FIN 501 Financial Management of Analyzing Firms Capital

Question

Analyzing a Firm’s Capital Structure

Mr. Hillbrandt has learned a lot about the financial side of running the business during the first year with the company and is now contemplating making changes to the corporate capital structure. He needs your assistance one more time.

ABC Golf Equipment Corporation has $10 million in assets (where the market value of the assets is equal to the book value of the assets) and no debt. The company’s marginal tax rate is currently 35% and has 500,000 shares outstanding. The company’s earnings before interest and taxes (EBIT) are $3.88 million. The firm’s stock price is $27 per share and the cost of equity is 11%.

The company is thinking of issuing bonds and simultaneously repurchasing a portion of its stock. If the company changes its capital structure from no debt to 25% debt based on market values, the firm’s cost of equity will increase to 13% because of the increased risk. The bonds can be sold at a cost of 9%. The firm’s earnings are not expected to grow over time. All of its earnings will be paid out as dividends.

Probability	EBIT ($)
0.05	- 1 million
0.25	2.3 million
0.40	4 million
0.25	5.8 million
0.05	6.1 million

Required:

Computations.

Make the computations necessary to answer the questions below. Don’t forget that Mr. Hillbrandt does appreciate your step-by-step computations to guide him through the analysis.

What impact will this utilization of this debt have on the value of the company?
What’s going to be the company’s EPS after the recapitalization?
What’s going to be the company’s new stock price?
The $3.88 million EBIT discussed above is determined from this probability distribution.
What’s the times interest earned ratio at each probability level?

Memo

Interpret the analysis already prepared and use the Excel computations as a basis for a memo to the CEO. Write a four or five paragraph memo. Make sure each question listed above is addressed. Start with an introduction and end with a recommendation. Each of the four or five paragraphs should have a heading.

Short Essay.

Do research to determine some significant considerations that go into selecting or changing the capital structure of a corporation. Start with an introduction and end with a summary or conclusion.

Answer

Memo

To: CEO

CC: CEO

From: Hillbrandt

Subject: Impact upon Firm’s Value due to Change in Capital Structure

1. Impact of Debt upon the Value of Firm: ABC Golf Equipment Corporation has raised $ 2.5 million of debt at the rate 9% resulting in the valuation of the company at $20.78 million as compared to $22.93 million earlier. The back up working of the valuation is as follows:

Cost of Equity after recapitalization	13%
Value of Equity (A) (EAT/Cost of equity)	18.28
Value of Debt (B)	2.50
Value of the company (A+B)	20.78

Recommendation: Present value of the firm that is $22.93 million is greater than the value of firm after taking the impact of debt (i.e. $22.93). It is suggested that Debt should not be employed in firm as it decreases the value of the firm.

2. EPS of ABC Golf Equipment Corporation after recapitalization: After raising the debt, an annual interest cost of $.23 million will arise which be resulting in EPS of $5.83 per share as compared to $5.04 per share under the existing zero debt structure. The tax benefit on the interest cost has resulted in increase in EPS. The EPS has reached as follows:

EBIT	$3.88
Interest Cost	0.23
EBT	$3.66
Tax @ 35%	$1.28
EAT	$2.38
No. of Shares after recapitalization	0.41
EPS after recapitalization	$5.83

Recommendation: EPS of ABC Golf Equipment Corporation has increased to $5.83 million from $5.04 million. According to the EPS, it is beneficial for the firm to recapitalize its capital structure.

3. New Stock Price of ABC Golf Equipment Corporation after recapitalization: The new capital structure has resulted in the favorable manner for the company and resulted in the hike in the share price of the company to $ 44.86 from $ 27.

New Stock Price =	Value of Equity
	No. of Equity Shares
=	44.86

Recommendation: Stock price of ABC Golf Equipment Corporation has increased to $44.86 from $27 million. According to the stock price of ABC Golf Equipment Corporation, it is beneficial for the firm to recapitalize its capital structure.

4. EBIT derived from probability distribution: As EBIT derived from probability distribution is same as it is provided, that is $3.88 million.

Probability Distribution	EBIT
0.05	(1.00)	(0.05)
0.25	2.30	0.58
0.40	4.00	1.60
0.25	5.80	1.45
0.05	6.10	0.31
EBIT on the basis of Probability Distribution		3.88

5. Interest earned ratio at each level of probability: Interest earned is calculated by dividing EBIT from interest for each level of probability.

Interest earned ratio =	EBIT
	Interest
Probability	0.05	0.25	0.4	0.25	0.05
EBIT	-$1.00	$2.30	$4.00	$5.80	$6.10
Interest	$0.23	$0.23	$0.23	$0.23	$0.23
Interest earned ratio (In times)	(4.44)	10.22	17.78	25.78	27.11

Recommendation: The value of the firm has go up after raising the debt funding , EPS has also go up because of the tax savings on the interest on debt. It is suggested that ABC Golf Equipment Corporation should recapitalize its capital structure.

Yours faithfully,

Mr. Hillbrandt

Short Essay

Introduction: Factors that should be considered by company while selecting or changing capital structure are Risk exposure of the firm, financial flexibility of the firm, company’s tax bracket, Growth rate, management of company , last but not the least is market conditions. These all are factors which should be considered by company before taking any decision regarding the restructuring of capital structure.

Risk exposure of company: It is the basic risk of firm’s activities. If the ratio of business risk will be high then debt ratio of the company will be low: Hanif, Mohammed (2001)

Financial Flexibility: It can be defined as the capability of the company to raise its capital during its bad period. If the debt level of company will be low then the financial flexibility of the company will be high.

Company’s tax bracket: Payments to debts are deductible. If company falls under high tax bracket then it will be beneficial for the company to employ more debts and vice versa will also be applicable.

Growth rate: It is also another important which should be considered by company for restructuring of capital structure. If company’s revenue is stable then less debt will be employed in capital structure of the company and vice versa will also be applicable.

Management of the company: whether management of the company is aggressive or conservative. If company’s management is aggressive then it will employs more debt and if management of the company is conservative then it will employs less debt and more equity in capital.

Market conditions: Company’s market condition should be considered. For example, if wants to purchase a new machinery then it is beneficial for firm to raise the fund from equity rather than employing debt- Mallin (1993)

Conclusion: It can be concluded that company should consider Risk exposure of the firm, financial flexibility of the firm, company’s tax bracket, Growth rate, management of company ,and its market conditions before taking any decision regarding capital restructuring.

References

Hanif, Mohammed (2001). Capital restructuring (3rd ed., Vol. 2). New York: Blackwell.

Riad, Janet Hontoir (2001). Financial Management (4th Ed., Vol. 3). London: Oxford University.

Mallin (1993). Techniques of Financial Management (1^st Ed, Vol. 2). London: Penguin.

Reek (2011). Dividend payout ratio Factors (1^st Ed, Vol.2). New York: Pearson Hall.

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