The Capital Structure Decision and the Cost of Capital - Case Study Example

XXXXXXXX Number: XXXXXXX XXXXXXX XXXXXX of XXXXXXX Corporate Finance Case 4 "The Capital Structure Decision And The Cost Of Capital" Advantages and Disadvantages of Debt Financing: There a number of advantages and disadvantages of debt financing. One of the biggest advantages of debt financing is that the bank or the institution that finances the loan does not get any part of the ownership. Also, here the amount repayable is fixed before hand and the interest levels that need to be paid are also fixed. Compared to the equity financing this form of financing provides the businesses with a higher level of freedom and ability to invest and grow the business. The obligations of debt is limited to the period and which there is not claim that can be made by the lender on the business. The debt financing can also prove to be a strong way to improve the credit rating of the firm (Marks, Robbins and Fernandez). This form of financing is relatively much cheaper for the small and medium business in the long run, however is expensive in the short term. The disadvantages of this form of financing are also quite high. One of the main disadvantages is that the borrower requires making regular monthly payments for both the principal as well as interest. This can be difficult for newly started businesses as they generally tend to have a shortage of funds making the payments very difficult. The severity of the payment delays and missed payments is also very high. Lenders charge late fees, and even possession of the collateral which can be harmful for the business. Also the late payments or missed payments have a direct impact on the credit rating of the company making it difficult to obtain other loans in the future (Reference for Business). Debt Financing and its effects on Rate of Return: When a company opts for a debt financing, there is a change in the cash flow of the company which accrue the equity. When there is an increase in the debt there is also a direct increase in the equity financing as well, which corresponds to an increase in the cost of equity financing as well. In every company the shareholders require a high rate of return and this as well pushes the cost of equity financing to a higher level. According to Proposition II of Modigliani and Miller, ‘the cost of equity is a linear function of the firms debt/equity-ratio’ (Clayman, Fridson and Troughton), hence this simply means that if there is an increase in the debt of a firm then there will also be an increase in the rate of return required by the investors as well. The two are directly proportional to each other. Optimal Capital Structure of the Firm: The optimal capital structure of a firm refers to a balanced capital structure with both debt and equity. Balancing out the capital structure and gaining a well balanced capital structure involved a number of issues. There are issues that concern the high costs that are involved in the use of debt instead of equity, and also the tax deductibility of interest expense that increases the use of debt in the firms capital structure. A right balance between the level of debt and the equity financing for a firm is referred to as an optimal capital structure for the firm. The optimal capital structure of a firm is also the amount of debt and equity that maximizes the value of the firm. Analysis of Companies: a) General Dynamics: General Dynamics basically deals with the manufacturing of aviation, land and expeditionary combat vehicles. The company is spread across the world and employs as many as 91,700 people. The company mainly deals with building, ‘armaments, and munitions; shipbuilding and marine systems; and mission-critical information systems and technologies’ (General Dynamics). The company deals with four main segments which includes, Aerospace Designs, Combat Systems, Marine Systems and Information Systems and Technology. The company provides complete land and expeditionary support for the US Military and the US Navy and also deals with the building of advanced business – jet aircrafts. The company was started in 1952 as a result of a merger between Electric Boat Company, Canadair Ltd. and other companies. The company has grown to become the world leaders and has been able to integrate as many as 43 businesses over the past ten years. General Dynamics has a high set of values that it follows and it ensures that the shareholders receive the best while it provides high quality products and services to commercial customers, military and other government offices. A major focus of the company is on excellence and also in the continuous improvements and innovations in the operations. The beta of the company has been found to be 1.24 (Yahoo Finance - GD), this simply implies that the company has a medium level of volatility and this would require that the company has a medium level debt ratio. b) Sprint: Sprint was founded in 1987 by entrepreneur named Morgan OBrien. The company was founded under the name of Fleet Net, which was then changed over the years in 1993 to Sprint. The company is the leaders in the American markets for the pin – drop clarity and for the voice and data services. The company has grown and developed and has created a new league of telecom companies and it provides local, wireless and also long distance services. The company believes and bases all its processes on a simple two step technique which includes, being innovative and provides best customer experience. The company has pioneered a number of things including the nationwide PCs Network in the US. The company has come to be known for the innovations that it provides along with the high use of technology and the excellent customer support and service that it provides (Sprint Nextel). The company has received a number of rewards and recognition for the customer service that it provides along with the excellence in the products and services as well. The beta value of Sprint has been found to be 1.17 (Yahoo Finance - S). This simply implies that the level of volatility is slightly high. This makes the firm slightly risky. The debt ratio for this company should be anything between medium and low. This is simply because the beta of the company is closer to the beta of the market which makes it relatively less risky and hence the choice of debt ratios. c) Dell: Dell Computer Corporation was started as by an eighteen year old Michael Dell, who as a student worked part time from his hostel room to format hard disks for the PCs of the fellow students and also worked on improving the memory space and disk drives and the modems of the IBM clones. This was the actual birth of the company and it was from here that Michael Dell moved on to build one of the world’s largest PC manufacturing companies (Dell Inc.). Dell at present holds as much as 13.2% of the total markets of the world, however the company has slipped down from its major position in the market over the past few years (Krangle). Dell uses a business model which is direct and very transparent and simple. The company’s business model is one which is focused on better execution and minimum inventory. The company’s beta has been found to be 1.32 (Yahoo Finance - Dell). This indicates the high level of risk that the company deals with each day. This simply indicates that the company requires having a high debt ratio. Works Cited Clayman, Michelle R., Martin S. Fridson and George H. Troughton. Corporate Finance: A Practical Approach (Cfa Institute Investment). Wiley , 2008. Dell Inc. About Dell. 2010. 26 February 2010 . General Dynamics. General Dynamics NASSCO Delivers USNS Matthew Perry . 2010. 26 February 2010 . Krangle, P. Dell Loses More Market Share In Q4 (DELL). 2009. 26 February 2010 . Marks, Kenneth H., et al. The Handbook of Financing Growth: Strategies, Capital Structure, and M&A Transactions. Wiley, 2009. Reference for Business. DEBT FINANCING . 2010. 19 February 2010 . Sprint Nextel. History. 2010. 26 February 2010 . Yahoo Finance - Dell. Dell Inc. (DELL). 2010. 26 February 2010 . Yahoo Finance - GD. General Dynamics Corp. (GD). 2010. 26 February 2010 . Yahoo Finance - S. Sprint Nextel Corp. (S). 2010. 27 February 2010 . Read More