Fin 501 Mod 4 Case
Assessing capital structure of a company is important since it will enable the management to understand the net value of the company. A company may do this by getting finances in different ways that will be able to fund for general operations of the business. For instance, the company gets debts or equity. Therefore a positive proportion of equity capital from the debt capital will be able to help understand the fitness level of a company. However, through understanding the company’s capital structure, the management then tries to come to decisions that will benefit the organization as a whole, for instance the management should consider on how different projects will be financed, the kind of structures its competitors have, the level of control by the management in decision making, and decisions that will be fair and beneficial to the stakeholders (Singhvi and Bodhanwala, 2006, p. 397).
Through a company having a thorough evaluation of its leverages, it will be able to understand whether it is making more losses or more profits. A company should assess the amount of debt, it uses in order to generate income from its projects or the assets they get from the debts. Therefore, by the company utilizing its debt, it will be able to reduce the risk of increasing its financial leverage. Poor utilization of the debt will mean that the company level of risk to earn less, after paying its interests and principal of the debt will be higher. Financial leverage is mostly considered by companies with the hope of benefiting from increasing its level of profitability (Daniel and Johnston, 2006, p. 112). Some factors that could lead to failure of the company increasing its profitability would be due to poor of utilizing the financial resources. Through fully utilizing the financial support given to the company, better decisions need to be made in managing the set projects and strategies to meet the organization’s common objectives.
By earning profits from its investments, the business will be able help the business into its long term growth as well as its future growth. The company can be able to assess the level of growth in this aspect by considering the sales profits of the company and future estimation, and the returns on investment and also its future estimation (Torok and Cordon, 2002, p. 65). The company has an a responsibility to have a frequent assessment of their customers’ requirement of their goods and services as well as the market requirement of the products in the company. Therefore, through this it is able to understand the level of demand it may get in the next financial period and the level of supply and cost to offer the market with what customers want.
EBIT = $ 3.88 million
Marginal tax rate of 35%
Outstanding shares = 500,000 @ $ 27 per share
Cost of equity is 11%
Recapitalization debt to 25% from issuing bonds to purchase stock and the equity cost will increase to 13%.
Bonds sold at a cost of 9%.
EPS before recapitalization = EBIT / outstanding shares
= $ 3.88 million / 500,000 = $ 7.76
EPS after recapitalization
(25 / 9) x $ 3.88 million debt $ 10.78 million
(9 / 25) x $ 3.88 equity $ 1.4 million
$ million 3.88 (1.02) / 500,000 = $ 7.92
25% of 500,000 = 125,000 is the amount of shares traded for a debt. If the price of the shares is $ 27, then 125,000 x 27 = $ 3,375,000 is the amount used to repurchase the portion of the stock. EBIT after recapitalization
13% x $ 3.88 million = $ 0.5044 million
$ million (3.88 + 0.5044) = $ 4.3844 million
EPS after recapitalization
EBIT / outstanding shares, that is
4.3844 / 375,000 = $ 11.69
Due to the swap of equity for debt, it is expected to have an expected cost of bankruptcy to have risen, however there becomes a challenge with regulatory constraints such as banks. The prices of the new stock are therefore expected to rise because as the percentage of the shares available dropped. The current price of the stock will therefore be
$ 27 + $ 11.69 = $ 38.69
The cost of the stock increases due to the borrowing of a debt that was used to purchase other stocks, and therefore the value of the current stock will be higher due to the level of decrease that was experienced from the swapping of bonds to debts (Damodaran, 2011, p. 314).
Interest earned Ratio
Times interest earned ratio is a debt ratio that is used to determine a company’s long-term solvency. It is mostly used to show how a company can be able to meet its interest expense rate obligations (McLean, 2003, p. 73).
Different variation in capital structure would lead to different results, but at most times the business usually involves itself as a financial risk that would cost the business capital seriously. Therefore, in this case where the company decided to have to acquire a debt to finance for other assets, it will have to pay for more of the principal and interest of the debt, before the investment earning pick up for the company to earn from the same. Without having a clear understanding of when the investment would start earning for the company, the company would be heading to bankruptcy which will be a dangerous thing for the management and its stakeholders (Brigham and Ehrhardt, 2008, p. 601).
An increase in the negative value of the EBIT for the company, means that the company had to spend some amount of its previous profits to cater for the tax credit (Brigham and Houston, 2008, p. 409).
$ 27 x 500,000 = 13,500,000
25% of 13500000 = 3,375,000 as debt.
The interest rate is 0.35 x 3,375,000 = 1,181,250
Equity of the remaining stock is $ 10,125,000 Shares outstanding is 375,000
Profitability EBIT ($) Interest ($) Pretax income
0.05 – 1 million 1,181,250 2,181,250
0.25 2.3 million 1,181,250 1,118,750
0.4 4 million 1,181,250 2,818,750
0.25 5.8 million 1,181,250 4,618,750
0.05 6.1 million 1,181,250 4,918,750
The company will be able to register better profits from the investments it made on the sales of new after sometime, assuming that the level of demand in the market does not change. However, the company can ensure that it still mobilizes on ensuring the current stock are fully on demand and also ensure that it engages in improving on the its expense usage by cutting down costs that would enable the company cater for the extra cost to pay for the principal and interest of the debt taken.
Brigham, E. F., & Ehrhardt, M. C. (2008). Financial management: Theory & practice. Mason, Ohio: Thomson Business and Economics.
Brigham, E., & Houston, J. (2008). Fundamentals of Financial Management, Concise Edition. Cengage Learning: Stamford, CT.
Damodaran, A. (2011). Applied corporate finance. Hoboken, NJ: John Wiley & Sons.
Johnston, D. C., & Johnston, D. (2006). Introduction to oil company financial analysis. Tulsa, Okla: PennWell.
McLean, R. A. (2003). Financial management in health care organizations. Clifton Park, NY: Delmar Learning.
Singhvi, N. M., & Bodhanwala, R. J. (2006). Management accounting: Text and cases. New-Delhi: Prentice-Hall of India.
Torok, R. M., & Cordon, P. J. (2002). Operational Profitability: Systematic Approaches for Continuous Improvement. New York: John Wiley & Sons.