Unit VII Proposal
Write a proposal for how to achieve the optimal cost of capital for Arrow Wind Farms from the unit lesson. You can make assumptions, but support your work with scholarly references.
? Your proposal should be at least three pages in length, double spaced.
? Use a minimum of three scholarly articles, in addition to the textbook, from the CSU Online Library, or other scholarly sources to support your work.
? In-text citations and reference page must be properly formatted using APA style guidelines. ? An abstract is not required.? Reference and title pages do not count towards the minimum page requirement.
Information about accessing the Blackboard Grading Rubric for this assignment is provided below.
DBA 8341, Corporate Finance 1
Course Learning Outcomes for Unit VII
Upon completion of this unit, students should be able to:
6. Distinguish between different capital structure strategies and payout theories firms use in strategic planning.
6.1 Compare and contrast justifications for different mixes of debt and equity in an organization’s capital structure.
6.2 Explain the optimal capital structure.
6.3 Justify alternative dividend policies.
Dustin Hardaway is the chief financial officer of Arrow Wind Farms, which has planned to expand into several neighboring states. Hardaway wants to optimize the existing capital structure. The company currently finances its assets with 70% equity and 30% debt. Market interest rates are currently low, but expected to rise soon as the economy recovers from recession.
Arrow has a tax rate of 35%, but does not have significant profits. For its first five years of business, the company conducted business only in Iowa. During its first three years, the company ran a loss and broke even just two years ago. Only recently has Arrow started realizing small profits. With development, the company expects significant growth of about 10% a year.
Because the company’s business relies mostly on equipment and not so much on people, fixed costs are high. With growth and added volume once Arrow covers fixed equipment costs, operating leverage should cause profits to rise sharply. If the volume fails to happen, the risk of loss is high.
Despite the risk, Arrow believes wind energy will grow because of the high cost of fossil fuel and rising popularity with consumers. Another reason Arrow has optimism about its growth comes from consumers’ need to conserve energy and the government’s push to use unconventional energy sources.
Although good cause exists for optimism, the need exists to combine alternative energy sources like wind with more conventional sources. The extent to which consumers will use wind energy is therefore uncertain. Arrow has decided it needs to look at other choices besides wind, but will not have a good idea about these projects for at least another five years.
Another issue involved in forecasting the demand and cash flows for new projects is the rapidly changing frontier for new technology. Innovation in the industry has taken place rapidly, which could change the future direction Arrow wishes to take.
Capital Structure: Theory and Taxes, pp. 412-431
Capital Structure: Balancing the Benefits and Costs of Debt, pp. 438-447
The Link between Capital Structure and Capital Budgeting, pp. 466-474
Payout Policy, pp. 479-494
See information below.
Learning Activities (Non-Graded)
See information below.
UNIT VII STUDY GUIDE
Capital Structure and Payout Theories
DBA 8341, Corporate Finance 2
Besides the changes in technology, Arrow faces uncertainty about how consumers will connect to the energy grid. Connection to the grid has major implications because consumers can sell unused energy they produce themselves to other consumers who do not have the equipment to produce their own energy. Tracking consumption and use of energy is a major issue which government has yet to settle.
Arrow will not have a clear understanding of the extent to which revenues from energy sales will rely on consumer affordability. Without any history of other revenues, projecting the net cost to consumers is difficult.
Due to the uncertainty, Arrow has to exercise caution when deciding on the mix of capital used to finance its operations. Too much debt can pose added risk the company does not want to take. Too much equity can hinder the ability to take advantage of low interest rates. Most important, no one knows how much demand how will come about and how much it will take to overcome both operating and financial leverage concerns.
The development into neighboring states will take a major investment and the company wants to keep the cost of capital low and the future cash stream high to satisfy shareholders. Because the company has a volatile history beta, estimates are shaky. Analysts have predicted beta all over the board for Arrow.
Although history has thrown beta estimates into question, the company believes it can estimate the cost of equity by adding a 4% risk premium to the cost of debt. Unstable earnings do not allow the company to use a stable growth rate to estimate cost of equity. Arrow estimated 4% risk premium by looking at other companies’ cost of capital in the industry.
Ronald Moy. (2013). Capital structure – EBIT EPS analysis
. Retrieved from http://youtu.be/MuRAuY8fBNQ
Ronald Moy. (2013). Capital structure – Operating leverage
. Retrieved from http://youtu.be/fdwZ9Iej3H0
Ronald Moy. (2013). Modigliani and Miller part 1
. Retrieved from http://youtu.be/SX-UX_n-6mY
Ronald Moy. (2013). Modigliani and Miller part 2
. Retrieved from http://youtu.be/gxKcxR5p6EA
Ronald Moy. (2013). Modigliani and Miller part 3
. Retrieved from http://youtu.be/WxFfby_OrPk
Learning Activities (Non-Graded)
Understanding terminology is not only vital to understanding a particular industry, profession, or field of study, but is also necessary to communicate effectively. This learning activity will help you build your professional vocabulary.
Non-graded Learning Activities are provided to aid students in their course of study. You do not have to submit them. If you have questions, contact your instructor for further guidance and information.
Click here to access Unit VII Learning Activity.