Financial Management Issues - Assignment Example

Running Head: [short [institute of affiliation] Questions/Problems DISCUSS the effect of capital structure on WACC. Capital structure determines WACC in such a way that the proportion of debt versus equity determines their relative combination given the different costs for each financing. When a company uses all-equity financing, the cost of capital that it uses is the cost of its equity. While the cost of debt is lower than the cost of equity, the utilization of debt decreases the cost of capital up to a certain point. This difference in choice of combination of the funding, or the capital structure therefore, affects WACC in that the different choices of financing have different costs in using them, respectively. 2. Is there such a thing as an “optimal capital structure”? What would you take into consideration in determining an “optimal capital structure”? What are some of the challenges of balancing debt holder’s concerns against equity holder’s concerns? Optimal capital structure is the combination of debt and equity that maximizes shareholder value. In order to maximize shareholder value, WACC has a role to play. Minimum WACC, usually the lowest weighted average cost of capital among all the combinations of debt and equity is used by the company to determine the required return to investors. In order to create value, the company has to create projects with returns that will surpass the cost of capital. The higher the cost of capital, the fewer the projects the company can accept in order to create value. Therefore, weighted average cost of capital, which is a function of the combination of debt and equity in terms of proportion, and the costs of each of the two financing have to be considered when determining an optimal capital structure. While the optimal capital structure is the rational thing to adopt in order to maximize shareholder value, it is usual that the structure will depend on the sentiments of the investors, or how conservative they are in taking risks. Availing more debt will prove to be riskier, and only up to a certain point will it give the company some advantages over the lower WACC. Higher debt also means to equity holders a lower EPS in times of recession and hard times for the company, as debt holders are first when it comes to the company’s payment of financing. Therefore these are some of the considerations when determining the capital structure. 3. Rushmore Corporation has estimated its cost of debt and equity as follows: Proportion of Debt Proportion of Equity Cost of Debt Cost of Equity WACC 0 1 0% 11.00% 0.11 0.1 0.9 3.70% 11.10% 0.1036 0.2 0.8 3.90% 11.50% 0.0998 0.3 0.7 4.20% 12.00% 0.0966 0.4 0.6 4.50% 12.80% 0.0948 0.5 0.5 5.10% 14.00% 0.0955 0.6 0.4 6.50% 16.00% 0.103 Given this information, calculate the WACC for each situation and identify the debt/equity mix that you would select. Support your choice with a discussion of why you selected that mix. 0.4 0.6 4.50% 12.80% 0.0948 I choose the combination of 40% debt and 60% equity as the weighted average cost of capital is at the lowest possible level at 9.48% given the combinations. I choose this because this minimizes the cost of capital that the investors demand of the company, which gives way to more projects that are likely to surpass the WACC and contribute more value to the company. This WACC is used by the company to determine which projects are to be accepted in order to create value for the shareholders. 4. Ice Leaf and Long Tea (both 40 percent tax rate) are two companies that are practically identical in every way except for their capital structures. Each of the capital goods manufacturing companies has $500 million in total assets. Their specific differences are shown here: Ice Leaf Long Tea Debt (8%) $250 million $75 million Common equity $250 million $425 million Number of common shares outstanding 25 million 42.5 million Like most capital goods manufacturers, Ice Leaf and Long Tea are subject to cyclical trends in the economy. Suppose that the EBIT level for both companies is $80 million during an expansion and $35 million during a recession. a. For both expansion and recession compute the earnings per share for each company. SCENARIO: EXPANSION ICE LEAF       LONG TEA               Long-term debt at 8% 250000000 Long-term debt at 8% 75000000 Common stock 250000000 Common stock 425000000         Total liabilities and equity 500000000 Total liabilities and equity 500000000         Common shares outstanding 25000000 Common shares outstanding* 42500000         Projected EPS Levels               EBIT 80000000 EBIT 80000000 Less: interest expense -20000000 Less: interest expense -6000000 Earnings before taxes (EBT) 60000000 Earnings before taxes (EBT) 74000000 Less: taxes at 40% -24000000 Less: taxes at 40% -29600000 Net income 36000000 Net income 44400000 Earnings available to common 36000000 Earnings available to common 44400000 EPS 1.44 EPS 1.0447059                 SCENARIO: RECESSION ICE LEAF       LONG TEA               Long-term debt at 8% 250000000 Long-term debt at 8% 75000000 Common stock 250000000 Common stock 425000000         Total liabilities and equity 500000000 Total liabilities and equity 500000000         Common shares outstanding 25000000 Common shares outstanding* 42500000         Projected EPS Levels               EBIT 35000000 EBIT 35000000 Less: interest expense -20000000 Less: interest expense -6000000 Earnings before taxes (EBT) 15000000 Earnings before taxes (EBT) 29000000 Less: taxes at 40% -6000000 Less: taxes at 40% -11600000 Net income 9000000 Net income 17400000 Earnings available to common 9000000 Earnings available to common 17400000 EPS 0.36 EPS 0.4094118                 b. Which stock is safer? Why? Long Tea’s stock is safer. As the market goes volatile, the firm’s primary means of funding which is equity is able to sustain its financial position. During down times, revenues are likely to fall which results in lower EBIT. When a company depends a good deal in debt financing, the cost of debt will put a strain in EBIT. As debtors are paid first in the company before the stockholders, earning per share will be dependent upon the residual earnings of the company, from which interest expense or the cost of debt is deducted. Therefore, the company which has less debt financing is less riskier, thus its stock is safer. c. The two companies have the same earnings per share at what EBIT level? ICE LEAF       LONG TEA               Long-term debt at 8% 250000000 Long-term debt at 8% 75000000 Common stock 250000000 Common stock 425000000         Total liabilities and equity 500000000 Total liabilities and equity 500000000         Common shares outstanding 25000000 Common shares outstanding* 42500000         Projected EPS Levels               EBIT 40000000 EBIT 40000000 Less: interest expense -20000000 Less: interest expense -6000000 Earnings before taxes (EBT) 20000000 Earnings before taxes (EBT) 34000000 Less: taxes at 40% -8000000 Less: taxes at 40% -13600000 Net income 12000000 Net income 20400000 Earnings available to common 12000000 Earnings available to common 20400000 EPS 0.48 EPS 0.48                 When EBIT level is at 40 million, both companies will earn the same level of EPS, which is 0.48 in earnings per share. 5. The Sterling Tire Company income statement for 2001 is as follows: Sterling Tire Company Income Statement For the Year Ended December 31, 2001 Sales (20,000 tires at $60 each) $1,200,000 Less: Variable costs (20,000 tires at $30) 600,000 Fixed costs 400,000 Earnings before interest and taxes (EBIT) 200,000 Interest expense 50,000 Earnings before taxes (EBT) 150,000 Income tax expense (30%) 45,000 Earnings after taxes (EAT) $ 105,000 Given this income statement, compute the following: a. Degree of operating leverage. DOL = 1 + (fixed costs / pretax profits) DOL = 1 + (400,000 / 150,000) DOL = 1 + 2.67 or 3.67 b. Degree of financial leverage. DFLEBIT = EBIT / (EBIT – I) DFLEBIT = 200,000 / (200000-45000) DFLEBIT = 200,000 / (155,000) or 1.29 d. Degree of combined leverage. DCL = DFLEBIT * DOL DCL = 3.67 * 1.29 DCL = 4.7343 Do you feel that this company is using an optimal (or good) combination of operating and financial leverage? While there is no comparison in which to base the findings, I can say that the optimum combination of operating and financial leverage will be determined by the risk appetite of the investor. The low financial leverage will protect the company during down times, especially because the sales of its product depend on the sales of other products, such as cars, which use tires as inputs. As for me, I would have increased the financial leverage in order to utilize debt and increase shareholder value. While larger combined leverage entails more risk, it also entails larger returns in order to compensate for the risk. CASE 1 Questions 1. Describe the QUICS. Are they debt, or are they equity? How do they differ from the convertible preferred stock? One characteristic of QUICS that enable it to qualify as debt is the payment of interest expenses. In contrast to preferred stocks which require payment of dividends, QUICS offer interest expenses. The other characteristic that enables it to qualify as debt is the tax deduction in interest payment for the corporation. Deduction of financing, such as that of interest expense is only allowed to be deducted in the income statement for payment of debts. The main difference that it has with the preferred stock is that the payments of interest in QUICS is a deductible expense to the company; whereas, the payment of dividends to preferred stocks are not because they are part of equity. 2. Why does this debt-for-equity exchange increase the risk of the common stock? How does the interest-deferral feature affect your interpretation of the QUICS? The risk of the common stock? As debt increases, the risk in common equity increases because of the use of leverage. The higher the financial leverage, the higher the risk that the firm has to absorb. The risk in common stock increases as leverage is used. The more financial leverage is used by a company, the larger it will reap during the good times, or when EBIT increases. However, during the bad times, the common stock will likely absorb the impact. Therefore, the increase in the financial leverage due to QUICS will make the common stock absorb more risk. 3. What trade-off did AMR have to evaluate as it considered whether to proceed with the exchange offer? The trade-off will be the additional payment due to the increase in the yield percentages in exchange for the interest saving that it could defer and reinvest first. Because the interest can be deferred, the company can save the payments and reinvest first in its operations. CASE 2 DISCUSS how the capital structures are similar (COMPARE) and how they are different (CONTRAST). The two companies’ capital structures are similar in a way that they both utilize a near 50/50 proportion for both debt and equity. As they grow their assets, they increase their structures by the percentage, and until recently does one of them, Coke, make a major change in the structure. The difference lies in the company’s approach to changing the capital structure. As both of them move from more equity to lessening it and employing more debt, they differ in approach. Pepsi does this by buying shares from their stockholders so the capital structure will be changed without an abrupt change in the proportion. Also, this buying of shares has been made gradual over the course of years. Coke’s approach on the other hand is to increase it by employing more debt. This distorts its proportion abruptly and causes some impacts on its credit rating, as stated in the annual report of the company. What significant actions have the companies taken recently that impact their capital structure? Over the past year, Coca Cola has increased in total assets which results in a huge increase in its long-term debt. As Pepsi has grown itself but not as huge as Coca Cola’s increase, the increase in long-term debt is relatively lower in terms of percentage. Pepsi on the other hand buys the shares from its shareholders. Prior to this increase, we can see that Pepsi has a more stable capital structure although its proportion is at 50/50. While Coke maintains a 49.75% and 50.25% capital structure, not far from Pepsi, this is a huge change to the company’s financial policy Which company do you think has a “stronger” capital structure? Explain your choice. I think Pepsi does have the stronger capital structure. The capital structure has remained stable over the course of the year and the company has supported its growth by the percentage of its financing. Coke has increased its long-term debt by a relatively huge percentage, which makes it a bit riskier. That is why, as to my opinion, Pepsi has a stronger structure. Reference List Keown, A. J., Martin, J. D., Petty, J. W., & Scott, Jr., D. F. (2005) Financial Management: Principles and Applications. New Jersey: Pearson Education, Inc. Read More