Business and Financial Risk - Research Paper Example

? Business and Financial Risk of the of the The project includes capital structure analysis of a public company. The company that has been chosen to perform the analysis is Coca Cola. In the first portion of the project, an introduction has been given about the company Coca Cola along with the present capital structure issues related to the company. In the second part of the project, the risks associated with the company have been analyzed based on the financial and non-financial factors. In the third part of the project, a brief description has been given on the capital structure theory and its implications on the business. In this portion, the MM approach for the capital structure theory has been described, and the assumptions have been stated and criticized. The main objective of this project is to show the importance of the capital structure of a company and its affect on the performance. A detailed analysis of the debt and equity financing has been done in this project from 2010 to 2012. Their implications have been discussed. In this project, it has also been shown how the capital structure of a company determines the business risk. Table of Contents Table of Contents 3 Introduction 4 Business and Financial Risks 5 Business Risks 5 Financial Risks 5 Modigilani and Miller’s Capital Structure Theory 6 Capital Structure Evidence and Implications 7 Optimal Capital Structure for the Company 9 Conclusion 11 References 12 Appendices 13 Introduction Coca Cola is a multinational beverage manufacturer, marketer and retailer of non-alcoholic beverages (Coca Cola, 2013a). It has its headquarters in Atlanta, Georgia. It was established in 1886 by John Pemberton who was a pharmacist in Columbus, Georgia (Coca Cola, 2013b). Initially the beverage was sold for 5 cents each glass at Jacob’s Pharmacy and regularly nine glasses were purchased. John Pemberton died within two years and after that the brand was bought by Asa Candler in 1889 (Coca Cola, 2013c). From 1900 to 1920, the company expanded to a great extent. Robert Woodruff was appointed as the President of the company just four years after it has been bought by his father from Asa Candler. He remained in that position for a period of more than sixty years. From 1950 to 1960, the company introduced different flavors of juices in its product line. Presently the company serves in most of the remote areas of the globe and has more than five hundred different drinking brands. The company is currently financing its operations with higher dependency on debt capital. There are various factors that affect the capital structure of the company. It needs to be financially flexible in order to adapt to the changes in the existing market. The financial performance of the company has improved significantly. The company is enjoying tax benefits because of the high debt financing. Thus, the tax position of the company is good. There are various other business risks which are reducing its growth opportunities. Business and Financial Risks The company has some risks which pose a threat to the projection of growth. Business Risks Changes in the Customer Preferences Presently, it has been observed that the customer’s preferences for non-alcoholic drinks have changed due to various health concerns, changes in their lifestyle and also the pressure from the competitive products in the market. The company should try to adapt to the changes with the current market conditions in order to lead the market and also to reach to other areas which have not been explored. Increase in Competition Among all the leading beverage manufacturing companies, PepsiCo is the major competitor of Coca Cola. There is also an increased competition from different beer manufacturing companies which provide various non-alcoholic products. Thus, Coca Cola is facing a threat from the strong competitors in the market. Financial Risks Fluctuations in Foreign Exchange Rates The company incurs liabilities in different currencies apart from that of dollar. The changes in the dollar value in foreign exchange rates have an effect on the revenues and the operating incomes for those items which are dealt in other currencies. Thus, the strengthening of one currency may result in the weakening of the other one affecting the entire financial results. Changes in the Interest Rates The company has increased its debt capital in order to lower down the capital cost. An increase in the rate of interest will have an adverse affect on the financial performance of the company. Modigilani and Miller’s Capital Structure Theory Capital structure can be defined as a mix of long-term debt, short-term debt, equity and various other sources for funding that a company uses in order to finance its long-term investments and assets (Lane & Milesi-Ferretti, 2000). The most important balance in the capital structure occurs between the total debt and the total equity in a particular company. It is an important tool used in the financial management to handle and control the cost of capital. Modigilani and Miller’s (MM) Capital Structure theory states that the market value of a company is calculated based on the earning power and the risk involved in its underlying assets. According to this theory, the market value of a firm is independent of the financing decision taken to finance the investments and the assets (Brigham & Ehrhardt, 2011). The assumptions made in this theory are: It should not include any tax. It should not include any transaction cost. It should not include any bankruptcy cost. Maintaining equivalence in the borrowing cost for the company as well as the investors. There should be symmetry in the market information provided to the company and the investors. There is no effect of the debt capital on the earnings of a company before charging interest and taxes. The assumptions of this theory do not assume tax and bankruptcy cost. This implies that the Weighted Average Cost of Capital will remain the same, whatever may be the borrowings of the company. Moreover, as there are no benefits due to the increase of debt capital, this implies that the capital structure does not have any influence on the stock prices. However, this is not true as the taxes and bankruptcy cost have an effect on the stock price of the company (Baker & Martin, 2011). Moreover, the capital structure has an effect on the value of the company. For example, increase in the use of debt financing by a company will reduce the cost of capital. On the other hand, the business turns out to be in a risky state. The benefit obtained from the debt financing in the form of tax benefits from the interest payments has not been recognized in this theory. Capital Structure Evidence and Implications There s a range of factors which are used to find out the capital structure of the company Coca Cola. The financial leverage ratio, which is the ratio of the total debt divided to the total equity, tells us the extent to which a particular business depends on the debt capital for financing its investments. The debt to capital ratio is also an important determinant of a company’s financial leverage which is obtained by dividing the debt capital by the total capital of the company. The total capital of the company comprises its debt capital and equity capital. The financial leverage ratio from 2010 to 2012 has been shown in Appendix 1. It has increased from 2010 to 2012, which implies that the company has increased the utilization of debt capital in the capital structure for the company. This can be shown in a graph: This can be risky for the company as the increase in the debt capital increases volatility. The company is increasing the debt finance. In 2012, it can be clearly seen that the company has utilized the equity capital and the debt capital almost equally in the total capital (Appendix 3). The dependency on the external source for financing the investment is highly volatile. The debt to total capital ratio from 2010 to 2012 has been shown in Appendix 2. It has increased from 2010 to 2012, which also implies the dependency of the company on its debt financing. This situation is risky, even if it is giving good return on investment. This can be shown in a graph: The capital structure of the company from 2010 to 2012 has been shown in Appendix 3 (Morningstar, 2013b). It shows the gradual shift of the company towards higher dependency on debt capital. Debt financing increases the risk of the return on investment. However, highly leveraged firms possess higher percentage of debt capital and provide high earnings to the shareholders. Optimal Capital Structure for the Company It is vital to determine the optimal capital structure of the company. The best debt to equity ratio of a company that helps to maximize its value is known as the optimal cost structure. The debt capital of the company from 2010 to 2012 is as shown below: Year Total Debt Shareholder's Equity 2012 32.6 32.8 2011 28.6 31.6 2010 23.4 31 (Source: Morningstar, 2013a) Proportion of debt capital: 2012 D/ (D+E) = 32.6/ (32.6+32.8) = 0.498470948. 2011 D/ (D+E)= 28.6/ (28.6+31.6) = 0.475083056. 2010 D/ (D+E)= 23.4/ (23.4+31) = 0.430147059. Proportion of equity capital: 2012 E/ (D+E)= 32.8/ (32.6+32.8) = 0.501529052. 2011 E/ (D+E)= 31.6/ (28.6+31.6) = 0.524916944. 2010 E/ (D+E)= 31/ (23.4+31) = 0.569852941. Gearing Ratio = Debt/Equity 2012 D/E= 0.993902439. 2011 D/E= 0.905063291. 2010 D/E= 0.75483871. Gearing is combining the debt and the equity finance in order to finance the total business operations. The company has increased the debt financing gradually and the gearing ratio has increased from 0.75 (in 2010) to 0.99 (in 2012). From the annual report, it can be seen that the value of equity as well as debt has increased from 2010 to 2012. The company is disbursing an increased amount of debt in order to enjoy tax benefit. However, it should be taken into consideration that the company should not increase its debt financing to such an extent that the situation becomes highly risky and weakens the financial strength of the company due to the extreme rate of borrowings from the external sources. Conclusion The investors have fear to invest in the stocks of the company because of various factors. Among them, excessive borrowing from the external sources can be one of the reasons. The company should adapt to the changes in the market and make its financing decisions accordingly. It should introduce innovative products in the product portfolio to increase the growth and attract the customers and the investors. References Coca Cola. (2013a). Brands. Retrieved from http://www.coca-colacompany.com/brands/the-coca-cola-company. Coca Cola. (2013b). Overview. Retrieved from http://www.coca-colacompany.com/contact-us/faqs. Coca Cola. (2013c). The chronicle of Coca-Cola: The Candler era. Retrieved from http://www.coca-colacompany.com/stories/the-chronicle-of-coca-cola-the-candler-era. Morningstar. (2013a). Balance sheet. Retrieved from http://financials.morningstar.com/balance-sheet/bs.html?t=KO®ion=usa. Morningstar. (2013b). Coca-Cola Co KO. Retrieved from http://quicktake.morningstar.com/stocknet/bonds.aspx?symbol=ko. Lane, P. R., & Milesi-Ferretti, G. M. (2000). External capital structure-theory and evidence. Washington: International Monetary Fund. Brigham, E. F., & Ehrhardt, M. C. (2011). Financial management: Theory and practice. Connecticut: Cengage Learning. Baker, H. K., & Martin, G. S. (2011). Capital structure and corporate financing decisions: Theory, evidence, and practice. New Jersey: John Wiley & Sons. Appendices Appendix 1: Year Financial Leverage Ratio 2012 0.993902439 2011 0.905063291 2010 0.75483871 Appendix 2: Year Debt to Capital Ratio 2012 0.498470948 2011 0.475083056 2010 0.430147059 Appendix 3: The capital structure of Coca Cola in 2010 has been shown below: The capital structure of Coca Cola in 2011 is as shown below: The capital structure of Coca Cola in the year 2012 is as shown below: Read More