Debentures, Optimum Capital Structure - Assignment Example

Question 1:

DEBENTURES

Debt which is not secured by physical assets is called a debenture. The creditworthiness and reputation of a person or organization incurring debt are mainly the security of the debentures. These are mid-term or long-term financing used by different businesses. There are advantages and disadvantages of debentures because of which some investors prefer to invest in debentures, and some do not (Arnold, 2008)

Many investors prefer using debentures as it helps in reducing the cost of capital of the company. Moreover, raising funds with debentures is beneficial as the company does not have to give the voting rights to anyone and thus, it gives them the flexibility to manage the business the way they want to(Arnold, 2008). Debentures are also helpful in increasing the returns to the shareholders, and they are also helpful in reducing the tax, as they are deducted before the earnings before interest and taxes and thus, it reduces the amount the firm has to pay for taxes (Gitman, 2003)

On the other hand, there are disadvantages of debentures as well. One of the major disadvantages of debentures is that it creates a permanent burden on the organization as they have to pay a fixed amount as interest for the debentures. Therefore, it also increases the risk of the organization(Gitman, 2003). Moreover, as debentures is a kind of debt, therefore, adding debentures impact the capital structure and total debt of the company, and it influences the ability of the company to take loans(Arnold, 2008).

Question 2a

Optimum Capital Structure

The capital structure shows how the company has raised its capital or defines the sources of the capital of the company. Every source of capital (debt and equity) has its cost(Arnold, 2008). The optimum capital structure is defined as the ratio of debt to equity where the firm can maximize its value. At optimum capital structure, the cost of capital of the firm is the lowest(Gitman, 2003). Thus, it means that if the equity in the capital structure increases, then it will increase the cost. Similarly, if the debt increases, then it will also impact the cost of capital. Including debt in the capital structure reduces the cost of capital as generally, debt has low cost than equity. However, including too much of debt in the capital structure makes the organization risky. Therefore, theoptimum capital structure provides the right balance between the cost and risk of the company (Arnold, 2008).

Question 2b

Net operating income

200,000

Total investment

500,000

Assumption: No. of Shares are

10,000

• If the firm uses no debt 10%

Debt

0

Equity

500,000

Market Value

500,000

the value of shares

50

Cost of Equity

40%

average cost of capital

40%

• If the firm uses Rs. 25,000 debentures

Debt

25,000

Equity

475,000

Market Value

500,000

the value of shares

47.5

Cost of Equity

42%

average cost of capital

40.55%

• If the firm uses Rs. 4, 00,000 debentures 13%

Debt

400,000

Equity

100,000

Market Value

500,000

the value of shares

10

Cost of Equity

200%

average cost of capital

50.40%

QUESTION 3

Type of Capital

Book Value Rs.

Market Value Rs.

Specific Costs (%)

Debt

400,000

380,000

5

Preference

100,000

110,000

6

Equity

600,000

900,000

18

Retained Earning

200,000

300,000

13

1,300,000

1,690,000

• Weighted Average Cost Of Capital Using Book value weights

The weighted average cost of capital using book value weight is 12.31%

• Weighted Average Cost Of Capital Using Market value weights

The weighted average cost of capital using market value weight is 13.41%

QUESTION 4

OPERATING LEVERAGE AND FINANCIAL LEVERAGE

Leverage in finance is defined as the concept of magnifying the returns of the company. The concept of leverage is used by the managers with the aim to increase the earnings and to capitalize on the benefits that leverage offers in magnifying and multiplying the earnings of the organization. This canbe done in two ways; operating leverage and financial leverage. Operating leverage analyzes the sales of the firm and its production cost. Operating leverage can be measured by the total fixed cost of the organization to the variable cost (Ross, Westerfield, and Jordan, 2009). The greater is the value of this ratio, the greater is the operating leverage. It can be explained as an organization has high operating leverage, and this would suggest that the company can increase its production without increasing its fixed cost. Thus, as the production of the company will increase, the fixed cost will remain the same, and it will help the company in magnifying the profits. On the other hand, the other concept of leverage is the financial leverage (Pike, and  Neale, 2009)

Financial leverage is defined as adding of debt in the capital structure will help in magnifying the returns of the shareholders. It can be calculated by dividing total debt of the organization to the owner’s equity. With adding more debt to the capital structure, an organization avails benefits by increasing the returns to the shareholders(Ross, Westerfield, and Jordan, 2009). However, adding more debt means increasing the risk of the company, so if the organization does not have sufficient cash on hand to meet its obligations, then this can be another cost, and it could impact the liquidity of the firm(Pike, and  Neale, 2009).

Both the leverage concepts are helpful in magnifying the returns of the shareholders. Operating leverage is used to magnify the returns of the company before interest and taxes (EBIT) whereas financial leverage is used to magnify the earnings of the shareholders (EPS).

Question 5

• Explain the factors affecting the dividend policy

There are different factors that affect the dividend policy of the organization. One of the main factors of the organization is to analyze the future cash flows and how the firm would like to raise these cash flows. If the firm requires capital or funds shortly, then it may change its dividend policy and retain more cash,and this could influence the dividend policy(Ross, Westerfield, and Jordan, 2009). Similarly, the other factor that impacts the dividend policy is attaining the optimum capital structure. To reduce the cost of capital, firms try to add or reduce debt and equity and this could be one of the factors that impact the dividend policy of the company(Pike, and Neale, 2009). The other factor is the stability of the firm and its cash flow. If the firm has stable cash flows and returns, then it is likely to pay more dividends to the shareholders and vice versa. Moreover, legal requirements also impact the dividend policy of the firm. In addition to this, other factors that impact the dividend policy are the economic condition; industry average returns particularly dividend payout ratio of similar firms,ability, and easiness to raise additional funds,etc.(McLaney, 2009).

• Modigliani and Miller’s approach to dividend policy

Modigliani–Miller approach presents the concept that the dividend payout of the company and its history of paying adividend is irrelevant for the investors. According to this concept, investors do not rely on or trust the history of the dividend of a company (McLaney, 2009). As per this theory, the value of an organization is unaffected by its finance if there are no taxes, agency costs, no cost for bankruptcy and the organization is operating in an efficient market(Ross, Westerfield, and Jordan, 2009). Moreover, as per Modigliani–Miller approach firms prefer first to take capital from the internal sources and then they prefer external sources. Internal source means retaining the earnings of the shareholders and paying fewerdividends(McLaney, 2009). According to Modigliani–Miller approach, the cost of debt and cost of equity are equal, and cost of capital is not influenced by leverage concept(Pike, and  Neale, 2009). However, this theory has been highly criticized as in practical; the perfect or efficient market does not exist. Moreover, as per theory the wealth of the shareholder is not affected because of dividends, however, in reality when investors are selling the shares they have to pay some transaction cost and for this purpose, they prefer dividends (McLaney, 2009).

Question 6a)

Payback Period

project costs

2,000,000

Profit Annual

300,000

Depreciation

12.50%

Tax

50%

Profit after depreciation

300,000

Tax 50%

150,000

Net Profit

150,000

Add Depreciation

250000

Net Profit With Depreciation

400,000

Payback Period

5.00

Payback Period for the project is 5 Years

Question 6b)

Net Cash Flows

Project X

Project Y

Year 0

- 20,000

- 30,000

Year 1

5,000

20,000

Year 2

10,000

10,000

Year 3

10,000

5,000

Year 4

3,000

3,000

Year 5

3,000

4,000

Net Present Value

3,850

4,305

As Net Present Value of Project Y is higher, therefore it should be accepted.