There is an inverse relationship between the present values of cash flows and the assets. If the interest rate in the markets increases, the present values go lower since future values will be discounted at a higher rate so that the become lower present values. On the other hand if the interest rates decrease, the present values are higher since the future values will be discounted ata a lower rate.
If a company raised its credit standards, it would experience decreased investment which would reduce it financing. Also it would not be able to make payments to is stock holders. If the situation would worsen, it would lead to bankruptcy since investors would go to the company’s competitors.
The weighted average cost of capital (WACC) measures the capital discount of a company’s income and expenditure. It is a component of the formula used for calculating the expected cost of new capital and it represents the rate that a company is expected to pay to finance its assets. It is thus the minimum return that a company must earn on its existing asset base to satisfy its creditors, owners, and other providers of capital, (Hazel, 1999). A company must earn at least it weighted average cost of capital on new investment for the purpose of financing it and ensuring that it gives back the expected and intended returns. If it does not, it would bring about losses into the company since the investment would not meet the goals of the company. The shareholders would also be expecting high capital gains but this will not happen so some may pull off resulting into loss of financing. The company would also not be able to make its interest payments.
The use of convertible debt in a company is beneficial because they offer good rates of return. It is also advantageous when it comes to company valuation. The company avoids the task of coming up with the value of the company which at times is different from that in the market. When people invest in the debt, it provides financing for the company since its value is not yet known. There is a higher risk of bankruptcy for the company if they fall due and the debts are not paid.
An investor can lose protection provided by the convertible debt if the company is not successful. If not converted to equity or stock when it falls due, the debt would remain payable if the lender calls it in. This is because the note is taken out against the company’s assets thus the lender would have no right to liquidate the assets to get his money.
The company would want to offer the convertible debt and get a repayment on time and they would also want to get returns out of it. The investors on the other hand would want to have enough time but there is never enough time. They would also prefer lower rates.
As a financial manager I would prefer to use the net present value and profitability index. This is because they both take into account the time value of money by discounting the cash flows of the projects. They also offer a decision criteria and they use all the cash flows of the project. They also consider the timing and magnitude of the cash flows by discounting them. Finally, they are both consistent with the shareholders wealth maximization goal since projects that offer negative benefits in present value terms will be rejected. In addition, profitability index is a ratio as opposed to an absolute figure and therefore can be used for evaluating project of different magnitudes.
I would not use the payback period and the discounted payback period because they do not consider all the cash flows of the project. The payback period also ignore the time value of money and does not give a decision criteria in case of single projects. I would not use the average rate of return because it ignores the time value of money and uses accounting profits instead of cash flows. The accounting profits may have accounting errors. Finally I would not use the internal rate of return because it is difficult to understand, uses unrealistic assumptions and cannot be use for mutually exclusive projects.
The benefit of placing a financially troubled company into chapter 11 bankruptcy proceedings is that an automatic stay will be imposed and the creditors will be bared from any claims to the company. There will also be no foreclosure. The company therefore can continue with its operations without any interruptions. It is also good because the court is in control of the company. However, the costs of the proceedings are high and there is an oversight of the court and the creditors. The company will also be under the duty of the court and the creditors and therefore must seek approval for any action outside the course of business. I believe it is a good vehicle to take because the company will be able to continue with its operations and thus can be able to pay all it dues with time.
References
Johnson Hazel, (1999), Determining Cost of Capital, The Key to Firm Value. London: FT Prentice Hall.
Eugene F. Brigham and Joel F. Houston (2011) Fundamentals of Financial Management
