Q3. a. Differentiate NI Approach and NOI Approach in capital structure decisions. Answer) Net Income (NI) Approach The Net Income Approach to the relationship between leverage cost of capital and value of the firm. It suggest that there is relationship between capital structure and the value of the firm and therefore, the firm can affect its value by increasing or decreasing the debt proportion in the overall financing mix. Assumptions of NI Approach 1. The total capital requirements of the firm are given and remain constant. 2. Cost of debt is less than cost of capital. 3. Both cost of debt and cost capital remain constant and increase in financial leverage i.e., use of more and more debt financing in the capital structure does affect the risk perception of the investors. The figure shows that the Ke and Kd are constant for all levels of leverages i.e., for all levels of debt financing. As the debt proportion or the financial leverage increases, the WACC decreases as the cost of debt is less than cost of equity. This result in the increase in value of the firm. In the figur...
In SIVMED’s case, based on the definition of WACC, all capital bases should be included in its WACC. These include its common stock, preferred stock, bonds and long-term borrowings. In addition to being able to compute for the costs of capital, the WACC also determines how much interest SIVMED has to pay for all its activities. The value of the firm’s stock, which we want to maximize, depends of the after-tax cash flow. Hence, after-tax values for WACC are also needed. Furthermore, cost of capital is used to determine the cost of each debt, stock or common equity. Being able to analyze these will be essential into deciding what and how new capital should be acquired. Hence, the present marginal costs are ideally more essential than historical costs.
11a. Answer: (Book Value WACC) Debt = 61.2 / 155.7 = 39% Preferred Stock = 15 / 155.7 = 10% Common Stock = 79.5 / 170.8 = 51% 2. Answer: (Market Value WACC) Debt = 30% Preferred Stock = 10% Common Stock = 60% C. Answer: Weighted Average Cost of Capital determines marginal cost of issuing new securities to finance projects. Such securities should be issued at market value. Therefore weights allocated to debt and equity in determining WACC should be based on market value.
In assessing Du Pont’s capital structure after the Conoco merger that significantly increased the company’s debt to equity ratio, an analyst must look at all benefits and drawbacks of a high debt ratio. The main reason why Du Pont ended up with a high debt to equity ratio after acquiring Conoco was due to the timing and price at which they bought Conoco. Du Pont ended up buying the firm at its peak, just before coal and oil prices started to fall and at a time when economic recession hurt the chemical industry of Du Pont. The additional response from analysts and Du Pont stockholders also forced Du Pont to think twice about their new expansion. The thought of bringing the debt ratio back to 25% was brought on by the fact that the company saw that high levels of capital spending were vital to the success of the firm and that high debt levels may put them at higher risk for defaulting.
Does the capital structure of a firm really matter? If so, how and why does it matter? Practitioners and scholars of corporate finance have debated these questions for several years and have found it difficult to come up with definitive answers. The classical work of Modigliani and Miller (1958) provided the impetus for what is now, orthodox corporate finance theory on the optimal capital structure of firms. They postulated that, in a perfect or frictionless capital market, the choice between debt and equity financing has no material effect on the value of the firm. Stern and Chew (2003) noted that following the Modigliani-Miller propositions, academic researchers in the 1960s and 1970s turned their attention to market imperfections that might make firm value depend on capital structure. They further noted that the main suspects were a tax code that encourages debt by making interest payments but not dividends tax-deductible and expected costs of financial distress that rise with increasing amount of debt. Towards the end of the 1970s, they noted, there was also discussion of signalling effects, such as the tendency for stock prices to fall significantly on the announcement of new equity issues and to rise on the news of stock buyouts. These effects seemed to confirm the existence of large information cost that could influence financing choices in the predictable ways.Myers (1984), however, noted that there is a conflict which has existed among the different theories and referred to is as the “capital structure puzzle.” Barclay and Smith (2005) noted that it has been the difficulty of coming up with conclusive tests of the competing theories. Firstly, they noted that model on capital structure typically are less precise than...
6. Capital structure and the discount rate 6.1. Features of debt and equity financing Financing through equity or debt has advantages and disadvantages as follows: Equity is more flexible for the company, since in a situation of lack of liquidity shareholders return could be delay or stopped, while debt interest always have to be paid (Atrill and McLaney, 2015). Debt is faster to obtain than a securities issue (Atrill and McLaney, 2015). Related to control, a debt does not provide lenders control over company´s operations and management decisions, except some previous agreements with lenders about limiting future borrowings, sale of assets and pay of dividends.
Kodak’s debt ratio has been improving since 2012 when it was considerably above 1. Their 2014 debt ratio is 0.89, which is very close to Hewlett-Packard and Sony. The debt-to-equity ratio of Kodak is the first signal within the ratios that the company is not performing well. Generally, this ratio should be below 1 and for Kodak in 2014 it was 8.83. Their equity is almost non-existent and this is signaling very weak balance sheet strength. Compared to Kodak, Hewlett-Packard and Sony are doing okay, but their ratios are both well above 1. In terms of ability to pay interest, Kodak’s only strong year was 2013. Their ratio has dipped in 2014, showing that they aren’t able to pay their interest or are struggling to pay it. Hewlett-Packard had no interest expense in their latest fiscal year and Sony’s ratio is very strong. In 2012, Kodak’s free cash flow was in the negatives (-$1,176,000). Surprisingly, it reached over two million in 2013, but then dropped to only $33,000 in 2014. Without sufficient cash flow, Kodak is going to have a difficult time increasing their shareholder value. Hewlett-Packard has free cash flow over five million dollars which is huge compared to Kodak. Kodak does not seem to have sufficient cash to handle their business obligations. The cash flow adequacy ratio should be above 1, but Kodak’s are negative. The competitors are around 0.5 for their cash flow adequacy ratio, which
It is a leverage ratio, which indicates a relationship between the debt and equity. The ratio indicates the total liabilities of the firm and the total shareholders’ equity both the figures are present in the company’s balance sheet.
Modigliani & Miller applied their theories with two modules, one which doesn’t include the taxes and this is their first finding, and another one with taxes to make it more realistic. The First Proposition without taxes: In this part Modigliani & Miller stated that the firm’s value is not affected by the structure of the capital between Equity and Debt, They proved this by having an example of two firms that have got the same conditions in everything, same cash flow, same operational risks and same opportunity costs. One of the firm’s capital structure is all equity and the other firm’s capital structure is a mixture between equity and debt, since the form of financing (debt or equity) can neither change the firm’s net operating income nor its operating risk, the values of levered and unlevered firms will be the same. They have concluded that the value of the levered firm = the value of the unlevered firm, only if they have the same conditions, same risk levels, cash and opportunity cost.
Thesis: Businesses deem financing necessary when they are just beginning, expanding, or recovering; Debt financing and equity financing have many advantages and disadvantages but also change the entire accounting method that is to be considered while running the business. Debt financing has both advantages and disadvantages. Debt financing is a business’ way to start up, expand, or recover by borrowing money from a person or company. The money borrowed has to be paid back along with the interest that was accrued during the length of time the loan was carried out. This option is great for company’s that do not want investors.
Higher leverage is very likely to create value for a firm considering capital structure change by exerting financial discipline and more efficient corporate strategy changes.
Capital structure of companies, the further researches may include the data over 2008-2009. Second, the author state the firms listed in undeveloped markets may have different policies, but we don’t get the conclusion which characteristic(s) may be most significant one(s) which affect the capital structure policies of public companies. Finally, we still want to know whether state-owned companies may have different policies even they are listed or cross-listed in developed markets.
Managers are encouraged to act more in the interest of shareholders and the amount of leverage in the capital structure affects firm profitability (Ebaid, 2009).
The residual income model has become a widely recognized tool in the valuation of equity stock of firms both in practice and research. Residual income is an economic concept which is obtained by deducting from a firm’s net income, charges with respect to shareholders' opportunity cost in generating the net income of such a firm. The residual income model was developed to cater for the lapses associated with the traditional financial statements (particularly the income statement), which are prepared to reflect earnings available to owners. Thus, from the traditional financial statements, the net income of a firm includes interest expense which simply represents the cost of debt capital since they are
The decisions around capital structure lie with the managerial members of the firm, however, it is the debt holders and shareholders who are more prone to bear risk. The normal business risk is always present, but when there is a higher level of debt the equity holders also bear an additional financial risk as there are additional charges relating to the financing. There is also a risk that if future liquidation or bankruptcy was to occur, the creditor hierarchy would favour debt holders first.
Debt financing is also borrowing against future earnings. This means that instead of using all future profits to grow the business or to pay owners, you have to allocate a portion to debt payments. Overuse of debt can severely limit future cash flow and stifle growth. Debt is a bet on your future ability to pay back the loan. What if your company hits hard times or the economy, once again, experiences a meltdown?