Managers should properly understand the capital structure of their organization since it plays a crucial role in influencing the overall performance of the entity. Having a deep insight into the capital structure is essential because it affects and allows a company to determine the cost of capital being used in operational activities (Le & Phan, 2017). Based on the concept of the free cash flow evaluation model, the total value of a firm is equivalent to the overall summation of its present free cash flow.
In the company, the capital structure affects the value of the firm. It impacts the free cash flow (FCF), which is the total amount of money available for an organization after deducting the capital expenditures incurred during the period of operation. The effect can also be realized on the corporation’s weighted average cost of capital (WACC). Similarly, it determines the percentage value of the business to be financed by debt (wd) and the cost for acquiring debt (rd).
VA = (FCF * [1 + g] / (WACC – g)
Business risk refers to the likelihood of various events interfering with the overall performance of the company, thus lowering the amount of revenue generated. It is also defined as the dangers that threaten a firm’s capability to reach its set objectives. Several factors influence the occurrences of business risk they include government regulations, the unpredictability of demand, the performance of the economy, sales volume and changes in customers preferences. For a company to mitigate the possible hazards, the financial management body should opt for a capital structure with a lower debt ratio to facilitate the firm’s ability to meet its debt.
The term operating leverage refers to an accounting technique that determines the extent to which a business can raise its operating income by increasing its revenue. A company either has high or low operating leverage during its operational period in the market. Businesses that operate using a high degree of operating leverage have a more fixed cost to pay for irrespective of whether all the goods were sold as forecasted. Unlike firms that apply low operating leverage in their processes, they will have limited fixed costs to cover.
Higher operating leverage increases the business risk for a company because, within the capital structure, a large proportion of operating fixed costs will require the corporation to settle them upon receiving revenues. This will raise the firm’s expenditure irrespective of the amount of sales received during the fiscal period. On the contrary, low operating leverage leads to a reduced level of threats for the organization.
This is the level of production where the accumulated revenue is equal to the overall expenditures. Given the fixed cost to be $200, the sales unit is $15, and the variable cost is $10.
Operating Break-Even Point = total fixed costs / (sales price – variable costs)
= $200 / ($15 – $10)
= $200 / $5
= $40
The company should use debt to finance its operational activities. In most cases, firms enjoy a tax benefit advantage associated with using debt as a source of finance. If the entity is financed with about 30% debt, it will receive roughly 6% of the overall value of the capital. The approach allows the business to spend little money in repaying stockholders, thus leaving the organization with adequate free cash flow.
On the basis of corporate tax, debt financing is highly favoured over equity. During the operation process, the benefits of financial leverage surpass the risks since a more significant portion of earnings before interest and taxes is channelled to investors; hence limited amount is subjected to taxation (Abdullah & Tursoy, 2019). This would allow the business organization to have more money at the end of the trading period. For example, Pizza Palace has a tax rate of 25%, which imply for every dollar of the debt borrowed, 25 cents will be added to the value of the firm. Similarly, based on the pecking order theory, the corporation can use obligations to finance their operations because they have lower costs of floatation compared to equity.
Considering the advantages associated with using debts to finance business activities, Pizza Palace should shift from using its equities to securing obligations. The firm has a good tax rating thus is capable of reaping the benefits to boost its overall growth. Debits also enable companies to have the ability to invest in short-term development. This would ensure they generate more revenue hence increasing the free cash flow for the business.
In general, debt financing increases the financial health of a business. A company will be able to expand its operation if it opts to use loans to finance its core activities. Therefore, managers should understand how debt and taxes operate so that they can take tax benefit advantage to add value to the firm. A capital structure centred on debits rather than equity will provide more income to the investors and the company.
References
Abdullah, H., & Tursoy, T. (2019). Capital structure and firm performance: Evidence of Germany under IFRS adoption. Review of Managerial Science, 1-20. Web.
Le, T. P. V., & Phan, T. B. N. (2017). Capital structure and firm performance: Empirical evidence from a small transition country. Research in International Business and Finance, 42, 710-726. Web.