Explanation
Business risk denotes the exposure of the company’s assets in the absence of debt in the capital structure. The risk is integral in the operations of the business.Some of the factors that have a significant impact on business risk are sales risk and input – cost ratio. In the case, Western Company faces business risk in the area of sales and the cost of operations. On the other hand, financial risk focuses on the leverage level of the company. It signifies the ability of the company to meet immediate financial objectives. The financial risk of a company is high when the business has high leverage
Measuring risk
Business risk
The contribution margin ratio shows that an increase in the amount of sales by $1 will result in an increase in the value of contribution margin by $0.57. A high contribution margin ratio is suitable. Further, since the value of the operating leverage effect of the company is greater than one, it implies that operating leverage exists in the company. This implies that the company is experiencing high business risk.
Financial risk
The current ratio and quick ratio are less than one. This implies that the company cannot meet its immediate financial obligations using current assets. The debt ratio shows that 24.3% of the total assets of the company is financed by debt. The debt to equity ratio is relatively high. This shows that the company has a high amount of debt in its capital structure. Thus, it can be concluded that the company has a high financial risk.The measurement of business and financial risk may incorporate measures of market risk such as beta.
How business risk affects optimal capital structure
Business risk affects the amount of debt and equity in the capital structure. When the company perceives that the business risk in a certain period will increase, then the management will reduce the amount of debt because the cost of debt increased with the increase in the risk.
Business risk and industry of the firm
Business risk cannot be discussed in isolation of the industry in which the business operates. This arises from the knowledge that the industry has a significant impact on the operations of a business. Changes in a given industry such as new rules and regulations, will definitely have an impact on the operations of businesses in it. Further, some industries tend to have higher business risk than others. For instance, a firm in the retail industry has higher business risk than utility industry.
Capital structure analysis
Determination of stock prices
The stock price is estimated as shown in the formula below.
The intrinsic value of stock = D1/ (Ke -g)
Expected dividend = 1.18
Growth rate = 2.68%
Variation in the number of shares
Recapitalization entails changing the composition of the capital structure. The number of shares will decline when the price after recapitalization increases. On the other hand, the number of shares will increase when the price of recapitalization decreases.
Optimal capital structure
The optimal capital structure is at the point where WACC is at the minimum level. From the spreadsheet model table, the minimum WACC is at 6.90%. At this point, the cost of debt is 8.0% while the cost of equity is 10.70%. Further, the book value debt ratio is 61.8%.
The impact of a change in debt level on other variables
As the amount of additional debt increases, the WACC declines up to the optimal level of capital, then it starts to increase. Further, the TIE reduces as the amount of additional debt increases. Thus, as debt increases, the amount of interest expense increases. This reduces the TIE. It can also be observed that the EPS increases as the amount of additional debt increases. This can be as a result of reduction of the number of shares in the capital structure as debt increases. Further, it can be observed that EPS is not maximized at the same debt level that maximizes the stock price. It is apparent that the EPS incessantly augmented past the intensity at which the price of the stock was maximum.
Business risk and capital structure
An increase in business risk increases the cost of debt and equity. This will significantly affect debt more than equity. The amount of debt in the optimal structure will decrease. On the other hand, when business risk decreases, the debt in the optimal structure will increase.
Modigliani and Miller (MM)
MM argued that dividend payment has no effect on the value of the firm. In the case of Western Company, it can be observed that dividend payment has an impact on the capital structure. It can be observed that as the dividend per share increased from $1.18 to $1.39, the intrinsic value of stock increased from $16.55 to $16.63. The increase in the value of shares reflects on the value of the firm and capital structure.
Quantitative capital structure analysis
The quantitative analysis of the capital does not take into consideration qualitative factors that influence the target capital structure such as growth opportunities for the firm, the uniqueness of the firm, industry effects, the size of the firm and the profitability. In the event that the company seeks for new funds, it should take into account the optimal target structure. It should at all times seek to minimize the cost of capital. The target capital structure should be used as a point estimate for internal control purposes.
AA rating goal
I agree with suggestions that the company should ensure that the third subsidiary with BBB rating is enhanced to AA. BBB is in the category of medium credit quality investment grade while AA and AAA show high credit quality investment grade. The company should focus on AA and not AAA. The disadvantage of AAA rating is that a bond with little degree of default offers lower interest rates to investors. This may be a challenge when raising capital.
Changing the capital structure
A significant change in the target capital structure would require a change in the amount of debt or equity by a large margin. This move can only be achieved through recapitalization, either by increasing, reducing debt, repurchasing shares or issuing new changes. The transition cannot be achieved within a short period of time. It can only be achieved in the long run. The investors should be informed of significant changes in the capital structure because such changes affect their investment decision.
Future need of capital
The optimal capital structure has an impact on the speed of growth of the entity. Thus, the future need for capital will have an impact on the target capital structure. A company that is growing fast will have a target capital structure that is different from that of a company that is growing slowly. A fast growing company will require more funds to support growth and is likely to have more debt in the capital structure than a slow growing company. Further, a company with a certain future capital need will have a stable target capital structure.
Top down and bottom up
The company should use the bottom-up approach in its capital structure. This approach takes into account the various risks faced by the difference subsidiaries. Thus, calculation of WACC should be based on the different capital structures for the different subsidiaries.
Dividend policy
The dividend policy of the company should be outlined when coming up with the target capital structure because the dividends have an impact on the value of the firm and by extension, the capital structure. I do not agree with the MM model because as discussed above, the increase in dividend increases the value of shares and this affects the capital structure.
Parent company guarantees
The advantage of allowing the subsidiary to issue its own debt is that it does not significantly affect the leverage of the parent company. The disadvantage is that it might not be in the best interest of the overall company. When the parent company issues the debt, the cost of borrowing is reduced. However, it increases the leverage of the parent company. When the parent company guarantees a loan, it will not affect its leverage. However, the parent might pay the loan when the subsidiary defaults.