# Capital Structure Essay

Custom Student Mr. Teacher ENG 1001-04 21 May 2016

## Capital Structure

Capital structure is how a company finances its overall operations and growth by using funds from equity or debt (Investopedia, 2012). Of course, every company must determine its preference on its debt-to-equity ratio and determine which capital structure works best for them. Some approaches to analyzing capital structure are:

1.EBIT – EPS: This analyzes the impact of debt on earnings per share (EPS). Optimizing shareholder’s wealth is the optimum goal and therefore, this approach analyzes the high EPS based on an expected range of earnings before income taxes (EBIT). 2.Valuation: Determines impact of debt use on shareholder’s value by determining the level of debt at which the benefits of increased debt no longer outweigh the increased risks and expenses associated with financing (Wenk, 2012) 3.Cash Flow: Analyzes a firm’s debt capacity by using the weighted average of cost of capital (WACC).

The WACC is a calculation of a firm’s cost of capital in which each capital source (bonds, stock and other long-term debt) are proportionally weighted to determine how much interest the company has to pay for every dollar it finances (Investopedia, 2012).

Look more: capital budgeting examples essay

Part of Competition Bikes’ (CB) main consideration in the decision to merge or acquire Canadian Biking is working capital. Lets use the EBIT – EPS approach to determine how to maximize shareholder return while minimizing the cost of capital. We currently know Canadian Biking’s moderate sales forecast of EBIT figures for the next 5 years (Year 9 – 13), therefore we can apply the EBIT – EPS approach to choose an optimal capital structure.

The total of capital sources in each of the 5 years is \$600,000. We will use EBIT – EPS to determine which assortment of bonds*, preferred stock, and common stock is the best option to increase Canadian Biking’s EPS. The five alternative capital structures include: Option 1: 100% Bonds (fully financed)

Option 2: 50% Preferred Stock & 50% Common Stock (no bonds)
Option 3: 20% Bonds & 80% Common Stock
Option 4: 40% Bonds & 60% Common Stock
Option 5: 60% Bonds & 40% Common Stock
*Annual bond interest rate is 9%

After using the EBIT – EPS approach using the forecasted EBIT amounts for Years 9 through 13, we can average the EPS for each of the 5 years to determine which capital structure produced the highest EPS. The EPS averages computed for the capital structure options are: Option 1: Average EPS = .0452

Option 2: Average EPS = .0542
Option 3: Average EPS = .0526
Option 4: Average EPS = .051
Option 5: Average EPS = .0494

Based on the EBIT – EPS approach, the recommended capital structure is option 2, “50% preferred stock & 50% common stock”. This is the best capital structure mainly because there are two things to consider: 1) long-term debt and associated interest expense and, 2) equity and # of common shares. Option 2 is the best capital structure because there are no bonds and therefore, no interest expense. For example, if we look at option 1 in Year 9, and the bond interest is 9%, then the bond interest expense is \$54,000 (.09*600,00). This lowers the income before taxes by \$54,000. Although companies can finance debt and use the interest expense deduction to lower their taxable income, it doesn’t make sense for Canadian Bikes to fully finance their capital, because the interest expense costs outweigh the benefit of the tax deduction, resulting in a significant decrease in total income available for common stock.

Additionally, because the capital structure consists of 300,000 shares of preferred stock, the company must pay dividends of 5%, reducing the company’s total income available for common stock by \$15,000 (.05 * 300,000). Although this reduces the total income available for common stock, the company will maximize its EPS by only having 50% capital in common stock. This reduces the total number of common shares outstanding, which means less shares to divide the total income among. Therefore, Option 2 is the most optimal capital structure that considers minimizing long-term debt expenses and the optimal number of common shares in order to maximize shareholder return.

CAPITAL BUDGETING:

Competition Bikes’ is considering building a manufacturing facility in a new Canadian location. The total investment for this project would be \$600,000 USD. This consists of \$400,000 to build the facility and an additional \$200,000 in working capital to support operational costs. The company has projected cash flows over the next five years; therefore we can use cash flow budgeting methods such as net present value (NPV) and Internal Rate of Return (IRR) that consider time value of money for long-term investments (Pearson Education, Inc., 2008).

Net present value analyzes the profitability of a project by determining the difference between the present value of the project’s cash inflows and outflows followed by subtracting the initial investment. (Investopedia, 2012). The decision rule applied to NPV is fairly simple, if the NPV is positive, invest; if the difference is negative, do not invest. Competition Bikes applies NPV to forecasted low and moderate sales for the next 5 years.

After using the forecasted sales for low demand, the total present value (after subtracting cash outflows from inflows) is \$560,719. If we subtract the initial investment of \$600,000 from this amount, the NPV is -\$39,281. This is a significant warning that the company should not proceed in building a manufacturing facility. On the other hand, if we use the forecasted sales for moderate demand, the total present value is \$608,447. If we subtract the initial investment of \$600,000, the NPV is \$8,447. Therefore a positive NPV indicates the company should proceed with building the manufacturing facility.

The biggest concern is determining which NPV to lean towards based on low or moderate sales. Unfortunately, the risk of having low sales outweighs the profitability benefit of having moderate sales. It is too risky for CB to move forward with the investment based on the NPV of low sales (-\$39,281). In order for the company to profit from this investment, CB would need to have a moderate sales demand at minimum!

The present value in NPV is calculated using an interest rate, also known as the required rate of return. CB’s required rate of return is 10%. When this interest rate is altered or calculated to make the total present value equal to the initial investment, the NPV becomes equal to zero; this is called the internal rate of return (IRR) (Pearson Education, Inc., 2008). The IRR is what a company can expect to earn from investing in the project and the higher the IRR, the more desirable the investment. The calculated IRR for low demand cash flows is 8.2% and the IRR for moderate demand cash flows is 10.4%.

Based on these IRR figures, the company should not pursue the capital investment because the average IRR between both low and moderate sales is 9.3%. This is below the company’s required return on capital (hurdle rate) of 10% to pursue a capital investment. Again, the company would need to have a moderate sales demand, at minimum for this capital investment to be profitable and should therefore not pursue building a new manufacturing facility.

WORKING CAPITAL:

CB must effectively obtain and manage working capital for the expansion of the operation. CB must first look at their operating cycle, cash conversion cycle and free cash flow factors in order to improve production and management of working capital. Let’s discuss the company’s current status of each of the working capital and cash flow factors and determine how the company can improve in these areas.

First, the operating cycle involves CB sending the distributor a monthly invoice for all raw materials ordered with terms of net/30 days. This can be improved by renegotiating the payment terms will distributors to net/15 days. This would increase cash flows by improving payment turn around time and accounts receivable collections. Additionally, the company can improve its relations with its distributers to increase effectiveness of its collection process. Another operating cycle factor is ordering and paying for inventory. Currently, the company pays for inventory in the month following production and all inventory ordered for the month is used leaving inventory levels (at the end of each month) at consistent levels. In order to improve working capital the company should utilize and lower its year ending inventory balance.

For example, at the end of Year 8, the company had \$91,573 worth of inventory left over. The company should utilize the current inventory on hand before ordering similar raw material items. This will decease cash flows and leave fewer inventories on hand at the end of the year. Currently the average time in inventory is 25 days. This is a substantial turnaround time currently, however in the future, the company can consider replacing labor workers with fixed asset items to improve production time. This will satisfy customer demand by decreasing delivery time and improve cash flows by invoicing customers more frequently than 25 days after production.

CB’s cash conversion cycle factors also impact working capital. Currently, the CB’s suppliers invoice at the end of the month for orders that month with terms of net/15. CB does an excellent job of preserving its cash flows by paying the invoices on the 15th of the month following the order.. CB can improve its working capital by negotiating for longer payment terms, i.e. net/30 days, allowing for more time for the company to earn money to pay their invoices. If this is not possible, the company can improve its forecasting measurements for ordering supplies and order the majority of the supplies needed for the month at the beginning of the month.

This would increase the amount of time the company has sufficient supplies on hand without having to pay more money, (because the suppliers will still invoice for the orders at the end of the month, regardless of how early in the month the supplies were ordered). This can increase working capital because it acts as a contingency plan, to reduce the likelihood of running out of supplies, avoiding delays, or ordering supplies in excess.

Free cash flow factors also affect CB’s working capital. Currently, the company recognizes depreciation in both manufacturing overhead and as depreciation expenses depending on the fixed asset. The company can use their depreciation data to increase management of cash flows by predicting when the company will have to spend a significant amount of money to replace an asset when its useful life expires. This will prepare CB for those unwanted – although necessary – fixed asset costs.

Currently the corporation’s marginal tax rate is 25%. The company can consider obtaining working capital by financing debt. This will leave the company with an interest expense at the end of the year, which is deductible from gross earnings and results in paying lower taxes. After CB improves its working capital, let’s discuss how CB can use its working capital for the lease vs. buy option for a factory building in Canada.

CB can use its working capital to cover the \$50,000 down payment (or buy out option if they decide to lease) and \$200,000 for operational costs of the new factory. According to the data provided for the lease vs. buy option, the lease option will preserve cash outflows of \$12,339, (purchase cash outflows are \$333,999 and lease cash outflows are \$321,660). Therefore, the company should lease the manufacturing facility to preserve cash outflows. Leasing the facility will also allow CB to deduct annual interest payments (6% interest) from the gross earnings to lower their tax payments. This will increase the company’s net earnings at the end of the year, also resulting in higher retained earnings and increased shareholder value.

MERGER OR ACQUISITION:

CB should consider many factors when deciding to merge or acquire Canadian Biking. Let’s analyze the pros and cons between a merge vs. acquisition and determine what the best move would be for CB. First off, if the company were to merge with Canadian Biking, the potential EPS would increase by approximately .021. This shows potential for increased ownership earnings, but is it significant enough? At the same token, the price/earnings ratio for Canadian Bikes at the end of Year 8 was 9 and CB’s was 70. This shows that CB’s current investors are expecting greater earnings in Year 9 and are willing to pay \$70 for \$1 of current earnings. This is not the case with Canadian Biking’s investors.

Unfortunately a low P/E ratio of 9 indicates that investors are not expecting a significant growth in company earnings. This raises a concern if the merge will result in a potential increase of .021 in EPS. On the other hand, a merge would result in lower costs because CB would not be purchasing Canadian Biking outright. Canadian Biking also has a lower cost competition bike that can decrease production costs and complement CB’s current bike model being offered. This will result in greater net earnings and cash flows.

If the company were to acquire Canadian Bikes, CB can expect a gradual increase in cash inflows over the next 5 years. However, the current offered sales price for Canadian Biking is \$286,000; this is 30% more than what the company was valued at, at the end of Year 8. Although CB has enough working capital to make the purchase, it would take 5 years of gradually increasing cash inflows to recoup the price tag of \$286,000. This means it could take approximately 5 years, before shareholders saw a significant increase in earnings per share.

Based on the pro and cons, CB should merge with Canadian Bikes to lower their production and delivery costs, increase net income, EPS and cash flows, and preserve working capital. The price to acquire Canadian Biking is simply unreasonable based on predicted cash inflows over the next 5 years. The merger will enhance CB’s market position in Canada by having a local distributer to handle all customer orders and provide cost effective and great customer service to the growing Canadian market.

References
Investopedia. (2012). Capital Structure. Retrieved from http://www.kotzinvaluation.com/articles/capital-structure.htm Investopedia. (2012). Weighted Average Cost of Capital. Retrieved from http://www.investopedia.com/terms/w/wacc.asp#axzz2Azkq4E2V Investopedia. (2012). Net Present Value. Retrieved from http://www.investopedia.com/terms/n/npv.asp#axzz2Azkq4E2 Pearson Education, Inc.. (2008). Horngren Accounting. Retrieved from http://wpscms.pearsoncmg.com/wps/media/objects/6716/6877765/hha08_flash_main.html?chapter=null&page=1042&anchory=null&pstart=null&pend=null Wenk, D. (2012). Using an optimal capital structure in business valuation. Retrieved from http://www.kotzinvaluation.com/articles/capital-structure.htm

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• University/College: University of Arkansas System

• Type of paper: Thesis/Dissertation Chapter

• Date: 21 May 2016

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