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Financial Analysis of Capital Structure - Term Paper Example

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Financial Analysis of Capital Structure

The decision regarding finding the optimum mix of equity and debt capital depends on capital spending, expected returns, optimum levels of debt, liquidity, cash levels, interest rates and risks, and dividend policy (Mallicoat, 2011). The following is a snapshot of the possible Capital Structures that Competition Bikes Inc. could acquire while expanding to Canada. The following were the alternatives available while choosing the right Capital Structure mix: 1. Capital Structure consisting only of bonds 2. A capital structure consisting of only stocks, with 50% preferred and 50% Common Stock 3. With 20% bonds and 80% common stock 4. Capital Structure consisting of bonds of 40% and Common Stock 60% EPS (Earning Per Share) is the portion of company’s profit that is allocated to each share of the common stock. It is the most important measure or figure for any shareholder. However, we would analyze the capital structure not only according to the EPS but also analyze the risk inherent in the capital structure. The first alternative of the capital structure comprising only of bonds would allow the company to borrow capital at an interest rate that is lower than the interest rate for other types of borrowing. Bonds are written promises to pay back specific amount at a certain date and some interest payments at specific rates. They are pretty similar to the conventional loans with a few perks. Debt financing is favorable than equity financing as interest expense is tax deductible. However, one problem with this form of capital structure is that it is more risky as corporations are required to make interest payment even when they are not making profits making them vulnerable to bankruptcy and solvency (Brown, 2006). The EPS of this capital structure is also lowest at -0.042 under the current scenario. Hence, having the capital structure completely rely on bonds is a very risky option, specifically for Competition Bikes Inc. when they are expanding and exploring new opportunities. The second alternative is of 50% preferred stock and 50% common stock. Preferred stock offer dividend incentive to the shareholder as they are second in line to be paid after the bond holders when a company is facing a loss making them more risky than the common stock. Common stocks are favorable for companies with good financial health. However, the risk of losing ownership is inherent in common stocks as stock holders have the right to elect the board of directors. Moreover, equity financing is more expensive than debt financing and it is not feasible for a capital structure to be totally based on it (Other ways of raising capital – stocks and bonds, 2011). Therefore, the Capital Structure must include both debt and equity financing. All the third, fourth and fifth alternatives are mix of equity and debt financing. We need to find the right kind of mix between equity and debt. As debt is more risky and equity is more expensive and the objective of the company’s capital structure is to maximize shareholder return, we can decide on the basis of Earning per Share (EPS). EPS is the earning of each outstanding share. An important aspect of EPS is the capital required to generate the income used in the calculation of EPS. As all our Capital Structure alternatives use the same amount of capital, we can decide on the basic of the highest value of EPS while keeping the risk factor under check. Since Competition Bikes Inc. is expanding in Canada, they need time before they can start making large ...Show more

Summary

Recommendations of Capital Structure A corporation’s capital is divided into two forms of capital: equity and debt capital. A combination of both of these types in different percentages is known as capital structure. The combination percentages depend on a number of factors…
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Financial Analysis of Capital Structure essay example
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