Before choosing a financing method for the company the capital structure must be considered to ensure that after the investment the company is able to remain solvent. Capital structure is determined by the mixture of long-term debt and equity used by the firm to finance its operations. A company’s capital structure is analyzed together with its cost of capital while considering various types of financial plans to be pursued by the company.
Capital structure determines the Valuation of a company using its cost of common capital. Valuation is concerned with the determination of the value of the company. The value of a firm is important not only to its existing and prospective shareholders but also quite useful when a firm is considering acquiring or merging with another firm as well as obtaining capital.
A capital structure consists of two sources of funds and has certain characteristic differences. These sources are simplified as debt and equity although can be broken into various long-term financing into its debt and equity components including stockholders’ equity, preferred stock, common stock retained earnings, and long-term debts.
- Debt capital includes any type of long-term funds obtained by borrowing. There are various types of long-term debt. It can be secured or unsecured, senior or subordinated, raised by the sale of bonds, or through a negotiated long-term loan. Many large manufacturing firms have more than one type of debt on their books. Probably the most common type of long–term debt instrument is the corporate bond.
- Equity capital consists of the long-term funds provided by the firm’s owners. Unlike borrowed funds that must be repaid at a specified date, equity capital is expected to remain in the firm for an infinite period of time. The three basic sources of equity capital to the firm are preferred stock, common stock, and equity capital differs. Common stock is typically the most expensive.
The capital structure of the company shows how much of the company assets are financed by the company through debt and how much from equity. The company while trying to source for funds must consider the optimal cost that will not affect the capital to structure further each source of capital has its own cost of capital and its effect on the long term sustainability of the firm there are a few constraints that the firm uses in determining the firm capital that will be chosen. The most important aspect is the gearing aspect.
Gearing is an important concept in connection with capital structure. Gearing is said to exist wherever a company is financed partly by debt. The more debt there is, the more highly geared is the company. Debt creates a fixed annual charge against profits in the form of interest payments. This causes a magnification of any fluctuations in the residual profits available to equity holders, i.e. they become riskier. This increase in risk due to gearing is known as financial risk. it is to be distinguished from the commercial risk to which any business, however, financed, is subject.
There are two opposing theories of capital structure and its relationship to the cost of capital. The first of these, the traditional theory, says that, since debt is cheaper than equity, it will pay initially it increases the amount of debt financing used. At some critical point, financial risk will begin to impinge on the cost of equity it will be disadvantageous to expand it further. There is thus a minimum cost combination of debt and equity which should be sought.
The second theory is associated with the names of Modigliani and Miller and asserts that the cost of capital relates to the value of the business as an economic entity and is independent of the method of finance. This theory would imply that the financial manager had no important decision to make regarding capital structure. A company may sometimes find it desirable to reorganize its capital structure. The ways in which this may be done should be noted.
The current capital structure of the company
The table below shows that company reliance on creditor financing is very high and has been fluctuating from 2000 to 2003. At the same time company is building equity finance during the same four years. This increase in equity finance came mostly from an increase in retained earnings of the company. The company paid no dividend to its outside shareholders. Instead, it has decided to reinvest its annual profit into the business instead of relying on outside financing. The decrease in total liabilities seems to be due to an equal decrease in the current liabilities of the company. This decrease in current liabilities of the company, therefore, results in improved current and acid test ratio for the year 2002. The interest coverage ratio is improving.
Financing option 1- equity offering
New ratios
Financing option 1- debenture offering
New ratios
I will advise the board to go for option 1 which reduces the reliance on debt capital which is currently on the highest. Financing option 1 will reduce reliance on debt capital which will reduce the risk of bankruptcy or insolvency of the firm. currently, the firm relies on debt to finance its operations. This needs to be reduced to a level but is acceptable by the creditors. An increase in debt will create problems of insolvency and the long-term survival of the firm.
The firm has a more equity capital structure and they want to raise more capital they should consider debt capital so as to reduce the weighted average cost of capital. The current capital structure seems to be very expensive for the firm as they are less equity capital.
Work Cited
- Ghetti A., Terrific introduction to financial management; Amazon, 2008 pg218-223
- Gitman L.J., Principles of Managerial Finance,1990,Harper and Bow pp.336-350
- Mclaney E. Business Finance Theory And Practice,2003, Prentice Hall, pp.290-305
- Schlosser M., Business Finance Application , Models And Cases, Prentice hall, 2002,pp. 144-146