Capital Structure Essay Example for Free

Capital Structure EssayCapital twist is how a come with finances its overall trading ope professionalportionns and growth by using funds from equity or debt (Investopedia, 2012). Of course, every partnership must determine its preference on its debt-to-equity ratio and determine which chapiter expression works best for them. Some approaches to analyzing capital structure ar1.EBIT EPS This analyzes the impact of debt on earnings per share (EPS). Optimizing shareholders wealth is the best goal and thence, this approach analyzes the high EPS establish on an expected range of earnings before income taxes (EBIT). 2.Valuation Determines impact of debt use on shareholders quantify 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 F show date Analyzes a firms debt substance by using the weighted average of cost of capital (WACC).The WACC is a calculation of a firms cost of capital in which distributively capital source (bonds, stock and other long-term debt) are proportionally weighted to determine how much lodge in the caller-up has to throw for every clam it finances (Investopedia, 2012).Look morecapital budgeting examples essayPart of Competition Bikes (CB) main take careation in the decision to merge or acquire Canadian Biking is working capital. allows use the EBIT EPS approach to determine how to maximize shareholder reverse while minimizing the cost of capital. We currently know Canadian Bikings dull unprocessed revenue forecast of EBIT figures for the next 5 years ( division 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 survival of the fittest to increase Canadian Bikings EPS. The five alternativ e capital structures include woof 1 100% Bonds (fully financed)Option 2 50% Preferred line of products 50% Common Stock (no bonds)Option 3 20% Bonds 80% Common StockOption 4 40% Bonds 60% Common StockOption 5 60% Bonds 40% Common Stock*Annual bond affaire rate is 9%After using the EBIT EPS approach using the forecasted EBIT amounts for Years 9 done 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 = .0452Option 2 Average EPS = .0542Option 3 Average EPS = .0526Option 4 Average EPS = .051Option 5 Average EPS = .0494Based 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 invade expense and, 2) equity and of common shares. Option 2 is the best capital st ructure 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 doesnt 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 purchasable 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 companys 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 shar es outstanding, which means less(prenominal) shares to divide the total income among. Therefore, Option 2 is the most optimal capital structure that considers minimizing long-termdebt expenses and the optimal number of common shares in order to maximize shareholder return.CAPITAL BUDGETINGCompetition Bikes is considering manikining a manufacturing facility in a new Canadian location. The total investment for this forcing out 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 give set (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 projects cash inflows and outflo ws 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 mental synthesis 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 negligibleThe present value in NPV is calculated using an interest rate, also known as the required rate of return. CBs 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(prenominal) 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 p ursue the capital investment because the average IRR between both(prenominal) low and moderate sales is 9.3%. This is below the companys 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 CAPITALCB 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 yield and management of working capital. Lets discuss the companys 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 clobbers ordered with legal injury of net/30 eld. This can be improved by renegotia ting 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 orderto 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. Thi s 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.CBs cash conversion cycle factors also impact working capital. Currently, the CBs 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 soothsaying measurements for ordering supplies and order the majority of the supplies needed for the month at the beginning of the month.This would increase t he 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 CBs 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 entropy 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 recyclable life expires. This will prepare CB for those unwanted although necessary fixed asset costs.Currently thecorporations marginal tax rate is 25%. The company can consider obtaining w orking 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, lets discuss how CB can use its working capital for the lease vs. bribe 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 companys net earnings at the end of the year, also resulting in higher retained earnings and increased shareholder value.MERGER OR ACQUISITIONCB should consider many factors when deciding to merge or acquire Canadian Biking. Lets 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 voltage EPS would increase by approximately .021. This shows potential for increased ownership earnings, but is it significant enough? At the same token, the bell/earnings ratio for Canadian Bikes at the end of Year 8 was 9 and CBs was 70. This shows that CBs 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 Bikings 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 rhythm that can decrease production costs and complement CBs current bike model being offered. This will result ingreater 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 value 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 cas h flows, and preserve working capital. The price to acquire Canadian Biking is simply ill-judged based on predicted cash inflows over the next 5 years. The merger will enhance CBs 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.ReferencesInvestopedia. (2012). Capital Structure. Retrieved from http//www.kotzinvaluation.com/articles/capital-structure.htm Investopedia. (2012). plodding Average Cost of Capital. Retrieved from http//www.investopedia.com/terms/w/wacc.aspaxzz2Azkq4E2V Investopedia. (2012). Net Present Value. Retrieved from http//www.investopedia.com/terms/n/npv.aspaxzz2Azkq4E2 Pearson Education, Inc.. (2008). Horngren Accounting. Retrieved from http//wpscms.pearsoncmg.com/wps/media/objects/6716/6877765/hha08_flash_main.html?chapter=nullpage=1042anchory=nullpstart=nullpend=null Wenk, D. (2012). Using an optimal capital structure in affair valuation. Retrieved from http//www.kotzinvaluation.com/articles/capital-structure.htm