The financial leverage and cost of capital are the two important aspects for the effective business functioning. It is required to set up strong harmonization between both if company wants to sustain its business in long run. This report has reflected that key understanding on the optimum capital structure based on the cost of capital and financial leverage of company. Financial leverage shows the business sustainability risk of company if it fails to have enough earnings before interest and tax and its interest coverage out of the available earning. This report has reflected the cost of levered equity, debt funding, capital structure and use of the capital budgeting tools to determine the terminal values, initial investment and cash flow for the accepted business projects.
Given,
|
Particulars |
Amount or number |
|
Short-term debt (inclusive of current portion of long term debt) |
$ 2,000,000,000 |
|
Long term debt |
$ 4,000,000,000 |
|
Total shareholder’s equity |
$ 10,000,000,000 |
|
Number of ordinary shares outstanding |
2,500,000,000 |
|
Current stock price |
$ 30 |
|
Current yield to maturity on stocks (RD) |
3% |
|
Cost of unleveraged equity under current market situations (RU) |
12% |
|
Industry average market debt to equity ratio |
17.5% |
This above given information is given in the report and on the basis of the same rest computation is made.
Computation is done as below.
|
Particulars |
Amount |
|
Market value of equity (E) |
(2,500,000,000 x 30) = $ 75,000,000,000 |
|
Total liabilities (D) |
2,000,000,000 + 4,000,000,000 = $ 6,000,000,000 |
All the discussions made in this part are regarding the perfect market. The perfect markets are those in which there are no tax rates, or any transactions costs. The value of the firm in this kind of market is not affected anyhow by the capital structure. The calculation of the market value is just equivalent to the cash flows that the company has generated. The has also been argued by the Franco Modigliani and Merton Miller while stating the fact that with the perfect capital market where there is no effect of taxes, bankruptcy costs, agency costs, and asymmetric information, and other external factors then the value of a firm is unaffected by how that firm is financed and what capital structure it has been maintaining. Therefore, low and high financial leverage and use of tax deductible expenses will have no role to play while determining the capital structure.
Market debt to equity ratio shows the ratio of the debt that the company has in comparison to the current value that the entity has in the market. As the current market value of the company is used, this ratio helps in providing a better measure for analysing the solvency position of the organisation (Lewis, and Tan, 2016). The formula used for calculating the market debt to equity ratio is stated as follows:
Market debt to equity = total liabilities (short-term and long-term)
Total liabilities + market value of equity
= 6,000,000,000 x 100
(6,000,000,000 + 75,000,000,000)
= 7.41%
As per the proposition II presented by Modigliani-Miller, a levered cost of equity encompasses in itself a financing premium along with the cost that comes on the unlevered equity. This financing premium has the same value which is computed by the Market value debt- equity ratio. Taxes are ignored because Modigliani-Miller approach is followed (Chen, and Strebulaev, 2016). As a result the formula for computing the cost of levered equity can be presented as follows:
Cost of levered equity (RE) = cost of unlevered equity (RU) + market debt-equity ratio (RU – RD)
Where, RD refers to the return demanded on debt.
So, cost of levered equity (RE) = 12 + 0.0741 (12 – 3)
= 12 + 0.6669
= 12.67%
COMMENT: as the proportion of debt is not that high in the organisation, the cost of equity has not been affected much by adding leverage effect into it. But the rise of 0.67 is the new demand which the shareholders are expecting for their investments and returns on the same gets riskier after debt are introduced in the company. Even though the equity returns are increased after debts are introduced, still more risk comes uninvited (Boyer, Lim, and Lyons, 2017).
Weighted average cost of capital helps in computing a cost rate that is equal to the weighted average of the cost which is incurred on debt and the equity (Frank, and Shen, 2016).
Formula:
Weighted average cost of capital (WACC/RWACC) = {E/ (E+D)} X RE + {D/ (E+D)} X RD
= 75,000,000,000 x 0.1267 6,000,000,000 x .03
(75,000,000,000 + 6,000,000,000) (75,000,000,000 + 6,000,000,000)
= {0.9259 x 0.1267} + {0.0741 x 0.03}
= 0.1173 + 0.0022
= 12 %
COMMENT: the above calculation shows that the company is operating in a perfect capital market. This is so because as per Modigliani-Miller when the capital markets are perfect, the capital structure of the organisation has no effect on the firm’s WACC, and the same tends equal to firm’s unlevered cost of equity, which is 12 % in this case (Garcia, Saravia, and Yepes, 2016).
When the company issues $ 1 billion stock and repurchases debt, the situation comes as follows:
|
Particulars |
Amount |
|
Market value of equity (E) |
(2,500,000,000 x 30) + 1,000,000,000 = $ 76,000,000,000 |
|
Total liabilities (D) |
2,000,000,000 + 4,000,000,000 – 1,000,000,000 = $ 5,000,000,000 |
For this market debt to equity is to be recalculated. It can be done as follows:
Market debt to equity = 5,000,000,000
(5,000,000,000 + 76,000,000,000)
= 6.17 %
COMMENT: the debt in comparison to equity has further reduced.
The cost of levered equity comes to (new RE) = 12 + 0.0617 (12 – 3)
= 12.43%
COMMENT: the lessening of debt in the capital structure do not does away with the risks. Risks are present till the date debts are there and hence results in increasing the return demanded by the shareholders.
The weighted average cost of capital is computed as follows:
New WACC (new RWACC)
= 76,000,000,000 x 0.1243 5,000,000,000 x .03
(76,000,000,000 + 5,000,000,000) (76,000,000,000 + 5,000,000,000)
= 12 %
COMMENT: hence, there is no impact of change in the capital structure on the weighted average cost of capital of the organisation. It is still 12%. The reason is same. The perfect capita markets are not affected by any change that happens in the capital structure of the organisation. The weighted average cost of capital always comes equal to the unlevered cost of equity (Arrow, 2017).
When the company raises $ 5 billion debt and repurchases stock, the situation comes as follows:
|
Particulars |
Amount |
|
Market value of equity (E) |
(2,500,000,000 x 30) – 5,000,000,000 = $ 70,000,000,000 |
|
Total liabilities (D) |
2,000,000,000 + 4,000,000,000 + 5,000,000,000 = $ 11,000,000,000 |
Applying the formula used above, the market debt to equity ratio comes down to be:
Market debt to equity = 11,000,000,000
(70,000,000,000 + 11,000,000,000)
= 13.58 %
COMMENT: the market debt to equity has improved after the company has raised a further debt of $ 5,000,000,000. The capital structure value remains the same, only the components have changed.
Cost of levered equity (RE) = cost of unlevered equity (RU) + {market debt-equity ratio x (1 – 0.40) x (RU – RD)}
Cost of levered equity (RE) = 12 + {0.1385 x 0.60 x (12 – 3)}
= 12 + 0.7479
= 12.75%
COMMENT: the rise in debt has raised the risk that is present in the firm. As a result the company’s shareholders demands from the firm have increased and that has increased the levered cost of equity of the organisation.
Weighted average cost of capital (WACC/RWACC) = {E/ (E+D)} X RE + {D/ (E+D)} X (1-0.40) X RD
= 70,000,000,000 x 0.1243 11,000,000,000 x .03 x 0.6
(70,000,000,000 + 11,000,000,000) (70,000,000,000 + 11,000,000,000)
= 10.74 + 0.0024
= 10.75%
COMMENT:
The raised component of debt and the introduction of the tax rate of 40 % have helped the company in decreasing the weighted average cost of capital of the company. This shows that when there is tax prevailing in the country and the company is also using debt in its capital structure, the advantage of leverage can be taken by the company. This helps and benefits the firm in achieving maximum value. Because there are no perfect markets and hence the value of the firm is dependent on the capital structure of the company (Stringham, and Vogel, 2018).
OVERALL COMMENT: when the capital markets are imperfect the dependency of the firm on debt up to a certain level helps the organisation in achieving maximum value for itself. This is because of the tax shield that is enjoyed on the interest paid. The overall costs are lowered for the company. This is also synthesised by the pecked order theory. As per this approach an optimal level of debt is must to attain optimal value for the organisation. And as per traditional approach also, the weighted average cost is able to be lowered with an optimum mix of debt and equity (Graham, et. al 2017).
Given,
|
Particulars |
Amount |
|
Price of machinery |
$275,000 |
|
Installation cost |
$ 25000 |
|
Life |
6 years |
|
Depreciation |
Straight line |
|
Scrap value |
Nil |
|
Net working capital required |
$ 12000 |
|
Saving in operating cost |
$ 55000 |
|
Income tax rate |
35% |
|
Sale receipt on sale of machine in year 6 |
$ 60,000 |
Initial investment outlay comprises of all the cost incurred on the purchase as well as on the setting up and installing of the machinery in the entity premises. The working capital that is required for the project is also considered as a part of the initial outlay (Gotze, Northcott, and Schuster, 2016). This is the money that is required to do a project. These includes the money that is required to purchase the product, its transportation and fixing charges and finally the additional working capital that may be required as a result of the new equipment.
So, initial investment = 275,000 + 25,000 + 12000
= $ 312,000
Terminal cash flow is the amount of capital that the investor will get back as salvage value after you dispose an item
Computation of a year’s cash flow:
|
Particulars |
Amount ($) |
|
Savings in operating costs |
55,000 |
|
Less: depreciation (275,000 + 25,000)/6 |
50,000 |
|
Operating profit before tax |
5,000 |
|
Less: tax @ 35 % (5000 x 0.35) |
1,750 |
|
Operating profit after tax |
3,250 |
|
Add: depreciation |
50,000 |
|
Annual cash flows |
53,250 |
The terminal cash flow in this case shall be the sale value that will be generated in year 6 on disposition of the asset and the working capital released along with the annual cash flows. The tax incurred on the sale value gain shall be deducted. As the scrap value is zero, hence the whole amount of $ 60,000 is a gain for the organisation (Abor, 2017). The computation is shown as follows:
Terminal cash flow = gain on sale x (1 – tax rate) + working capital released + annual cash flow
= 60,000 (1-0.35) + 12,000 + 53,250
= 39,000 + 12,000 + 53,250
= $ 104,250
Whenever new machinery is introduced in the business, the entity need some amount of money to run the machinery in the day to day working. Hence when the initial investment outlay is planned the working capital requirement is also added into it. However, on sale of the machinery, that portion of the working capital is no more required and hence released in the terminal year. So, the terminal cash flow shows as a cash inflow the release of the working capital (Bhattacharya, 2014).
For this requirement, the organisation needs to compute the net present value. The net present value can be calculated using the discount rate of 14 %. The table below shows the discount factors for 6 years and the discounted cash flows:
|
Year |
Discount factor (a) |
Cash inflow (b) |
Discounted cash inflow (a x b) |
|
1 (1/1.14) |
0.8771 |
53,250 |
46706 |
|
2 (1/1.14)2 |
0.7695 |
53,250 |
40976 |
|
3 (1/1.14)3 |
0.6797 |
53,250 |
36194 |
|
4 (1/1.14)4 |
0.5921 |
53,250 |
31529 |
|
5 (1/1.14)5 |
0.5194 |
53,250 |
27658 |
|
6 (1/1.14)5 |
0.4556 |
104,250 |
47496 |
|
TOTAL DISCOUNTED CASH INFLOW OF PROJECT |
230559 |
So net present value = total of discounted cash inflows – initial cash outflow (Rossi, 2015).
= 230559 – 312000
= – $81441
As the net present value of the project is negative, hence the investment should not be made by the organisation.
The firm can use debt financing to get tax shield on the interest expense, and thus can increase the annual cash inflow. The annual cash flow shall get increase due to the tax savings mad on the interest paid. The tax saving shall be treated as a cash inflow which shall increase the cash inflow. However, the value of the project increases for the reason that the use of leverage leads to a reduction in the cost of capital. Other than the net present value method, there is an adjusted present value method which takes into account the benefits that the entity gets when it uses debt in its capital structure. this makes the APV method preferable than the net present value method.
Note- After assessing the information it could be inferred that timeline for positive NPV cannot be prepared, as the operating profits are getting negative on deducting interest.
For the successful and hassle free running of any business, the organisation needs sufficient funds. These cannot be obtained overnight. The firm needs to gather complete knowledge into its fund requirements and the sources from which it can suffice its fund needs. As a result, the organisation needs to incorporate financial planning into its business. Financial planning shall help the business to understand the requirements of its funds and the way they can be optimally fulfilled.
Financial leverage is the other name of trading on equity. It entails the management accountant to understand how it can play around equity and debt to reach an optimal level where the value of the firm would reach its maximum and the cost of debt shall be least. Leveraging the firm’s capital structure means adding a debt component in the entity’s capital structure. As a result the annual cash flows shall experience a raise, as the firm shall enjoy the benefits of tax shield on the interest expense. As the company’s cash flow position shall get strong, it shall be able to achieve a sustainable survival (Bhardwaj, 2018). The available resources are allocated to the most profitable project so maximizing the owner’s wealth. It is analyzed that when the best is chosen it will easily penetrate the market and this will ensure that the business growths.
Because of proper financial planning and involving financial leverage, the firm shall be able to make good use of the risks involved (Alviniussen, and Jankensgard, 2015). Financial planning shall also help the organisation to formulate a proper finance budget and monitor the performance with the actual results to identify the deficiencies and the ways to overcome the deficiencies. Further, by a proper financial plan, the organisation shall be able to properly use a combination of debt and equity in its capital structure. Both financial and operating leverage are about fixed charges and when they are combined, one can be able to calculate the whole risk of a business. This risk is of not being able to cover all the fixed cost expenses. If these fixed expenses are high it means the combined leverage will be high. To add ease, the operating, financial and combined leverage are explained below:
The graph below shows the different stages of the corporate lifecycle:
Different business cycles (Petch, 2018)
Courtship stage
This is the stage at which the promoters bring up the idea of starting a business. The feasibility study is done here along with taking the decision regarding the sources of finance and the targeted customer market. The business has not started yet and is only conceptualised here in this stage (Agibalov, Zaporozhtseva, and Tkacheva, 2016).
The launch stage
This is the most initial stage in which the business has just initiated. The sales are extremely low at this stage generally. The business faces difficulties in funding and finding new financers. The profit is almost negligible, and even some business houses suffer losses in this stage. This is the stage at which the importance of marketing is realised in order to boost the sales. There is no scope of savings here, only reinvestments are made in the business, even if any money is earned (Salamzadeh, and Kesim, 2015). At this stage the business mostly makes losses because of the new services or product introduced they are yet to be accepted in the market. At this stage much of the money that is earned is reinvested back in the business and also to fund new projects this is to ensure that the business survives in the other stages of business.
Growth Stage
At this stage the business faces a boom growth. The sales are at a level of rise that eventually increases the company’s profit level. The demand hits high and requires the entity to add more to its production and product range. The need to expand the business space is felt and the entity enters new markets. The capital required also rises as he production increases. The firm has the opportunity to penetrate roots into newer and untapped markets. New offers are offered to the consumers to keep them retained with the entity (Carnes, et. al 2017). The other form of growth is diversification where a business ventures into new business, new products. This requires a lot of capital which can be got from the financial institution. And lastly growth can be achieved by acquisition thus immediately increasing customers and the market area.
This is the saturation point at which the firm has achieved highest sales and the growth becomes stagnant. There is no further rise that can happen until the firm innovates and expands its horizon (Delgado, Pereira, and Dias, 2015). It is considered that because of high competition and new entry of similar business. Market share steadily decreases.at this stage it is easy to access debt finance because at this stage business risk has been fully eliminated.
Decline stage
Here, the company feels the clutches of tight competition and experiences a reduction in the sales and the market share. The company is required to gear up here, in order to level back to maturity stage (Huang, 2016).
In the courtship and launch stage, the company can only resort to self-financing, or can take loan as finance from family, friends or relatives. The company at this stage has only bloomed up and it not certain in the eyes of the lenders regarding its creditworthiness. Hence, no unknown lender is easily ready to finance the capital requirements. It is how the relatives and friends are left as the best option.
In the growth, maturity and declining stage, the firm has established itself well. So it can try for equity, and/or debt financing. In this financing money can be taken from external sources on the basis of credibility of the firm. The cost of finance is also lesser here than what in the launch stage. This is so because now the company has a varied availability of finances and could easily harness the finance which provides the company with more benefits and least cost.
The different types of finances help the organisation to remove its dependency on a single source of finance. This shall hep he organisation to get funds as and when required. With the use of digital environment, the company is able to market its business and performance. On the basis of that new financers could be hacked from the market. Moreover, with the world being globalised nowadays, it has become easier to tap international finances also. The dependency on the nation limited sources of finances has vanished. All the benefits if the international and digital environment has allowed the organisations to decrease their funding costs at an overall basis. There is no need for the firm now to depend itself on a single and expensive source of finance.
Conclusion
Financial structure is the mix of both debt and equity finance that is undertaken by a business to optimize on shareholders wealth. All types of finances have their own advantage and disadvantages which have to be considered by company while raising funds from the business. Now in the end, it could be inferred that if proper financing is used then company may easily overcome the financial sustainability risk. Nonetheless, in case of sluggish market condition, company should keep the debt funding low and equity funding high so that it could survive even when business is facing issue in earning profit. The crux of the report is that equity and debt capital in the capital structure should be determined on the basis of the internal and external factors of the business.
References
Abor, J.Y., (2017). Evaluating Capital Investment Decisions: Capital Budgeting. In Entrepreneurial Finance for MSMEs (pp. 293-320). Palgrave Macmillan, Cham.
Agibalov, A.V., Zaporozhtseva, L.A. and Tkacheva, J.V., 2016. The concept of formation of economically safe life cycle of agricultural enterprises. Russian Journal of Agricultural and Socio-Economic Sciences, 55(7).
Alviniussen, A. and Jankensgard, H., (2015). Enterprise risk budgeting: bringing risk management into the financial planning process. Australia: Routledge.
Arrow, K.J., (2017). Optimal capital policy with irreversible investment. In Value, capital and growth (pp. 1-20). Australia: Routledge.
Bhardwaj, A., (2018). Financial Leverage and Firm’s Value: A study of capital Structure of Selected Manufacturing Sector Firms, Australia: Pearson
Bhattacharya, H., (2014). Working capital management: Strategies and techniques. 2nd ed Australia: PHI Learning Pvt. Ltd..
Boyer, B., Lim, R. and Lyons, B., (2017). Estimating the Cost of Equity in Emerging Markets: A Case Study. American Journal of Management, 17(2), pp.58-64.
Carnes, C.M., Chirico, F., Hitt, M.A., Huh, D.W. and Pisano, V., (2017). Resource orchestration for innovation: Structuring and bundling resources in growth-and maturity-stage firms. Long range planning, 50(4), pp.472-486.
Chen, Z. and Strebulaev, I.A., (2016). Bargaining power, business cycle and levered equity risk.4th ed, Australia, Barian Publisher
Delgado, M., Pereira, R. and Dias, A., (2015). Consequences of investment contract duration on the valuation of firms in maturity stage. World Review of Entrepreneurship, Management and Sustainable Development, (2-3), pp.217-231.
Frank, M.Z. and Shen, T., (2016). Investment and the weighted average cost of capital. Journal of Financial Economics, 119(2), pp.300-315.
Garcia, C., Saravia, J. and Yepes, D., (2016). The weighted average cost of capital over the life-cycle of the firm: is the overinvestment problem of mature firms intensified by a higher WACC?.
Givoly, D., Hayn, C. and Katz, S., (2017). The changing relevance of accounting information to debt holders over time. Review of Accounting Studies, 22(1), pp.64-108.
Gotze, U., Northcott, D. and Schuster, P., (2016). INVESTMENT APPRAISAL. SPRINGER-VERLAG BERLIN AN.
Graham, J.R., Hanlon, M., Shevlin, T. and Shroff, N., (2017). Tax rates and corporate decision-making. The Review of Financial Studies, 30(9), pp.3128-3175.
Huang, T., 2016. Peeking at the ERP Decline stage: Japanese empirical evidence. Computers in Industry, 82, pp.224-232.
Lewis, C.M. and Tan, Y., (2016). Debt-equity choices, R&D investment and market timing. Journal of Financial Economics, 119(3), pp.599-610.
Petch, N. (2018). The Five Stages Of Your Business Lifecycle: Which Phase Are You In?. [online] Entrepreneur. Available at: https://www.entrepreneur.com/article/271290 [Accessed 3 Oct. 2018].
Rossi, M., (2015). The use of capital budgeting techniques: an outlook from Italy. International Journal of Management Practice, 8(1), pp.43-56.
Salamzadeh, A. and Kawamorita Kesim, H., (2015). Startup companies: life cycle and challenges. 2nd ed, Australia: Pearson.
Stringham, E. and Vogel, J., (2018). The leveraged invisible hand: how private equity enhances the market for corporate control and capitalism itself. European Journal of Law and Economics, 46(2), pp.223-244.
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