The Capital Structure of McDonalds Corporation - Essay Example

MCD has been steadily increasing its debt-equity ratio from the year 2007 through 2012. The following table represents the debt-equity ratio of the company for the last 5 years.

It can be seen from the above table that as the debt-equity ratio rises, the earnings per share of the company also rises and so does the market price per share of the company. Does this mean that the company should go on increasing debt to increase its earnings and thereby shareholder wealth? The trade-off theory ascertains that the optimal debt-equity ratio is 2:1(Optimal Capital Structure, 2012). In the same industry, the company such as AFC Industries has been found to have a debt-equity ratio as high as 2.62 as of August 2012 (Industry debt-equity ratio). The high amount of debt is good during the booming period but equally risky during downslides when revenues fall exponentially and the company may find it difficult to pay interest on its debt. That is the reason high leveraging is considered risky during recessionary periods, however, in the case of MCD, there is considerable scope to increase its debt-equity ratio to expand its business.

MCD’s Cost of Capital can be given using Capital Asset Pricing Model (CAPM)
K = RF + b (KM - RF), where
K is the cost of capital, RF denotes the risk-free return, b (beta) is the systematic risk of a stock relative to the market or index such as S&P. (KM - RF), denotes the equity risk premium that the market would like to earn over the risk-free return in the long run (Capital Asset Pricing Model (CAPM), 2012).
Currently, risk-free return RF can be taken as 1.5% which can be earned by investing in long-term treasury bonds.
Beta b is measured as = 0.31 (yahoo.com)
(KM - RF) can be taken as 7 percent that anybody would like to earn over and above risk-free return.
Thus, the cost of capital = 1.5 + 0.31 (7.0) = 3.67%
A higher debt-equity ratio would make more funds available to the company for business without raising any extra equity.
Currently, the shareholder's equity is $14.04B and the long-term debt is $13.57B (as per data from the second quarter of 2012).
This means that the company is operating at the debt-equity ratio of 13.75/14.04 = 0.98
When a company operates at a 2:1 (debt-equity) ratio means the company would have total debt available to them of $28.08B. That means the company would have an extra $14.25B in funds available that can be deployed in the asset formation or expansion of the business without raising any extra capital from the shareholders.
It is assumed that this extra capital adds to the business and thereby the EPS of the company in the same proportion (while all other things remain the same, of course!). Thus, extrapolating the current EPS of 5.32
One can derive the new EPS as 5.32 × (3/1.98) = 8
Assuming the same P/E ratio of 19 that MCD had during the year 2011, we have
New Market Price/share of the company, P = 19 × 8 = 152
New Market Capitalization or Market Value = Number of shares × market price/ share
= 16,600 × 152 = $38.35B

Dividend Policy
The company is in the fast-food business and runs a large chain of restaurants throughout the U.S. catering to the needs of its customers. Services and quality are crucial aspects of this kind of business. The economic downturn and high unemployment rate equally affect the company in maintaining the growth of the company and during difficult times, people spend less and save more for a lean period. Despite this, the company has been able to maintain reasonable growth and pay consistent dividends throughout all these years and since 1999 the dividend rate is growing at the rate of around 29 percent per annum on an average basis. That means dividends are doubling approximately every two and half years, which is certainly exemplary for the company such as McDonald’s. In fact, with the optimal debt-equity ratio the company will be more in a position to service its shareholders that will match or better its past dividend records.