Final Project Company Selected: McDonald's Corp. (MCD) One of the parameter that evaluates the strength of any company's balance sheet is capital structure. The company finances its asset base through proper mix of equity and debt. Debt means long term liability that the company indulges into to finance its asset formation along with equity or shareholder's money…
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 last 5 years. Year Dec. 2007 Dec. 2008 Dec. 2009 Dec. 2010 Dec. 2011 Debt-equity ratio, Source: ycharts.com 06087 0.7635 0.7538 0.8386 0.8687 EPS, Source: Nasdaq.com 1.98 3.76 4.11 4.58 5.27 Price per share, source: Key statistics 57.05 63.75 62.44 76.76 100.33 P/E, (by calculation) 30.22 16.42 15.47 16.75 19.03 It can be seen from the above table that as debt-equity ratio rises, earnings per share of the company also rises and so 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’s wealth? In fact, 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 debt-equity ratio as high as 2.62 as on August, 2012 (Industry debt-equity ratio). High amount of debt is good during booming period but equally risky during downslide when revenues fall exponentially and the company may find difficult to pay interest towards its debt. That is the reason high leveraging is considered risky during recessionary period, however, in 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 about the equity risk premium that market would like to earn over 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 the 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% 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 long term debt is $13.57B (as per data from second quarter 2012). This means that the company is operating at the debt-equity ratio of 13.75/14.04 = 0.98 When company operates at 2:1 (debt-equity) ratio means the company would have total debt available to them $28.08B. That means the company would have extra $14.25B 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 EPS of the company in the same proportion (while all other things remaining the same, of course!). Thus, extrapolating current EPS of 5.32 One can derive 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 fast-food business and runs a large chain of ...
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