Capital Strcture and Corporate Financing Decisions - Coursework Example

 QUESTION NO. 1 a) The return on equity under three economic conditions and before any debt is issued. As can be seen in the table above, the return on equity is greater in the case of economic expansion. The reason is that during the expansionary phase the EBIT is the highest at the given level of market value, whereas it is the lowest in case of recession because of the lower operating profits assuming no impact of taxes and interest. 1b) The return on equity under three economic conditions and after debt is issued The return on equity is the highest in the case of the expansionary phase, assuming the fixed interest amount and no taxes. 1c) ROE under the tax rate of 35% Repetition of Part 1a using tax rate of 35% Repetition of Part 1b using tax rate of 35% Applying the tax rates of 35% in both parts above, it can be observed that the ROE reduced significantly because of the reduction in net income at the given level of total market value. QUESTION NO. 2 2) using the assumption of risk free rate as risk premium the WACC can be calculated as follows The current unlevered beta is Betaunlev=Betalev/(1+(1-tax rate)(D/E)) = 0.699694 As the cost of equity increases significantly, using the marginal cost and the tax benefit of borrowing of 75 million dollars may have less than required effects. Therefore, the decision is not suitable. The tax benefit of borrowing is termed as the reduction in cost of capital but the net effect of additional borrowing show significant increase in weighted average cost of capital. Therefore, the additional borrowing leads to the conclusion that the decision of additional debt for the company is not proved to be suitable because the overall cost of funds will increase and the marginal benefits will have no affects. b) Without the additional debt the WACC = 6.97% With Additional Cost the WACC = 10.10% QUESTION NO 3 a) Assuming the Risk free rate as the risk premium as well the company will increase the cost of capital with increase in debt. The optimal cost of capital is the current cost of capital i.e. 7.40%. Other than 7.40% the optimal cost of capital is 10.12% with $200,000 of additional debt. Additional debt Value of Equity Remaining Shares (millions) New Rating Interest rate Levered Beta Cost of Equity After-tax Cost of Debt Cost of Capital - 3,000,000 200,000 BBB 7.50% 1.15 7.53% 6.15% 7.40% 200,000 2,800,000 186,667 BB 8.50% 2.05 10.69% 6.97% 10.12% 400000 2,600,000 173,333 B 9.50% 3.10 14.34% 7.79% 12.95% 600000 2,400,000 160,000 B- 11.00% 4.31 18.59% 9.02% 15.98% 800000 2,200,000 146,667 C 12.50% 5.75 23.63% 10.25% 19.17% b) After New Debt the Price per share will decrease to $10.24 Optimal cost of Capital other than existing cost 10.12% Old Cost of Capital- New Cost of Capital -2.72% Cost Savings - 89,900 Permanent Increase or decrease in value - 887,967.67 Decrease in Stock Price - 4.76 New Stock Price 10.24 c) Before additional debt the cost of capital was 7.40%, whereas after additional debt the cost of capital will be 10.12% at least QUESTION NO.4 a) Dependent Variables are the debt Ratios 1. Debt Ratio= Total Liabilities to Total Assets 2. Total Liabilities to total Shareholder’s equity 3. Total Debt To Total Assets Independent variables are as follows 1. Tangibility 2. Non Debt Tax Shield 3. Profitability 4. Growth Independent variables are considered as the major determinants of capital structure[Son05]. In addition, Bartholdy and Mateus (2008) also identified country specific factors and determinants of capital structure. The discussion of the determinants of capital structure and expected theoretical relationship between independent variables and capital structure choices are as follows. 1. Tangibility Tangibility refers to the asset structure. The concept discusses the differences that arise between creditors and the shareholders of the company. The conflict arise between the two parties according to agency cost theory model[Har91]. The shareholders can find incentive to move away from the optimal strategy to earn excess return. For the purpose of regression analysis, tangibility is measured as a ratio of Fixed Assets over Total Assets (Claessenes & Laven, 2006, p. 105). 2. Non Debt Tax Shield The increase in interest tax shields encourages the firms to shift the weight of the capital structure more towards debt[Mod58]. The tax advantage of leverage will be negatively affected when the other tax deductions increases like that of depreciation[Bar03]. For the purpose of regression analysis, the ratio of depreciation to total assets is used as the measure of non debt tax shield (Armitage, 2005, p. 208). 3. Profitability The preference of internal funds instead of external funds encourage the firms to increase the profitability and decrease the use of external sources of funds such as debt. The relationship between the leverage and profitability of the fund is conflicting and in most cases it is represented as a negative relationship to leverage[Mye03]. It is represented as the ratio of EBIT to total assets (Reilly & Brown, 2011, p. 292). 4. Growth Growth is represented as percentage change in total assets. The relationship between expected growth and leverage is positive. The reason is the higher demand for funds when growth increases. -1 The theoretical relationship between independent and capital structure choices are as follows (Baker & Martin, 2011.pp-23) Determinants Measures Relationship with Leverage Tangibility Fixed Assets/Total Assets Positive Non Debt Tax Shield Depreciation/ Total Assets Negative Profitability EBIT/ Total Assets Negative(Unclear) Growth Percentage Change in Total Assets Unclear B) Variable Summary Statistics   Tangibility Non Debt Tax Shield Profitability Growth Mean 0.18 0.05 0.06 0.35 Standard Deviation 0.14 0.06 0.11 12.65 Maximum 0.90 1.70 1.28 706.13 Minimum 0.00 0.00 -0.64 -1.00 C) Multiple Regression 1. Using the debt ratio i.e. total liabilities to total assets as the dependent variable, the regression resulst are as follows *Shows the significant at 95% Confidence Interval 2. Using Total Liabilities to total shareholders’ equity as dependent variable, the regression results are as follows *Shows significance at 95% Confidence Interval The regression equation shows that in case of total liabilities to total shareholders’ equity only growth in assets is represented as a significant variable, whereas the model as a whole is significant using the F-test. The calculated F-value is 1.34 whereas the significance F shows the value of 0.25, which shows that the model as a whole is suitable in predicting the dependent variable. On the other hand, considering the R Squared it is difficult to evaluate the explanatory power of the independent variables on dependent variable. Therefore, the F-test and the R squared give conflicting results in terms of regression. Moreover, the standard error is also higher 3. Using Total Debt to Total Assets as dependent variable the regression results are as follows *Shows the significance at 95 % Confidence Interval d) Comments on Results under the Existing Literature on Capital Structure The regression results of 500 companies show somewhat conflicting results with debt ratios. Theoretically, it is proved that the tangibility has a positive relationship to leverage, i.e. the increase in fixed assets may lead to increase in the requirement of borrowed funds, but the regression results show that the relationship is negative. This can be explained by the fact that the firms increase their fixed assets with retained earnings or by raising capital through increasing of outstanding shares. In case of increase in the tax shield, the regression results show that with the increase in liabilities the tax shield may increase. This can be described by the fact that the interest rates may be much higher than the depreciation expense, which may be the reason of minor positive relationship with leverage. Increase in profitability shows the negative relationship with leverage and growth in assets has minor positive relationship. Bibliography Son05: , (Song, 2005), Har91: , (Harris & Raviv, 1991), Mod58: , (Modigilani & Miller, 1958), Bar03: , (Bartholdy & Cesario, 2003), Mye03: , (Myers & Brealey, 2003), Read More