Nuances of Debentures, Optimum Capital Structure, Equity, Operating Leverage - Assignment Example

Financial Management Name Institutional Affiliation Question1 Debentures can be defined as a medium to long-standing debt tool normally used by relatively large companies to borrow money, however, a debenture loan is normally not safeguarded by physical assets or security. Debentures have fixed rate of interest unlike other loans and their security of the loan is determined by the overall creditworthiness and repute of the issuer. Debentures are mostly issued by corporations and the government to secure capital. Debentures are normally documented in an indenture just like any other type of bong. They are also the utmost collective long-term loans taken out by a business. Debentures can be classified into two types: Convertible and Non-Convertible debentures. Convertible debentures as the name say convert they can convert into equity shares later in a specified period of time of the issuing corporation. Convertible debentures are utmost striking to shareholders this is because of their capability to change and their nature of low interest rate. Non-convertible debentures are, however, the steady debentures which cannot be transformed into equity of the distributing company. Question 2 (a) Optimum capital structure can be defined as the best to equity ratio for a firm which exploits its worth. The capital configuration is said to offer stability among the debt-to-equity ranges and thus minimizing the company’s capital charge. However, to examine optimum capital structure the ratio of short and long-term debt would be measured. Furthermore, Optimum capital structure is a main obligation in any company’s business finance sector since firms can raise capital with either debt or equity. (b) Equity is equal to total income less shares hence = (Rs.2 00000 + Rs. 50000) – (Rs. 25000 + Rs. 400000) = Rs. 275000 Market value can be computed by multiplying the current market price by outstanding shares therefore, Rs. 200000 × (11/100 × 25000) = Rs. 55000000. The company’s value of shares can be calculated by subtracting the operating income from total investments. Rs. 500000 – Rs. 200000 = Rs. 300000 The average cost of capital can be computed by E/V Re + D/V Rd (1 – Tc) where Re is cost of equity, Rd is cost of debt, D is the market value of the firm’s debt, Tc is the corporate tax rate, E = market value of the firm’s equity, E/V is percentage of financing equity and D/V = percentage of financing debt therefore (7/100 × Rs. 275000) + (6/100 × Rs.50000 ( 1- Rs. 2750) ) = ( Rs 19250 ) + ( 827000) = Rs. 84266250 Question 3 Computation of weighted average cost of capital Source of funds costs (%) book value weight average cost Debt 5 40 8 Preference 6 10 1.67 Equity 18 60 3.33 Retained earnings 13 20 1.538 Question 4 Operating leverage has fixed bearing assets in the firm’s employment operation while as financial leverage has fixed financial charges bearing funds in a capital structure. The effect of fixed operating cost is measured by operating leverage while as effects of interest expenses are measured by financial leverage. Sales and EBIT are affected by operation leverage while as EPS is affected by financial leverage. The firm’s cost structure is affected by operating leverage while as financial leverage is responsible for the firm’s capital structure. The business risks are created by operating leverage while as the firm’s financial risk is brought about by financial leverage. Higher DOL causes high BEP and low profits hence the preference of low operating leverage while as high DFL is the best since a slight rise in EBIT causes greater rise in shareholders income. Question 5 (a) A company’s dividend policy can be affected by several factors which may also include factors affecting the type of dividend to be issued. Legal requirements These requirements include: net profit rule, the capital impairment rule and the insolvency rule. These remain the only roles imposed by law regarding dividend distribution. Liquidity position of the firm A company’s liquidity situation also disturbs the dividend policy since despite the company’s sufficient earnings if, the business’s incomes are not held in cash hence the business may not be able to fee cash dividend thus affecting the dividend policy. Repayment need A business requires some forms of debt hence meeting its stock requirements thus the credits need to be paid at maturity. Therefore, the business has to keep profits to repay its debts, thus reducing dividend payment capacity reduces. The expected return rate If a company has greater predictable return rates whenever it’s in a new investment the company prefers to keep it’s earnings so as to use them for reinvestment. These earnings may have been used for buying cash dividends hence affecting dividend policy due to inadequate cash to pay for dividends. The firm’s stability of earning This will affect dividend policy since a firm with relatively stable earnings pays for larger dividend than a company with unstable earning earnings hence affecting the company’s dividend policy. Desire of control If the need for extra funding arises a company might choose to issue a common stock this is because of anxiety of erosion control hence the company prefers to retain more earnings thus satisfying financial need which will end up reducing dividend payment capacity. Access to capital market Easy access to capital market leads to added funding hence does not need retained incomes thus the business’s payment capability of dividend becomes high affecting the firm’s dividend policy. The firm’s shareholders tax situation Shareholders prefer lower cash dividend since a high cash dividend leads to higher taxation hence preference of capital gain other than dividend gain which may also affect the firm’s dividend policy. B This theory is a major proponent of Dividend irrelevance since investors are not expected to pay some attention to the dividend history of a firm thus when calculating a firm’s valuation dividends are termed as irrelevant. This concept makes it to directly contrast with Dividend significance which terms dividends to remain the most significant in assessment of a firm. Modigliani – Miller theory suggests that the gains in dividends and capital are equal when returns on stock are considered. Hence explaining that they only impact to valuation is earnings which can be referred to as an uninterrupted outcome of a firm’s investment policy then the forthcoming prospects. Therefore, conferring to this policy when the investment policy becomes recognized to the stakeholder additional contribution on the history of the dividend will not be important. Modigliani – Miller further illustrate why dividends are not relevant to determine a firm’s valuation. This theory says that irrespective of whether a firm pays dividend. Investors of the firm are able to make cash flows which will be done from the stock depending on the need for cash hence if they need more money arises they can always sell part of their investment thus making up for the change. Similarly, if the stakeholder’s cash decrease they can continuously invest received dividend in the stock hence Modigliani-Miller stated that dividend policy does not affect a firm’s investment decision. However, their assumptions to this theory which include: the existence of perfect capital markets, no taxation, fixed investment policy and the inexistence of no risk of uncertainty. Question 6 Cost Rs. 2000000 Profit Rs. 300000 Payback period can be computed by adding the profits less tax divide by project cost. Rs. 300000 – Rs. 150000 = Rs 150000 Costs divide profit to get pack period 200000 ÷ 150000 = 13 1/3 months B Project X cash flows = Rs. 30000 Project Y cash flows = Rs. 40000 The company should accept project Y since it yields more profits for the company compared to X and has more cash flows. References Anthony Saunders. (2000). Financial institutions management: a modern perspective. McGraw-Hill College. Heaton, James B. "Managerial optimism and corporate finance." Financial management (2002): 33-45. Saunders, A., & Cornett, M. M. (2003). Financial institutions management: A risk management approach. Irwin/McGraw-Hill. Read More