Effect of Capital Structure on the Weighted Average Cost of Capital - Coursework Example

 TABLE OF CONTENT PAGES WACC 03 EFFECT OF CAPITAL STRUCTURE ON WACC 03 OPTIMAL STRUCTURE 04 CALCULATION OF WACC 06 CALCULATION EARNING PER SHARE 07 ESTIMATING LEVERAGES 10 QUICS 12 CAPITAL STRUCTURE COMPARASION 12 CONCLUSION 14 BIBLIOGRAPHY 14 REFERENCES 14 This study discusses about the cost of capital and weighted average cost of capital (WACC). It also includes estimation of WACC and different leverages and analysis through leverages and financial ratios are also included in the study. The study gives a very good idea about the capital and optimal capital structure and its implementations. Before defining the effect of capital structure on weighted average cost of capital (WACC), we should have a good idea about WACC. THE WEIGHTED AVERAGE COST OF CAPITAL (WACC): Firms are made to create surplus; it is possible to finance the firm entirely by total equity but due to the fear of bankruptcy most firms include different types of capital to finance the Corporation. Usually common stocks, preferred stocks and debt are three most often used types of debts. The investors who invest their money in the firm for hope to get a return on their investment are called stockholders or shareholders. In other words, evaluation of a proposed project should be based on the project’s cost of capital (Vernimmen, 2005). This is because when a company raises capital, there is usually no direct links between the return to the supplier of the company’s capital and the return on individual project. The corporation then uses the weighted average of these capitals for mixing in the firm’s overall equity to analyze the capital budgeting decisions. It takes into consideration the weighted average of all the capital and is thus referred as weighted average cost of capital (WACC). EFFECT OF CAPITAL STRUCTURE ON WACC: The firm’s mixture of debt and equity is called its capital expenditure. Although actual level of debt and equity may vary somewhat over time, most firms try to keep their financing mix close to a target capital structure. As we know that the WACC is a weighted average of relatively low-cost debt and high cost equity, so precisely we can say that capital structure change will affect the WACC to increase or decrease with respect to the change that occurs in the capital structure. OPTIMAL CAPITAL STRUCTURE: The firm’s mixture of debt and equity is called its capital structure. The fundamental source of a company’s value is the stream of net cash flows generated by it assets. This stream is usually referred to as the company’s net operating cash flow or earning before interest and taxes (EBIT). The capital structure adopted by a company divides the stream between different classes of investors. If a company is financed entirely by equity and there is no company tax, this entire stream is available to provide income to shareholders. If a company also borrows funds, the lenders have the first claim on the net operating cash flow and shareholders are entitled to the riskier, residual cash flow that remains after the lenders have been paid (Vernimmen, 2005). Manager should choose the capital structure that maximizes shareholder’s wealth. The basic approach is to consider a trial capital structure based on the market values of the debt and equity, and then estimate the wealth of the shareholders under this capital structure. This approach is repeated until an optimal capital structure is identified. We have to take 5 steps into consideration to determine an “optimal capital structure”, the steps are; 1. Estimate the interest rate the firm will pay 2. Estimate the cost of equity 3. Estimate the weighted average cost of capital (WACC) 4. Estimate the free cash flow and their present value, which is the value of the firm 5. Deduct the value of the debt to find the shareholders’ wealth which we want to maximize An investor in a company with a low debt-equity ratio is likely to attach a low probability to that company encountering the severe financial difficulties that we call financial distress. Therefore if such a company issues a small amount of additional debt, then under the classical tax system, the resulting tax savings are likely to outweigh the very small increase in expected cost of financial distress. The proportion of debt increases the probability of financial distress and its expected cost. The higher expected costs will offset the effect of the additional tax savings and eventually a point will be reached beyond which the value of the company starts to decrease (Bossaerts, 2001). These are the challenges of balancing debt holders concern against the equity holders. CALCULATION OF WACC: First we will calculate the weighted average cost of capital (WACC) of Rushmore Corporation before taking the affect of income tax. Proportion of Debt Cost of Debt Cost of Equity WACC 0.00 -- 11.0% 0.10 3.7% 11.1% 10.36% 0.20 3.9% 11.5% 9.98% 0.30 4.1% 12.0% 9.63% 0.40 4.5% 12.9% 9.54% 0.50 5.1% 14.0% 9.55% 0.60 6.5% 16.0% 13.5% It is pertinent to include the regulatory requirement which must be implemented by the corporations in order to standardize its debt to equity ratio. The regulatory requirement of debt/equity ration is 70:30 not below than that and can’t be more than that. It means that in total, the capital structure of the corporation must be 30% debt and 70% corporation’s own money. It can be clearly observed from the table that Rushmore Corporation have to select the WACC of “9.63%” because the total proportion in this WACC of debt and equity is 30% and 70% respectively in order to meet with the regulatory requirements. Rushmore Corporation’s overall chosen cost of capital is 9.63%. Therefore, to satisfy its investors, Corporation must generate a return on an average project of at least 9.63%. CALCULATING EARNING PER SHARES AND COMPARASIONS: Information we have: Ice Leaf Long Tea Debt (8%) $250 million $75 million Common Equity $250 million $ 425 million Number of Common Shares Outstanding 25 million 42.5 million Total Assets $500 million $500 million (a) First let’s talk about the expansion period. Incomes Rates Affects Earning before Interest and taxes (EBIT) $ 80 million Tax Rate 40% $ 32 million Profit After Tax (PAT) $ 48 million Earning per Share (EPS) “ICE LEAF” $1.92 per share Earning per Share (EPS) “LONG TEA” $1.129 per share Now let’s see the affect of recession on the corporation. Incomes Rates Affects Earning before Interest and taxes (EBIT) $ 35 million Tax Rate 40% $ 14 million Profit After Tax (PAT) $ 21 million Earning per Share (EPS) “ICE LEAF” $0.84 per share Earning per Share (EPS) “LONG TEA” $0.49 per share Recession leaves a bad impact on the Profit after tax as well as on the earning per share. It can be clearly seen that the profit after tax during expansion was $48 million and both the corporations “Ice Leaf” and “Long tea” earned $1.92 and $1.129 per share respectively. On the contrary, the profit after tax of $21 million during recession shows a decline of $27 million or (56.27%) of both the corporations which condensed the earning per share as well. (b) We can calculate four main ratios from the limited information to check which stock is less risky. The ratios are: (i) Return on Assets (ROA) (ii) Return on Equity (iii) Debt to asset ratio (DAR) (iv) Debt to equity ratio (DER) After calculating the ratios, the summary reveals that the ROA of both the corporations are same which is 9.6% while the Return on equity (ROE) of “Ice leaf” is far better than “Long tea” because the ROE manifest a huge difference in the figures of Ice Leaf and Long tea which shows 19.2% and 11.2% respectively. From an investor’s point of view, greater ROE ratio is worthwhile. Debt to asset ratio (DAR) reveals something different; after calculating DAR we came to know that the DAR of “Ice Leaf” is 50% while the DAR of “Long tea” is 15%. Creditors and investors look at this ratio when they are trying to decide what the chances are that the company won’t be able to make good on there business loans and financial obligations. As one might guess, creditors like this number to be low; the lower it is, the greater the chance that company will be able to ride out rough times. So from an investor’s point of view, “Long tea” company is more beneficial as compared to it competitor “Ice Leaf”. The debt to equity ratio (DER) indicates the relationship between external equities and internal equities. Calculation of that particular ratio shows that the “Ice Leaf” corporation has a 100% (DER) which shows that the corporation’s total equity comprises only on the debt while the DER of “Long Leaf” is 17% which shows the financial stability. If these ratios are considered then we can say that the stock of “Long leaf” is less risky as compared to “Ice Leaf’s” stock. (c) We have to select one corporation’s EPS based on the calculated EBIT where the EPS will be same for both the corporations. Let’s select “Ice leaf” EPS the base which is $1.92 per share on EBIT of $80 million. Now consider below mentioned data for “Long tea”, Incomes Rates Affects Earning before Interest and taxes (EBIT) $ 136 million Tax Rate 40% $ 54.4 million Profit After Tax (PAT) $ 81.6 million Earning per Share (EPS) “ICE LEAF” (base) $1.92 per share Earning per Share (EPS) “LONG TEA” $1.92 per share Above data shows that $136 million is the EBIT where the EPS of both the corporations is same with respect to the basement of “Ice Leaf” corporation’s EPS. ESTIMATING LEVERAGES: To compute the leverages we adopt the methodology which is mentioned below. THE STERLING TIRE COMPANY ($) Sales 1,200,000 Less : Variable Cost 600,000 Contribution Margin 600,000 Less : Fixed Cost 400,000 Earning Before interest and Taxes (EBIT) 200,000 Less : Expenses 50,000 Earning before taxes (EBT) 150,000 Less: Income Tax (30%) 45,000 Profit after tax (PAT) 105,000 Operating Leverage 3.00 Financial Leverage 1.33 Combined Leverage 4 After calculating the above leverages we observed that sterling tire company is using a poor optimal combination because the operating leverage is so high, and the higher a firm’s fixed cost, the greater it’s operating leverage. In the business terminology, high degree of operating leverage, when other factors are held constant, implies a relatively small change in sales and a large change in EBIT. While increasing financial leverage, increase the return on equity of the company but consequently it will enhance the risk associated with the business (Baxter, 1967). If I am suppose to do with the optimal structure of Sterling Tire Company, and then my first priority would be to mitigate the fixed cost from cutting the bonuses, reducing the man power, eliminating the additional fixed charges e.t.c. Let’s suppose I become successful to abate the fixed cost of the Corporation by $100,000 then it will condense the operating leverage to 2 and will help to increase the financial leverage from 1.33 to 1.5, while the combined leverage also manifest a decline from 4 to 3. QUARTELY INCOME CAPITAL SECURITIES (QUICS): There are a number of income securities which pay dividend annually. One type of preferred securities is quarterly income preferred securities (QUIPS) which have a structure which pays dividend quarterly. Hybrids of hybrids now include monthly income debt securities (MIDS), which have a maturity life of 30-50 years, issued directly by the parent company which guarantees monthly payments. Quarterly income capital securities (QUICS) are similar to QUIDS as these are exchangeable notes which after an initial period and at the company’s option, can be exchanged or converted into the issuer’s preferred stocks (Bossaerts, 2001). The main difference between QUICS and preferred stock is that the QUICS pays quarterly dividend while preferred stock pays monthly dividend but both are considered as debt for the corporation. Debt for equity exchange increases the risk of the common stocks because a corporation can’t redeem its preferred stocks. CAPITAL STRUCTURE COMPARASION: As we are well aware with the fact that Pepsi and Coca Cola are the two largest beverage companies of the world which are doing business in the same industry from a number of years. In order to compare and contrast the capital structure of both the companies, we have to aggregate the annual repots FY 2006 and extract a meaningful result. We are cognizant with the fact that the mix of debt and equity is called the capital structure. We can see that from the annual report that the total liabilities of Coca Cola and Pepsi increases as compared to the last year by 17.83% and 87% respectively. Some sort of significance can also be found in their earnings per share (EPS) which shows that the EPS of both the companies declines as compared to the last year. Coca Cola declines by 3.18% in earnings from shares as compared to last year, while Pepsi declines by 6.2%. In contrast, we observe that the equity of Coca Cola company decline by 7% FY 2006 as compared to the same period of the last year. On the contrary the equity of Pepsi is surge by 2% in 2006 as compared to the last year’s equity. Increment in liabilities is the most prominent significance which can be observed during the analysis as it impacts the capital structure because increase in liabilities or equity will affect the weighted average cost of capital which ultimately will affect the capital structure. From the calculations we observe that the operating leverage of Coca Cola Company is “2.54” and the financial leverage is “0.92” which made the combined leverage equals to “2.33” while the operating leverage of Pepsi is relatively low from Coca Cola. Operating leverage of Pepsi is “0.91” and financial leverage is “2.31” which makes the combined leverage equals to “3.22”. From the calculations we can observe that Pepsi has a better capital structure as compared to Coca Cola because of the lower operating leverage and higher financial leverage because operating leverage shows the high cost incurrence. CONCLUSION: From the above calculations and controversies we can say that Operating and financial leverages are helpful to get an idea about the capital structure of any organization. We also observed from the study that how the risk of a stock is calculated and from limited information how we can come to know that which stock is less risky. REFERNCES: Baxter, N (1967). Leverage, Risk of Ruin and the Cost of Capital. Journal of Finance 22, 3956-403. Vernimmen, Pierre Quiry, Pascal, Dallochio, Maurizio, Le Fur, Yann & Salvi, Antonio (2005) Corporate Finance: Theory and Practice. Wiley Bossaerts, Peter L. & degaard, Bernt Arne (2001). Lectures on Corporate Finance. World Scientific. Read More