Module 4 - Case
Capital Structure and Dividends
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.
- 1 million
Computations (use Excel).
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 (use Word).
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 (use Word).
Do research to determinesome significant considerations that go intoselecting or changing the capital structure of a corporation.Start with an introduction and end with a summary or conclusion. Use headings. Don’t forget to reference your sources. Maximum length of two pages.
Each submission should include two files: (1) An Excel file; and (2) A Word document. The Word document shows the memo first and short essay last. Assume a knowledgeable business audience and use required format and length. Individuals in business are busy and want information presented in an organized and concise manner.
Capital Structure and Dividend Policy Podcast. (2014). Pearson Learning Solutions, New York, NY.
Capital Structure and Dividend Policy Interactive Video. (2014). Pearson Learning Solutions, New York, NY.
Review these website links:
Damodaran, A. (2005). Finding the right financing mix: The capital structure decision. Retrieved June 2014 from http://pages.stern.nyu.edu/~adamodar/pdfiles/cfovhds/capstr.pdf
Harvey, C. (1995). WWWFinance: capital structure and payout policies. Retrieved June 2014 from http://www.duke.edu/~charvey/Classes/ba350/capstruc/capstruc.htm
Peavler, R. (2012). Debt and equity financing. Retrieved June 2014 from http://bizfinance.about.com/od/generalinformatio1/a/debtequityfin.htm
There are advantages and disadvantages to having debt in a corporation’s capital structure.
Corporations get a tax deduction from the interest paid on debt. On the other hand, dividends are not tax deductible. This helps to reduce the cost of debt since the after-tax cost of debt is used in the weighted average cost of capital and not the pre-tax cost of debt. The cost of equity is usually much higher and can be estimated through the Capital Asset Pricing Model (CAPM). If a firm is very successful, the stockholders don’t have to share the profits with debtholders since the return on debt is not a variable.
There are some problems with debt, though. As a company uses more debt in its capital structure, it increases the company’s risk. This increases the costs of equity and debt. If a company has financial problems and can’t cover its interest charges, the firm may have to go bankrupt if it can’t obtain additional financing.
Firms that have quite variable earnings and operating cash flows are better off having limited debt in their capital structures. Companies with more stable earnings and operating cash flows can utilize more debt in their capital structures.
Business risk is probably the most important factor that drives capital structure decisions. Business risk is the riskiness of a company’s operations if it doesn’t utilize debt. Financial risk is the increased shareholders’ risk from the use of debt in the capital structure. There’s no set optimal capital structure for all firms.
An investor’s total return consists of the capital gains yield and the dividend yield. Not all companies pay dividends; however, for those that do, it is an important component of an investor’s return, particularly for those seeking income. Individuals who are retired are usually the clientele most interested in dividends. If a stock’s price didn’t change all year, yet the company paid a healthy dividend yield, the investor would still earn a positive total return.
Successful companies typically accumulate a large amount of cash on their balance sheet. If the company has funded all the positive NPV projects that it wants to, it can look to paying a dividend or buying back stock. If it currently already pays a dividend, it can look to increase the dividend.
A company that increases its dividend or institutes a dividend provides a signal to the marketplace that it anticipates higher future cash flows at the firm since once a company increases or starts a dividend it rarely reduces or eliminates the dividend. On the other hand, a company that decreases its dividend or eliminates a dividend provides a signal to the marketplace that it anticipates lower future cash flows at the firm.
Bookboon.com. (2008). Corporate Finance. Retrieved from http://bookboon.com/en/economics-and-finance-ebooks
Welch, Ivo. (2014). Corporate Finance (3rd Ed.). Chpts 16 and 19. Retrieved from http://book.ivo-welch.info/ed3/toc.html