payable with total balance due in five years should
be classified as long term liability since it is due after 12 months.
With regards mortgage loan with payments made monthly over 5 years calls for
classifying the principle payments payable within a year as current liability in the balance
sheet and the remaining principle as long term liability. The interest component if not
paid should be treated as current liability as it is to be paid as and when it accrues
(Averkamp. 2016).

3) What are the three components of the cost of capital?
Cost of capital refers to the minimal rate of return on the investment that a person is
expected to earn such that the market value of the shares of the company does not
decline. This is a consonance with the overall firm’s objective of wealth maximization.
The three components of cost of capital are cost of debt, cost of preferred stock and cost
of common stock (Ord. 2016).
4) Calculate the after tax cost of debt using the following information
A company issues $2 million at 9% interest with a 15% tax rate.
What is the after-tax cost of debt?
Calculate the cost of issuing preferred stock using the same information above.
What is the preferred stock interest cost?
Using the information above, what are the advantages and disadvantages of both
methods?
The after tax cost of debt => [(2000000*9%)-15%]/2000000=>7.65%
The cost of issuing preferred stock is =>9%
The market value of the preferred stocks are very much reactive to the interest rates. If
the interest rate goes up then the value of the preferred shares will decline thereby giving
a better rate to the investors and if the interest rates decline then the opposite will happen.
The advantages of issuing preferred stock is that the investors have the safety of receiving
a pre-determined dividend that must be paid before any dividend is being paid to the
equity shareholders. Further in case of liquidation, the preferred stockholders have a right
to claim on the assets of the company in lieu of all the unpaid dividends prior to the
equity shareholders. The disadvantages is that from an investors’ viewpoint, there
ownership right is not as similar to the equity shareholders. They do not possess any right
to vote and the fixed dividend that looks attractive may seem to be less attractive in case
the company starts to earn super normal profits thereby giving better dividends to the
equity shareholders.

The advantages of debt financing is that the company does not dilute its control over the
company, gets advantage for taxes as interest cost is an allowable expenditure and it is
easy and less costly to raise money via taking debt. However the disadvantages it offers is
also manifolds, there may be circumstances where the company may be required to
mortgage any of its assets for taking loan and the credit rating fo the borrower should be
good enough to get loan at a good interest rate.
5) What are some reasons a company would chose not to offer cash dividends? What
impact might this have on the business operations?
Reasons a company would chose not to give cash dividends are :
1. Paying cash dividend leads to actual outflow of cash which otherwise would have
used for the operations of the company.
2. The share price also has a negative implication to the extent the dividend is being
paid.
If a company chooses not to pay cash dividends, then it would be able to finance its
various business operations and projects with the help of owned funds as dividends are
amount paid out of retained earnings and this in turn would also reduce the debt burden
from the company. This would also help them to gain better dividends in future as
funding own projects which would yield better results in future would lead to placing the
company in a better position than present (Boyte-White, 2015).
REFERENCES
Averkamp,H. (2016). How Should a mortgage loan payable be reported on a classified alance
sheet. Retrieved from https://www.accountingcoach.com/blog/mortgage-loan-payable-
balance-sheet
Boyte-White, C. (2015). 4 Reasons a Company Might Suspend Its Dividends. Retrieved from
http://www.investopedia.com/articles/investing/101215/4-reasons-company-might-
suspend-its-dividend.asp

Ord,T. (2016). Cost of Capital Components- Formula and Risks. Retrieved from
http://www.mysmp.com/fundamental-analysis/cost-of-capital.html
Investopedia.com. (2017). Which is better a cash dividend or a stock dividend? Retrieved from
http://www.investopedia.com/ask/answers/05/stockcashdividend.asp
The Receivables Exchange. (2011). Understanding Bank Loan Covenants : What do you need to
know before your sign. Retrieved from
http://businessfinancemag.com/site-files/businessfinancemag.com/files/archive/
businessfinancemag.com/files/misc_file/ReceivablesExchange-Whitepaper-Bank-Loan-
Covenants.pdf