Debt and Equity Capital - Essay Example

PART -A (a) Calculation of market value of Gibson in case it is not taken over by Alserford Ltd 000) Operating cash flow north south total tax@30% operating profit after tax cost of capital market value 12000 12000 24000 7200 16800 18% 93333.3333 12000 8000 20000 6000 14000 18% 77777.7778 16000 8000 24000 7200 16800 18% 93333.3333 20000 4000 24000 7200 16800 18% 93333.3333 Answer: The market value of Gibson Ltd in the absence of any take over is $ 93,333,000 (b) Taxable operating profit Total head office cost profit less head office cost capital expenditure after capital expenditure salvage value value to be paid north south 12000 12000 24000 2000 22000 8000 14000 12000 8000 20000 2000 18000 18000 16000 8000 24000 3000 21000 21000 24000 20000 4000 24000 3000 21000 21000 12000 total 74000 36000 38000 Answer: If the suggestions of strategic manager are completely ignored, the maximum amount that Alresford Ltd will have to pay is $38,000,000 (c) Three options are discussed separately: 1. Termination of south division's operations Taxable operating profit Total head office cost profit less head office coat capital expenditure after capital expenditure salvage value value to be paid north south 12000 12000 24000 2000 22000 8000 14000 12000 12000 24000 2000 22000 22000 20000 16000 11000 27000 3000 24000 24000 16000 20000 4000 24000 3000 21000 21000 total 81000 36000 45000 2. Taxable operating profit head office cost north south Total profit less head office coat savings in transport cost capital expenditure after capital expenditure salvage value value to be paid 12000 12000 24000 2000 22000 600 8000 13400 12000 8000 20000 2000 18000 600 17400 16000 8000 24000 3000 21000 600 20400 24000 20000 4000 24000 3000 21000 600 20400 12000 total 71600 36000 35600 3. Taxable operating profit Total head office cost profit less head office cost advertising profit capital expenditure after capital expenditure salvage value value to be paid north south 12000 12000 24000 2000 22000 3600 18400 8000 10400 12000 8000 20000 2000 18000 3600 14400 14400 18400 8000 26400 3000 23400 3600 19800 19800 24000 22400 4000 26400 3000 23400 3600 19800 19800 12000 total 64400 36000 28400 Since the least payment to be paid by Alresford to Gibson under third option, i.e., 28400, it is advisable to go ahead with third option. (d) Under Imputation system, the tax payable by the company is deductible for the tax computation of shareholders. The imputation system, when the company's tax is avoided the calculation will be as follows: Operating cash flow north south total cost of capital market value 12000 12000 24000 18% 4320 12000 8000 20000 18% 3600 16000 8000 24000 18% 4320 20000 4000 24000 18% 4320 PART B The Cost and Benefits of Debt Introduction Among the various sources of capital, debt is an important and popular source of long term fund for small as well as big firms. Other sources include equity and preference shares and retained earnings. Debt is a long term arrangement with a lender by a company to avail finance on a certain set of conditions. The lender may be banks and financial institutions, public, and other corporations issuing debt securities. The company can avail debt capital in various forms such as bonds, long term loans from banks and financial institutions etc. Bond is the most common form of debt security issued by a corporation. Bonds are issued by governments also in time of financial crisis. Debt is the least cost and hence the most popular source of capital for corporations. In addition to that it has many advantages. As bonds are the common form of debt capital, bonds and debt are often used interchangeably. Moreover, the attributes of bonds as a source of long term capital are similar to any other debt capital. Therefore, the following discussion of cost and benefits of debt is common to bonds and long term loans. Cost of Debt Debt is a long term agreement with a lender (bank or public) by a company to avail funds on the condition that interest shall be paid by the latter to the former during the period of debt and the principal shall be paid at the end of maturity period. The interest to be payable by the company to the lender is known as the cost of debt. In other words, cost of debt is the interest payable by the company to the lender for using the latter's hard earned money. The interest payment is to be made annually or semi-annually depending upon the terms of agreement. However, the interest payment cannot be fully taken as the cost of capital because debt capital has certain privileges over other sources of capital, because of which debt has become the popular source of long term fund. The cost of debt can be calculated as below (investopedia) This is the simplest method of calculating the cost of debt. As stated already, cost of debt is not exactly equal to the interest payment to be made by the borrower to the lender. The actual interest must be reduced by corporate tax. The rationale behind reducing the interest payment by tax rate is that interest payment is a tax deductible expense, i.e., it is deducted from the current years profit as revenue expenditure (in the income statement) before the computation of tax, resulting in a tax advantage. This tax advantage availed by the firm is technically known as tax shield. This is because, if the tax had been computed before the interest payment, the tax amount would have been higher. Therefore, while computing cost of debt, the tax rate must be deducted from the actual payment of interest. For example, if 'X Ltd'. has issued bonds at a coupon rate of 10% and the firm is in the tax rate of 50%, the effective/actual cost of capital comes to 5% because of the tax advantage the firm is getting on account of interest being treated as a charge against current years profit. Benefits of Debt The benefits of debt can be discussed in the following manner 1. As regards companies are considered, debt capital is the most beneficial source of long term fund. The first and foremost benefit of this source of capital is its lowest interest rate unlike equity. The rate of return expected by investors/lenders is the lowest for debt capital as they are assured periodical payment in the form of interest and the principal at maturity. The risk is minimum for debt from investors' point of view. Therefore, investors need relatively low rate of return. This is the least cost source of external fund for a firm. 2. Tax shield ( Harbus Fredric 2002, p.33) 3. The rate of return remains the same during the tenure of debt. The coupon rate agreed upon by the borrower and the lender does not vary during the period of debt. 4. The effective cost of debt is lower than the coupon rate (fixes interest rate) because of t tax shield. 5. The benefits out of leverage. The use of debt capital in the capital structure along with equity can magnify the return to equity shareholders. 6. The floating cost (incidental expenses at the time of issue of security) is lower than equity as the formalities to be complied with when debt security is issued is the minimum. 7. Debt is the ideal source of finance at the time of emergency. However, the point to be noticed is that debt is a risky source of fund from the firm's point of view. Because, once debt source is used, the firm is under legal obligation to pay periodical interest to the lenders and repayment of principal. But, in the case of equity, the payment of dividend is not only variable but also the payment is up to the discretion of the firm. Therefore, firm should try to optimize the use of debt capital along with equity. Explain the variables that are relevant to the capital structure optimization exercise. Explain how the capital structure is adjusted and why Capital structure decision is one of the crucial decisions taken by a finance manger. In a broad sense, the term capital structure refers to the mixture of different sources of long term funds. However, in a narrow sense, capital structure means the mixture or combination of debt and equity capital. Capital structure is important because an optimum combination of debt and equity can reduce the overall (weighted average) cost of capital and thereby firm's market value can be enhanced. Debt is a contractual obligation between the company and the lender and hence a creditorship security whereas equity is an ownership security and the firm is under no legal obligation to pay dividend or principal amount. Every firm try to get an optimum capital structure so that the return to equity shareholders can be increased and cost of capital can be reduced. The following variables are to be taken care of at the time of capital structure optimization. (Harbus Fredric 2002, p.37-40) Cost of Debt The reduced interest rate is the one reason for the relevance of capital structure decisions. Unless the debt cost is lower than equity cost, the question of optimization of capital structure do not arise. Proportion of Debt and Equity The proportion between debt and equity in the capital structure also does matter in deciding the capital structure. As the debt is having lowest cost, the increase use of which can reduce overall cost capital computed by taking the total cost of both debt and equity capital. Leverage Leverage is the tendency of the residual income (return available to equity share holders) to vary in accordance with the combination of debt and equity. If the leverage is positive/favorable, it is an indication that the capital structure is reaching optimization stage. If the leverage is negative/unfavorable (return to equity shareholders declines), the firm has to be vigilant about the use of further debt capital. The expectations of equity shareholders The expectation of equity shareholders as to the risk and benefits about the use of debt, the risky source of fund, should also be taken care of at the time of capital structure optimization. When debt is more and more added in the capital structure, equity shareholders expectations as to the riskness will increase which will result in increase cost of equity capital. The cost of Equity As the cost of equity is something expected by the equity investors over their investment, it goes on increasing as the risk of increased use of debt increases. Cost of equity as subject to change should also be considered. The optimum capital structure is adjusted by getting a trade-off between debt and equity. The question what trade-off is depends upon a number of factors and they need not be the same for all firms and often for the same firm at different time points. An optimum capital structure is that combination of debt and equity where overall cost of capital is lowest and value of firm is maximum. In other words, optimum capital structure is said to exist when the return to equity shareholders is highest and firms' cost of capital id lowest. It is situation of capital mix, where firm has maximum value in the market. However, the determination of optimum capital structure is a quite difficult task, which requires utmost care from the part of finance manager to finds a perfect balance between debt and equity. References Debt Vs Equity. 2002. Dynamic Quality. Viewed 29 November, 2008 Hamilton. N.d. Debt and Equity Capital. Viewed 28 November, 2008 Harbus Fredric, Heine Roger (2002). Journal of Applied Corporate Finance: Toward a More Complete Model of Optimum Capital Structure. p.33 Honig Gary. N.d. Financing using Equity Vs Debt. Viewed 29 November, 2008 Investopedia (n.d.) Cost of Debt. Viewed on 28 November, 2008. McConnon Jim. (n.d.) Capital Sources for you Business. Viewed 28 November, 2008. Seetharaman Anand, Zane Swanson & Bin Srinidhi. 2003, The Capital Structure Paradigm: Evolution of Debt/Equity choices. Praeger. Page Number 1- 10. Sherman Andrew. 2002. Understanding the Different Sources of Capital. 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