Question

"If a negative EFN (External Financing Needed, aka AFN) is lessening the firms debt because of the ability to pay off existing debt, then it is also reducing the cost of capital. This means that the firm does not have to use as many funds, as a percent (WACC), in order to operate at a level of at least breaking even. If a firm wants to reduce its WACC it should use its negative EFN to pay off debt."

The above statement is incorrect. Please correct this.

Answer 1

Additional Funds is calculated as the excess of required increase in assets over the increase in liabilities and increase in retained earnings

= (Assets /Sales) * (Change in sales ) - (Liabilities/Sales) * ( Change in sales) - New Level of sales * Net Profit Margin * Retention Ratio

Negative figure means there is surplus in capital.

The optimal WACC is a mix of debt and equity (Debt is usually less expensive than giving up equity). This can be achieved by having some debt in the capital structure, since debt is relatively cheaper than equity, while avoiding the extremes of too little gearing (WACC can be decreased further) or too much gearing (the company suffers from bankruptcy costs, agency costs and tax exhaustion). .