Capital Structure Decision - Research Paper Example

Capital Structure Capital Structure Decision The capital structure of an organization can be described as the mix of debt and equity that a business has and is an important consideration for any business, while evaluating capital structure, assessment of the overall cost of capital is an important consideration. In terms of decision making over capital items, the weighted cost of capital is usually the sum of the cost of equity as well as the total cost of debt and the cost of preferred stocks with respect to their proportions in the business. Factors considered in evaluation Debt is an important constituent to the capital structure of an organization; however, the uptake of debt has several implications to a business, first, debt leads to an organization having to increase the business risk. The enterprise’s business risk goes up due to its high contribution to the enterprise, in this case, the high contribution of debt such as in option one leads to the debt holders having a high control of the enterprise. As a result, the organization or investment becomes vulnerable for takeover, if the business does not meet the interest payments, as goes into bankruptcy. Secondly, reduces the stake of the enterprise shareholders in that they have to work on servicing the debt at the expense of making profits, which a business’s prime objective(Martin & Baker, 2013). In the consideration of debt options, it is important to consider the debt period, in most cases, long-range debts are highly favorable since the organization utilizes the funds for a long period before repaying the sum value of the bond. Hence, the organization is able to enjoy a return on the investment and even re-invest the excess funds or paid dividends to equity and other shareholders in the business. Short time range bonds such as option three, four and five negatively affects business shareholders, this is because, the business is forced to source for funds and pay the creditors irrespective of whether it has generated profits or not, the bottom line is that the business has a responsibility to repay the funds within the agreed period. Given the long-term nature of projects, the funding requirement leads to complications, as the return may not be realized in good time to pay the sum value as per that date. When this situation arises, the business becomes ripe for takeover according to the provisions of business law. In the light of these, careful considerations have to be made before the business can settle on certain kinds of financing and the activities upon which funding is needed. Careful evaluation can give the business competitive advantages, since it is able to manage successful business investments and other ventures that would have otherwise been impossible with its constrained funds, Having considered debt options, the business has to decide on various investment options that have the lowest weighted average cost of capital. The lower the average cost of capital, the higher the threshold the investment must meet to be viable, for this reason, careful selection is mandatory. Secondly, its imperative to know that the lower the capital cost the higher the return that the business will have to retain, for this reason, the business needs to arrive a clear balance that taken into consideration the amount of debt and the associated risks in terms of repayment schedule. In it is important for the business owners and investment managers to understand that a debt is only aimed at leveraging the business from the short term financial obstacles. In this case, it has to be the final resort when all other options have completely failed, the type of investment which funding is sort for should have the potential of creating and sustaining the debt’s repayment schedules comfortably without strain, this way the business stands to build its credit image among lenders and financial institutions Evaluation of the Total Income Available For Common Stock The first option has the highest cost on the organization in the evaluation of the total cost available for common stock, standing at $46,800. The best performing is option three which stands at $9,360, in this light, the third option is the best option at this point. The second option had no impact on the earnings before interest and depreciation were taken into consideration. It is clear that reliance on this basis alone can be misguiding in the process of selecting the most viable capital structure for the business in the short and long term. Evaluation of Earnings per Common Stock Share The highest number of common shares outstanding stands at 1455, 000, which is in the third option, in this regard, it is evident that the option had been eroded sufficiently. It is a common observation that the third option has the lowest number of outstanding shares, in this regard; the option attracts higher earnings for its common stock holders. Year Nine Option 1 Option 2 Option 3 Option 4 Option 5 Alternative Capital Sources 9% Bonds 50% Preferred (5%, $50 par) and 50% Common Stock 9% Bonds and Common Stock 9% Bonds and Common Stock 12% Bonds and Common Stock Earnings before Interest and Tax (EBIT) 75,446 75,446 75,446 75,446 75,446 Interest on Bonds 72000 0 14400 28800 43200 Income before tax (EBT) 3445.76 75445.76 61045.76 46645.76 32245.76 Income Tax (35% marginal rate) 1206.016 26406.02 21366.02 16326.02 11286.02 Net Income 2239.744 49039.74 39679.74 30319.74 20959.74 Preferred Stock Dividends 15000 Total Income Available for Common Stock 2239.744 34039.74 39679.74 30319.74 20959.74 Common Stock Shares Outstanding 975000 1275000 1455000 1335000 1215000 Earnings per Common Stock share 0.002297 0.026698 0.027271 0.022711 0.017251 In the first year of investment, in terms of the earnings per common stock share, the third option can be seen as having the highest value of returns to its esteemed shareholders. Year 10 Option 1 Option 2 Option 3 Option 4 Option 5 Alternative Capital Sources 9% Bonds 50% Preferred (5%, $50 par) and 50% Common Stock 9% Bonds and Common Stock 9% Bonds and Common Stock 12% Bonds and Common Stock Earnings before Interest and Tax (EBIT) 86,122 86,122 86,122 86,122 86,122 Interest on Bonds 72000 0 14400 28800 43200 Income before tax (EBT) 14122.47 86122.47 71722.47 57322.47 42922.47 Income Tax (35% marginal rate) 4942.864 30142.86 25102.86 20062.86 15022.86 Net Income 9179.605 55979.61 46619.61 37259.61 27899.61 Preferred Stock Dividends 15000 Total Income Available for Common Stock 9179.605 40979.61 46619.61 37259.61 27899.61 Common Stock Shares Outstanding 975000 1275000 1455000 1335000 1215000 Earnings per Common Stock share 0.009415 0.032141 0.032041 0.02791 0.022963 In the second year of investment, in terms of the earnings per common stock share, the second option presents the highest value in terms of returns to its shareholders. Year 11 Option 1 Option 2 Option 3 Option 4 Option 5 Alternative Capital Sources 9% Bonds 50% Preferred (5%, $50 par) and 50% Common Stock 9% Bonds and Common Stock 9% Bonds and Common Stock 12% Bonds and Common Stock Earnings before Interest and Tax (EBIT) 100,387 100,387 100,387 100,387 100,387 Interest on Bonds 72000 0 14400 28800 43200 Income before tax (EBT) 28387.39 100387.4 85987.39 71587.39 57187.39 Income Tax (35% marginal rate) 9935.587 35135.59 30095.59 25055.59 20015.59 Net Income 18451.8 65251.8 55891.8 46531.8 37171.8 Preferred Stock Dividends 15000 Total Income Available for Common Stock 18451.8 50251.8 55891.8 46531.8 37171.8 Common Stock Shares Outstanding 975000 1275000 1455000 1335000 1215000 Earnings per Common Stock share 0.018925 0.039413 0.038414 0.034855 0.030594 In the third year of investment, in terms of the earnings per common stock share, the second option also has the highest value of returns to its particular shareholders. Year Twelve Option 1 Option 2 Option 3 Option 4 Option 5 Alternative Capital Sources 9% Bonds 50% Preferred (5%, $50 par) and 50% Common Stock 9% Bonds and Common Stock 9% Bonds and Common Stock 12% Bonds and Common Stock Earnings before Interest and Tax (EBIT) 118,088 118,088 118,088 118,088 118,088 Interest on Bonds 72000 0 14400 28800 43200 Income before tax (EBT) 46087.65 118087.6 103687.6 89287.65 74887.65 Income Tax (35% marginal rate) 16130.68 41330.68 36290.68 31250.68 26210.68 Net Income 29956.97 76756.97 67396.97 58036.97 48676.97 Preferred Stock Dividends 15000 Total Income Available for Common Stock 29956.97 61756.97 67396.97 58036.97 48676.97 Common Stock Shares Outstanding 975000 1275000 1455000 1335000 1215000 Earnings per Common Stock share 0.030725 0.048437 0.046321 0.043473 0.040063 In the fourth year of investment, in terms of the earnings per common stock share, the second option presents the highest value of returns to its shareholders. Year 13 Option 1 Option 2 Option 3 Option 4 Option 5 Alternative Capital Sources 9% Bonds 50% Preferred (5%, $50 par) and 50% Common Stock 9% Bonds and Common Stock 9% Bonds and Common Stock 12% Bonds and Common Stock Earnings before Interest and Tax (EBIT) 135,632 135,632 135,632 135,632 135,632 Interest on Bonds 72000 0 14400 28800 43200 Income before tax (EBT) 63632.31 135632.3 121232.3 106832.3 92432.31 Income Tax (35% marginal rate) 22271.31 47471.31 42431.31 37391.31 32351.31 Net Income 41361 88161 78801 69441 60081 Preferred Stock Dividends 15000 Total Income Available for Common Stock 41361 73161 78801 69441 60081 Common Stock Shares Outstanding 975000 1275000 1455000 1335000 1215000 Earnings per Common Stock share 0.042422 0.057381 0.054159 0.052016 0.049449 In the fifth year of investment, in terms of the earnings per common stock share, the second option also presents the highest value of returns to its shareholders. Overall Assessment According to the tables given above, the second option provides higher earnings per common stock share over four of the five years of investment presented. The third option follows closely, presenting few investment returns to its shareholders in single year only, the option has a has an additional disadvantage because it has a five-year bond that has to be repaid, this is the reason why it presented small returns to shareholders The five period of the bond will reduce the cash flows of the organization in the fifth year of due to the need to the repay the bond according to the agreed terms and conditions, in this regard; the second option seems to be the best option for the business’ shareholders. This is because, the option keeps the firm firmly in the control of its debts and shareholders, however, it is important to realize that the proportion of preference shareholders at fifty percent should has to be a reason for concern for the business’ common stock shareholders (Ehrhardt & Brigham, 2014). Capital Budgeting Net Cash Flow Evaluation The net cash flow indicates that the business has been increasing its net cash flow over the period from $66,618 to $90,532 between the ninth and thirteenth, this is during the times when the business has experienced a low demand. In the case of a moderate demand, the net cash flow increases from $69,040 to $108,161 hence, the moderate demand provides a higher net cash flow. Under this two periods, the business should be better placed to make its investment decisions by taking advantage of the expected return in the two periods. Net Present Value Evaluation In the evaluation of the net present value of the project, the low demand has a net present value of a loss of $26,740; on the other hand, the net present value of the project for the moderate demand option will be $2,243. This indicates that the option of a moderate demand provides a positive present value that is the favorable return for the business. Internal Rate of Return Evaluation The internal rate of return for the business in the case of a low demand is 8.7% whereas in the case of moderate demand it is 10.1%, for this reason, the overall internal rate of return on the investment is higher for the moderate demand. The higher the internal rate of return, the more favorable it is for a business as it indicates the ability of the business to provide a high return for its shareholders. Secondly, at an internal rate of return of 8.7%, the first option has an internal rate of return that lies below the investment threshold of 10%; for this reason, in addition to the option of a low demand being unfavorable due to being lower than the option of a moderate demand, it does not meet the investment threshold. Overall Evaluation It is important to realize that in the course of evaluation, there are several issues that come about, in the first place, the low demand option does not meet the threshold of investment due to its internal rate of return being negative. Secondly, the organization has a moderate demand that barely exceeds the internal rate of return as it is at 10.1% in comparison to the expected 10%. In consequence, the organization is at a precautious position as the occurrence of a low demand as an even a smaller proportion of the total demand will lead to the business failing to meet effectively its expected capital threshold. The third issue coming about involves the business providing a low return for its shareholders as the present value of the investment is low at $2,243 during a moderate demand. In the case of a low demand, the business would be unable to generate a positive present value, in overall, the business has a low threshold gain for its investments, in this development, there is reduced assurance for any meaningful gains to the business (Ehrhardt & Brigham, 2014). Working Capital After Tax Cash Flow Evaluation The leasing option has lower sum payments than the purchasing option, when the outgoing cash flows are not discounted. In the option of leasing, the loan repayments will amount to $83,089 for the five-year period. In the case of the after tax cash flows on purchasing, the payments will range from $80,439 to $86,143 over the fiver year duration, at the same time, the sum of loan repayments under leasing option amount to $415,445. Alternatively, In the case of a purchasing option, there is a significant change in the total amounts, reaching at $416,040. Net Present Value Evaluation In the evaluation of leasing and purchasing cash flows when it is discounted, the overall present value of cash flows indicates a larger difference. In the option of leasing, the outgoing cash flows would amount to $283,752; on the other hand, the purchasing option brings a different perspective in terms of figures involved, in this option, the amount stands at $399,774. This indicates that the purchasing option would have more costs than the leasing option, which would amount to $116,022 (Horngren, et al., 2012) Overall Evaluation In the case of the leasing option, the outsourcing of the operating costs leads to more gains for the firm in the long haul. This option gives room for operating costs including maintenance to be handled by professionals with expertise of the machinery and facility type. Furthermore, the organization can opt out of the purchase of the facility, hence lead to lower cash outflows, for that reason, leasing is the better option for the organization in the short and long term. Obtaining and managing of working capital Working capital is the backbone of the business, in this light; it can obtain working capital through the decrease of days of receivables and the extension of days of payables. The firm should therefore seek to have sufficient working capital to meet its present budgetary needs as earlier planned. The firm can further manage the working capital through keeping to payment and receivables schedules and having a tight budgetary framework, in addition, the charging of interest on the working capital would benefit the firm. Merger versus acquisition options Merger Evaluation In the case of a merger, Competition Bikes would be a beneficiary of the deal, in the first place, the overall earnings per share at Competition Bikes are a ninth of that at Canadian Biking. Hence, it indicates that Canadian Biking provides a better return for its shareholders, secondly, in comparison, the market price per share of Competition Bikes is 43% lower than that of Canadian Biking, this means that in case of a merger, it would mean advantages that are more competitive for Competition Bikes. The price to earnings ratio provides the described situation in a more clear way, this is because, the price to earnings ratio at Competition Bikes stands at 22 whereas that at Canadian Biking stands at 9. At the same time, if Competition Bikes is overvalued at the time of the merger, its earnings per share would rise significantly after the process by over sixty-five percent. Acquisition Evaluation In the case that Competition Bike acquires Canadian bikes, Canadian bikes would be a suitable acquisition for multiple reasons. First, the firm has an increasing after tax earnings that are growing from $30,000 in year nine to $43,923 in year thirteen. Secondly, the cash flows of the Canadian Biking are also growing from $50,000 in year nine to $63,923 in year thirteen. Furthermore, the firm will register continued growth in the following years after year thirteen of ten percent, which is a more profitable initiative. The offer price of the organization is standing at $286,000; with its price per share standing at $1.43, this is in comparison to the current market price per share, which stands at $1.10. The overall premium on acquisition price per share is thirty percent, which is also in comparison to the premium on the value of the organization, which stands at 34.8% while the total present value for the firm is $212,138. On the other hand, the premium over the net present value is much larger as it is twofold given that the net present value is $136,338.       Present Value Present Years   After tax earnings per year* factor (10%) Value 9   30,000 0.909 27,270 10   33,000 0.826 27,258 11   36,300 0.751 27,261 12   39,930 0.683 27,272 13   43,923 0.621 27,276 Total   183,153   136,338 Overall Evaluation The acquisition option is the overall recommendation to Competition Bikes for the following reasons. Competition Bikes Canadian Biking Total Value Market Value $682,500.00 $220,000.00 $902,500.00 merger $676,875.00 $225,625.00 value (loss) -0.82% 2.56% In the case of a merger, the total value of the two firms as per the market price would be $902,500, in this case, the premium on the acquisition of Canadian Biking would be 30%. This is in addition to the premium on net present value of 34%, whereas, the premium on Canadian Biking during merging is 2.56%. The second reason in proposition for the merger is that it would result in merging of Canadian Biking at a lower value. Secondly, just an in acquisition, the shareholders of Competition Biking would benefit from the growth of Canadian Biking, something that is highly welcomed by any business shareholders. The third reason is that Canadian Biking is undervalued at the market in comparison to Competition Bikes, for this reason, it would provide a larger premium for shareholders of Competition Bikes (Fabozzi, 2011). However, in case of a merger, the firm would have to dilute the shareholding of the organization thus reducing control of the shareholders of Competition Bikes. In addition, the merged organization would face common merging problems in a normal merger; these problems include regulatory challenges of delisting as well as merging; union and employee management challenges; changes in the organization structure including the board of directors. In conclusion In general, business mergers that are properly planned and executed have huge benefit to shareholders of the individual businesses, first, the merger that is created presented a greater enterprise with an increased capital and market base. The merger creates a pool of ideas from the individual business since this is a result of the increased pool of labour, which is needed to cater for the increased customer base. The merger will be better placed to undertake huge investments since it has the much-needed financial muscle. At the same time, the firm is able to enjoy economies of scale from its increased market operations, this way; it is able to enjoy marketing, financial and economies among other economies of scale arising from the merger. However, there are cases where mergers have led to creation of monopolies that later become exploitative to the market. Monopolies arise because of the mergers production of economies which influences the market price of their goods and services in the market, as a result, other business are forced to bow down as they cannot follow suit in reducing the prices of their final products However, governments are other customer protection agencies are always steadfast to champion for the rights of customers who in these cases become price takers, with little ability to raise concerns over the developments in the market. Before the merging process, there has to be a careful analysis of the short and long-term outcomes, this is because, mergers that fail to pick up as expected results in heavy losses to investors besides loosing on the lucrative investment opportunities. References Ehrhardt, M. C., & Brigham, E. F. (2014). Corporate finance: A focused approach. Mason Ohio: South-Western. Fabozzi, F. J. (2011). The theory and practice of investment management. Hoboken, N.J: Wiley. Horngren, C. T., Harrison, W. T., & Oliver, M. S. (2012). Financial & managerial accounting: The managerial chapters.Boston: Prentice Hall. Martin, G. S., & Baker, H. K. (2013). Capital structure and corporate financing decisions: Theory, evidence, and practice. Hoboken, N.J: Wiley. Read More