How Corporate Decisions Involving Capital Structure Impact the Value of a Business - Assignment Example

• What is capital structure, and how do corporate decisions involving capital structure impact the value of a business?

Capital structure is a broad term that denotes the proportion of a business entity’s capital that is acquired through equity or debt. According to Chandra (2010), a firm may decide to allocate some of the cash flow to a fixed component dedicated to meeting its obligations towards debt capital, and another component towards equity shareholders. Essentially, capital structure is a component of the financial structure of a business that is concerned with long-term sources of business funding. Since it shuns the short-term financing components, it shows the permanency of the financing decisions relating to the net-worth, preferred stock and long-term debts (Chowdhury & Paul Chowdhury, 2010). Many firms try to find and maintain an optimal capital structure in its operations. A decision concerned with the proportion of the two types of securities, debt, and equity, is called the capital structure decision of a business.

The corporate decisions involving the capital structure affect the share price, cost management, investment opportunities, growth and value of a business. The impacts of capital structure decisions on the business value are mostly concerned with value maximization. The purpose of value maximization is to increase the ownership interests and value of claims owed to shareholders of a business. As such, any business aims to have an appropriately designed capital structure that increases the aggregate of the claims(Bierman, 2003). The exact manner in which the capital structure of a firm influences its value is subject to debate. Several economists have put forward their models to stipulate the manner and conditions under which the firm's capital structure influences the value. The Modigliani and Miller (MM) model, crafted in 1958, is one of the most prominent and provides the basis for other recent theories. They argue that the value of a firm is independent of its capital structure under certain conditions (Chowdhury & Paul Chowdhury, 2010). However, they assert that the value of a firm is positively related to its capital structure if there are tax-deductible interest payments. Myers wrote in 1988 that the there is no optimal capital structure that can increase the value of a business (Adair, 2011). Alternatively, decisions on capital structure affect the value of a firm should be evaluated based on the industry of a business on a case-by-case basis. Other economic researchers assert that a capital structure that maximizes the value of a firm may exist while considering market imperfections such as agency and bankruptcy costs.

The cost of a capital can be used to find the value of a firm. A business that uses a mixed capital structure needs to calculate the Weighted Average Capital Cost (WACC) to determine its value by discounting its future cash flows (Pratt & Grabowski, 2014). Since the firm’s value is negatively correlated with the discount rate, minimizing the WACC rate maximizes the value claimable by stakeholders. This implies that the proportion of debt-equity that gives the lowest WACC is the most optimal to influence the management’s decisions.

• What is Free Cash Flow, how is it measured, and how does corporate management of it impact the value of a business?

The free cash flow of a company (FCF) refers to the excess amount of money that remains after the payment of dividends and capital expenditures. The cash is used to pay for the operations of the entity that maximizes the shareholder value (Bierman, 2003). For instance, the operating cash pays for new product development, buying back stock or increasing the dividend’s value. An increasing free cash flow may be an indicator of good performance from the growth of the business. Conversely, a reducing cash flow may be a sign of poor performance. However, not all situations of reducing free cash flows indicate trouble because the firm may have spent on new capital expenditures or product launch.

The statement of cash flow is the basic document used in the calculation of the free cash flow. Free cash flow is computed by subtracting the total of capital expenditures and dividends paid from the total cash from business operations (Pratt & Grabowski, 2014). The dividends paid and capital expenditures represent real cash payments and must be subtracted from cash from operations. However, some companies are not mandated to pay dividends. As such, the calculation of free cash flow does not take dividends paid into an account.

Free cash flow is a measure of the ability of a business to generate cash or profits. The corporate management of free cash flow increases the value of a firm since it leaves the businesses with cash to invest further. The more investments the firm makes from the free cash flow, the more likely a firm is to increase its value if it manages the new assets properly (Bierman, 2003). Consequently, the firm develops the ability to pay higher dividends through the proper utilization of the free cash to make profitable investments.

• How do Merger and Acquisition (M&A) decisions impact the value of a business? Please answer this question from the perspective of both the acquiring firm shareholders and the selling firm shareholders. In addition, explain how value is created or destroyed in M&A.

Decisions on mergers and acquisitions have significant ramifications on the value of the formed business. Mergers and acquisitions give the business several benefits such as synergy, increased ability to beat off competition, diversification and growth opportunities (Cooper & Finkelstein, 2009). These benefits have direct and indirect impacts on the value of the firm. The decision to engage in merger or acquisitions affect the value of bonds and stocks. Based on past examples or acquisitions, evidence suggests that shareholders in the acquired firms gain significantly. Shareholders gain a typical amount of 30% in tender offers that are valued above the market prices. They also gain 20% in mergers that are valued above the prevailing market prices one month before the merger is announced to the public(Cooper & Finkelstein, 2009). In most cases, the stock prices of the acquiring firm remain flat after the merger announcement. The stock prices of the target company rise after a merger announcement. Shareholders in the bidding companies tend to gain little amounts. The loss of value after a merger announcement is likely to happen in the event of an overvaluation by the bidding company. According to Cooper and Finkelstein (2009), there are times when the management decisions do not focus on increasing the value for the sake of shareholders. Such decisions are based on the future benefits as opposed to the immediate economic benefits of the shareholders due to increased market value.

Value creation in mergers and acquisition is created through increased capabilities on the newly established entity. The resultant economic gains such as economies of scale enable the company to reduce its costs of operations. Mergers and acquisitions also create value by combining complementary resources that allow a firm to have a better control of the supply chain. Value maximization also results through the elimination of operational efficiencies and reaping of tax benefits (Cooper & Finkelstein, 2009). Most of the reasons give the firm the power to increase its market power and share. Value creation results from increased market power, garnering of benefits and reduction of inefficiencies. It is vital to consider that mergers and acquisitions may be complex to value, establish the benefits and costs accurately, handle the legal, and tax requirements. Additionally, value creation may not be a guarantee as the market may be volatile and resistant to the established enterprise.

• What is a cash distribution decision, and how does it impact the value of a business? Be sure to explain the advantages and disadvantages of dividends, open market share repurchases, fixed-price share repurchases and Dutch auction share repurchases.

A cash distribution decision refers to the adopted manner of distributing a firm’s cash between investments and cash payments to shareholders in terms of dividends. The presence of an optimal cash distribution decision or policy depends on the preferences of the investors concerning capital gains or dividend yields (Pratt & Grabowski, 2014). A business’s distribution policy that decides to pay the stockholders more as opposed to reinvesting in the business largely neglects the role of increasing the value of the business for a sustainable period. However, the market value of a business can be spearheaded by a cash distribution decision that retains or increases its stock by paying less to stakeholders. This ensures that there are more capital gains that translate to increased value.

Paying dividends indicate that a company is in a good financial position. It also predicts the expectations of the future performance by a method called information signaling(Chandra, 2010). Paying dividends is advantageous because it assures stakeholders of reliable earnings. Dividends carry a level of certainty as opposed to capital gains. For investors, paying dividends proves the company is stable. Dividends are disadvantageous because they leave the company with low retained earnings for investment. A company’s growth becomes limited by paying high dividends. When a company fails to pay dividends regularly, clients may leave in search of regular dividends. Paying dividends also require accurate and continuous record keeping which is time-consuming.

Companies buy back shares from stockholders through repurchases. Open market share repurchases offer companies a convenient way of buying back shares on an ongoing basis. It also gives the company the needed flexibility to distribute value. The major disadvantage of open market share repurchases is the inability to predict how it will impact the value of the company. Companies are also not obliged to stick to their announcement of share repurchases (Adair, 2011). The government also restricts open market share repurchases. The government puts a ceiling on the number of shares that a firm can buy back in a day. Dealing with these restrictions is cumbersome. Fixed-price share repurchases confirm the exact price and the maximum number of shares. This is advantageous as the management can operate with accuracy after the stockholder tender back the number of shares they intend to sell. However, it does not guarantee the management that it will achieve the target number of shares it wills to but back. Dutch auction repurchases consider the number of shares that stockholders are willing to sell at a series of prices. It is advantageous to stockholders as they can get higher values for their shares due to the price flexibility (Adair, 2011). It also gives the company a higher probability of achieving its target repurchases. However, it is risky for the company as the price flexibility puts the stockholders in the driving seat. The company spends more on repurchases than it had expected.

• What is the weighted average cost of capital (WACC) and how do you calculate it? Why is the determination of an accurate WACC important for a business? Finally, please explain the CAPM formula, including how to calculate each of its components……..and, please explain the difference between a levered beta and an unlevered beta.

When deciding the rate at which to compensate its investors, a company uses an average rate of return known as the weighted average cost of return (WACC). A firms cost of capital is computed and the weights represent fractions of each funding source in the capital structure used by a company (Pratt & Grabowski, 2014). Since a company juggles between getting its financing from debt or equity, it is importance to calculate WACC because it helps a company to find out how expensive it is to raise the funds for operations and future projects. A low WACC indicates that is cheap to finance future operations. The management of a firm can sanction the increased use of its cheap funding sources. For instance, a decision to issue more bonds than stocks implies that a company intends to utilize more debt as a cheap funding source. The company would decrease its WACC because the debt to equity ratio would be high, meaning that debt is cheaper to acquire than equity.

The following formula is used in the calculation of WACC

(Source: Pratt & Grabowski, 2014)

E= Market value of a company’s equity

D= Market Value of a company’s debt

Re= Cost of equity

Rd= Cost of debt

V= E+D

D/V= Percentage of financing representing debt

E/V= Percentage of financing representing equity

TC= Corporate tax rate

The capital asset pricing model (CAPM) finds the cost of capital.It is calculated as following

CAPM= re=rf+β× (rm − rf)

rf=Risk-free rate (usually indicated at 4%)

β= Predicted levered equity beta

(rm − rf) = Market risk premium (usually indicated at7%)

In the CAPM formula, Beta represents the level of stocks’ risks relative to the stock market. It is crucial to use the appropriate Beta to account for risks while calculating the cost of equity. Beta is determined by plotting a graph of market’s returns against stock’s returns at separate intervals over a regressing line and a period through the emergent data points (Pratt & Grabowski, 2014). Unlevered Beta refers Beta that is used in weighing equity. It is assumed that funding through equity is not as risky as funding through debt. Additionally, each equity funding source carries a varied risk. Unlevered beta scraps off the risks of debt. The levered beta considers the real situation of the capital structure used by a firm. To get the levered beta, a process of re-levering occurs. The unlevered Beta is regarded as the “industry” Beta of the company under valuation.