Corporate Finance: Critical Examination of Company’s Capital Structure

This report provides a critical examination of the capital structure of a company, including market debt to equity ratio, cost of levered equity, current weighted average cost of capital, and implications of introducing tax rate and debt issuance. It also covers the use of capital budgeting tools to determine the terminal values, initial investment, and cash flow for accepted business projects.

CORPORATE
FINANCE

Table of Contents
Introduction...........................................................................................................................................3
QUESTION 1........................................................................................................................................4
PART 1..............................................................................................................................................5
a) MARKET DEBT TO EQUITY RATIO................................................................................5
b) Cost of levered equity based on market debt to equity ratio..................................................6
c) Current weighted average cost of capital...............................................................................7
d) When the company issues $ 1 billion in stock to repurchase debt..........................................7
PART 2..............................................................................................................................................9
IMPLICATION OF INTRODUCING TAX RATE OF 40 % AND DEBT ISSUANCE OF $ 5
BILLION TO REPURCHASE STOCK........................................................................................9
QUESTION 2......................................................................................................................................11
a) INITIAL INVESTMENT OUTLAY.......................................................................................12
b) TERMINAL CASH FLOW IN YEAR 6.................................................................................12
c) TREATMENT OF WORKING CAPITAL.............................................................................13
d) IF THE PROJECT’S RATE OF RETURN IS 14% SHOULD THE EQUIPMENT BE
PURCHASED?................................................................................................................................14
e) HOW TO USE DEBT FINANCING TO INCREASE NET PRESENT VALUE....................15
QUESTION 3......................................................................................................................................15
QUESTION 4......................................................................................................................................16
EVALUATION OF CORPORATE LIFECYCLE...........................................................................16
TYPES OF BUSINESS FINANCES...............................................................................................17
BENEFIT OF DIFFERENT TYPES OF FINANCING...................................................................18
Conclusion...........................................................................................................................................18
REFERENCES....................................................................................................................................19

Introduction
The financial leverage and cost of capital are the two important aspects for the
effective business functioning. It is required to set up strong harmonization between both if
company wants to sustain its business in long run. This report has reflected that key
understanding on the optimum capital structure based on the cost of capital and financial
leverage of company. Financial leverage shows the business sustainability risk of company if
it fails to have enough earnings before interest and tax and its interest coverage out of the
available earning. This report has reflected the cost of levered equity, debt funding, capital
structure and use of the capital budgeting tools to determine the terminal values, initial
investment and cash flow for the accepted business projects.

QUESTION 1
CRITICAL EXAMINATION OF COMPANY’S CAPITAL STRUCTURE
Given,
Particulars Amount or number
Short-term debt (inclusive of current portion
of long term debt)
$ 2,000,000,000
Long term debt $ 4,000,000,000
Total shareholder’s equity $ 10,000,000,000
Number of ordinary shares outstanding 2,500,000,000
Current stock price $ 30
Current yield to maturity on stocks (RD) 3%
Cost of unleveraged equity under current
market situations (RU)
12%
Industry average market debt to equity ratio 17.5%
This above given information is given in the report and on the basis of the same rest
computation is made.
Computation is done as below.

Particulars Amount
Market value of equity (E) (2,500,000,000 x 30)
= $ 75,000,000,000
Total liabilities (D) 2,000,000,000 + 4,000,000,000
= $ 6,000,000,000
PART 1
All the discussions made in this part are regarding the perfect market. The perfect
markets are those in which there are no tax rates, or any transactions costs. The value of the
firm in this kind of market is not affected anyhow by the capital structure. The calculation of
the market value is just equivalent to the cash flows that the company has generated. The has
also been argued by the Franco Modigliani and Merton Miller while stating the fact that with
the perfect capital market where there is no effect of taxes, bankruptcy costs, agency costs,
and asymmetric information, and other external factors then the value of a firm is unaffected
by how that firm is financed and what capital structure it has been maintaining. Therefore,
low and high financial leverage and use of tax deductible expenses will have no role to play
while determining the capital structure.
a) MARKET DEBT TO EQUITY RATIO
Market debt to equity ratio shows the ratio of the debt that the company has in comparison to
the current value that the entity has in the market. As the current market value of the
company is used, this ratio helps in providing a better measure for analysing the solvency
position of the organisation (Lewis, and Tan, 2016). The formula used for calculating the
market debt to equity ratio is stated as follows:

Market debt to equity = total liabilities (short-term and long-term)
Total liabilities + market value of equity
= 6,000,000,000 x 100
(6,000,000,000 + 75,000,000,000)
= 7.41%
 COMMENT: the market debt to equity ratio for the company is 7.41 % which is less than the
industry average. It shows that the company might not be availing the benefit of leverage
position as the other competitors are doing. However, if the ratio is not to be compared with
the industry average, then too it is low, because the company has high equity and lower debt.
It can add more debt to have benefits of better leverage position in future (Givoly, Hayn, and
Katz, 2017).
b) Cost of levered equity based on market debt to equity ratio
As per the proposition II presented by Modigliani-Miller, a levered cost of equity
encompasses in itself a financing premium along with the cost that comes on the unlevered
equity. This financing premium has the same value which is computed by the Market value
debt- equity ratio. Taxes are ignored because Modigliani-Miller approach is followed (Chen,
and Strebulaev, 2016). As a result the formula for computing the cost of levered equity can
be presented as follows:
Cost of levered equity (RE) = cost of unlevered equity (RU) + market debt-equity ratio
(RU – RD)
Where, RD refers to the return demanded on debt.
So, cost of levered equity (RE) = 12 + 0.0741 (12 – 3)
= 12 + 0.6669
= 12.67%
COMMENT: as the proportion of debt is not that high in the organisation, the cost of equity
has not been affected much by adding leverage effect into it. But the rise of 0.67 is the new

demand which the shareholders are expecting for their investments and returns on the same
gets riskier after debt are introduced in the company. Even though the equity returns are
increased after debts are introduced, still more risk comes uninvited (Boyer, Lim, and Lyons,
2017).
c) Current weighted average cost of capital
Weighted average cost of capital helps in computing a cost rate that is equal to the weighted
average of the cost which is incurred on debt and the equity (Frank, and Shen, 2016).
Formula:
Weighted average cost of capital (WACC/RWACC) = {E/ (E+D)} X RE + {D/ (E+D)} X RD
= 75,000,000,000 x 0.1267 6,000,000,000
x .03
(75,000,000,000 + 6,000,000,000) (75,000,000,000 + 6,000,000,000)
= {0.9259 x 0.1267} + {0.0741 x 0.03}
= 0.1173 + 0.0022
= 12 %
COMMENT: the above calculation shows that the company is operating in a perfect capital
market. This is so because as per Modigliani-Miller when the capital markets are perfect, the
capital structure of the organisation has no effect on the firm’s WACC, and the same tends
equal to firm’s unlevered cost of equity, which is 12 % in this case (Garcia, Saravia, and
Yepes, 2016).
d) When the company issues $ 1 billion in stock to repurchase debt
When the company issues $ 1 billion stock and repurchases debt, the situation comes as
follows:
Particulars Amount

Market value of equity (E) (2,500,000,000 x 30) + 1,000,000,000
= $ 76,000,000,000
Total liabilities (D) 2,000,000,000 + 4,000,000,000 –
1,000,000,000
= $ 5,000,000,000
 COST OF LEVERED EQUITY BASED ON MARKET DEBT TO EQUITY RATIO
For this market debt to equity is to be recalculated. It can be done as follows:
Market debt to equity = 5,000,000,000
(5,000,000,000 + 76,000,000,000)
= 6.17 %
COMMENT: the debt in comparison to equity has further reduced.
 COST OF LEVERED EQUITY BASED ON MARKET DEBT TO EQUITY RATIO
The cost of levered equity comes to (new RE) = 12 + 0.0617 (12 – 3)
= 12.43%
COMMENT: the lessening of debt in the capital structure do not does away with the risks.
Risks are present till the date debts are there and hence results in increasing the return
demanded by the shareholders.
 WEIGHTED AVERAGE COST OF CAPITAL
The weighted average cost of capital is computed as follows:
New WACC (new RWACC)
= 76,000,000,000 x 0.1243 5,000,000,000
x .03
(76,000,000,000 + 5,000,000,000) (76,000,000,000 + 5,000,000,000)
= 12 %

COMMENT: hence, there is no impact of change in the capital structure on the weighted
average cost of capital of the organisation. It is still 12%. The reason is same. The perfect
capita markets are not affected by any change that happens in the capital structure of the
organisation. The weighted average cost of capital always comes equal to the unlevered cost
of equity (Arrow, 2017).
PART 2
IMPLICATION OF INTRODUCING TAX RATE OF 40 % AND DEBT ISSUANCE
OF $ 5 BILLION TO REPURCHASE STOCK
When the company raises $ 5 billion debt and repurchases stock, the situation comes as
follows:
Particulars Amount
Market value of equity (E) (2,500,000,000 x 30) - 5,000,000,000
= $ 70,000,000,000
Total liabilities (D) 2,000,000,000 + 4,000,000,000 +
5,000,000,000
= $ 11,000,000,000
a) MARKET DEBT TO EQUITY RATIO
Applying the formula used above, the market debt to equity ratio comes down to be:
Market debt to equity = 11,000,000,000
(70,000,000,000 + 11,000,000,000)
= 13.58 %
COMMENT: the market debt to equity has improved after the company has raised a further
debt of $ 5,000,000,000. The capital structure value remains the same, only the components
have changed.

b) COST OF LEVERED EQUITY BASED ON MARKET DEBT TO EQUITY RATIO
Cost of levered equity (RE) = cost of unlevered equity (RU) + {market debt-equity ratio x
(1 – 0.40) x (RU – RD)}
Cost of levered equity (RE) = 12 + {0.1385 x 0.60 x (12 – 3)}
= 12 + 0.7479
= 12.75%
COMMENT: the rise in debt has raised the risk that is present in the firm. As a result the
company’s shareholders demands from the firm have increased and that has increased the
levered cost of equity of the organisation.
c) Weighted average cost of capital
Weighted average cost of capital (WACC/RWACC) = {E/ (E+D)} X RE + {D/ (E+D)} X (1-
0.40) X RD
= 70,000,000,000 x 0.1243 11,000,000,000
x .03 x 0.6
(70,000,000,000 + 11,000,000,000) (70,000,000,000 +
11,000,000,000)
= 10.74 + 0.0024
= 10.75%
COMMENT:
The raised component of debt and the introduction of the tax rate of 40 % have helped the
company in decreasing the weighted average cost of capital of the company. This shows that
when there is tax prevailing in the country and the company is also using debt in its capital
structure, the advantage of leverage can be taken by the company. This helps and benefits the
firm in achieving maximum value. Because there are no perfect markets and hence the value
of the firm is dependent on the capital structure of the company (Stringham, and Vogel,
2018).

OVERALL COMMENT: when the capital markets are imperfect the dependency of the
firm on debt up to a certain level helps the organisation in achieving maximum value for
itself. This is because of the tax shield that is enjoyed on the interest paid. The overall costs
are lowered for the company. This is also synthesised by the pecked order theory. As per this
approach an optimal level of debt is must to attain optimal value for the organisation. And as
per traditional approach also, the weighted average cost is able to be lowered with an
optimum mix of debt and equity (Graham, et. al 2017).
QUESTION 2
Given,
Particulars Amount
Price of machinery $275,000
Installation cost $ 25000
Life 6 years
Depreciation Straight line
Scrap value Nil
Net working capital required $ 12000
Saving in operating cost $ 55000
Income tax rate 35%
Sale receipt on sale of machine in year 6 $ 60,000

a) INITIAL INVESTMENT OUTLAY
Initial investment outlay comprises of all the cost incurred on the purchase as well as on the
setting up and installing of the machinery in the entity premises. The working capital that is
required for the project is also considered as a part of the initial outlay (Gotze, Northcott, and
Schuster, 2016). This is the money that is required to do a project. These includes the money
that is required to purchase the product, its transportation and fixing charges and finally the
additional working capital that may be required as a result of the new equipment.
So, initial investment = 275,000 + 25,000 + 12000
= $ 312,000
b) TERMINAL CASH FLOW IN YEAR 6
Terminal cash flow is the amount of capital that the investor will get back as salvage
value after you dispose an item
Computation of a year’s cash flow:
Particulars Amount ($)
Savings in operating costs 55,000
Less: depreciation (275,000 + 25,000)/6 50,000
Operating profit before tax 5,000
Less: tax @ 35 % (5000 x 0.35) 1,750
Operating profit after tax 3,250
Add: depreciation 50,000

Annual cash flows 53,250
The terminal cash flow in this case shall be the sale value that will be generated in year 6 on
disposition of the asset and the working capital released along with the annual cash flows.
The tax incurred on the sale value gain shall be deducted. As the scrap value is zero, hence
the whole amount of $ 60,000 is a gain for the organisation (Abor, 2017). The computation is
shown as follows:
Terminal cash flow = gain on sale x (1 – tax rate) + working capital released + annual cash
flow
= 60,000 (1-0.35) + 12,000 + 53,250
= 39,000 + 12,000 + 53,250
= $ 104,250
c) TREATMENT OF WORKING CAPITAL
Whenever new machinery is introduced in the business, the entity need some amount of
money to run the machinery in the day to day working. Hence when the initial investment
outlay is planned the working capital requirement is also added into it. However, on sale of
the machinery, that portion of the working capital is no more required and hence released in
the terminal year. So, the terminal cash flow shows as a cash inflow the release of the
working capital (Bhattacharya, 2014).
d) IF THE PROJECT’S RATE OF RETURN IS 14% SHOULD THE EQUIPMENT BE
PURCHASED?
For this requirement, the organisation needs to compute the net present value. The net present
value can be calculated using the discount rate of 14 %. The table below shows the discount
factors for 6 years and the discounted cash flows:

Year Discount factor (a) Cash inflow (b) Discounted cash
inflow (a x b)
1 (1/1.14) 0.8771 53,250 46706
2 (1/1.14)2 0.7695 53,250 40976
3 (1/1.14)3 0.6797 53,250 36194
4 (1/1.14)4 0.5921 53,250 31529
5 (1/1.14)5 0.5194 53,250 27658
6 (1/1.14)5 0.4556 104,250 47496
TOTAL DISCOUNTED CASH INFLOW OF PROJECT 230559
So net present value = total of discounted cash inflows – initial cash outflow (Rossi, 2015).
= 230559 – 312000
= - $81441
As the net present value of the project is negative, hence the investment should not be made
by the organisation.
e) HOW TO USE DEBT FINANCING TO INCREASE NET PRESENT VALUE
The firm can use debt financing to get tax shield on the interest expense, and thus can
increase the annual cash inflow. The annual cash flow shall get increase due to the tax
savings mad on the interest paid. The tax saving shall be treated as a cash inflow which shall
increase the cash inflow. However, the value of the project increases for the reason that the

use of leverage leads to a reduction in the cost of capital. Other than the net present value
method, there is an adjusted present value method which takes into account the benefits that
the entity gets when it uses debt in its capital structure. this makes the APV method
preferable than the net present value method.
Note- After assessing the information it could be inferred that timeline for positive NPV
cannot be prepared, as the operating profits are getting negative on deducting interest.
QUESTION 3
For the successful and hassle free running of any business, the organisation needs sufficient
funds. These cannot be obtained overnight. The firm needs to gather complete knowledge
into its fund requirements and the sources from which it can suffice its fund needs. As a
result, the organisation needs to incorporate financial planning into its business. Financial
planning shall help the business to understand the requirements of its funds and the way they
can be optimally fulfilled.
Financial leverage is the other name of trading on equity. It entails the management
accountant to understand how it can play around equity and debt to reach an optimal level
where the value of the firm would reach its maximum and the cost of debt shall be least.
Leveraging the firm’s capital structure means adding a debt component in the entity’s capital
structure. As a result the annual cash flows shall experience a raise, as the firm shall enjoy the
benefits of tax shield on the interest expense. As the company’s cash flow position shall get
strong, it shall be able to achieve a sustainable survival (Bhardwaj, 2018). The available
resources are allocated to the most profitable project so maximizing the owner’s wealth. It is
analyzed that when the best is chosen it will easily penetrate the market and this will ensure
that the business growths.
Because of proper financial planning and involving financial leverage, the firm shall be able
to make good use of the risks involved (Alviniussen, and Jankensgard, 2015). Financial
planning shall also help the organisation to formulate a proper finance budget and monitor the
performance with the actual results to identify the deficiencies and the ways to overcome the
deficiencies. Further, by a proper financial plan, the organisation shall be able to properly use
a combination of debt and equity in its capital structure. Both financial and operating
leverage are about fixed charges and when they are combined, one can be able to calculate
the whole risk of a business. This risk is of not being able to cover all the fixed cost expenses.

If these fixed expenses are high it means the combined leverage will be high. To add ease, the
operating, financial and combined leverage are explained below:
 The financial leverage is conceptualised with the fact that the use of borrowed fund up
to an optimal level in the capital structure hall allow the firm to make use of the
benefits of the increment in the share price and a decrement in the overall cost of
capital.
 Operating leverage, calculates the level up to which the operating income of a concern
can be increased by it by increasing the level of operating revenue.
 Combined leverage, as the name is suggesting shows the combined effect that the
operating and financial leverage cast on the business.
QUESTION 4
EVALUATION OF CORPORATE LIFECYCLE
The graph below shows the different stages of the corporate lifecycle:
Different business cycles (Petch, 2018)
COURTSHIP STAGE
This is the stage at which the promoters bring up the idea of starting a business. The
feasibility study is done here along with taking the decision regarding the sources of finance
and the targeted customer market. The business has not started yet and is only conceptualised
here in this stage (Agibalov, Zaporozhtseva, and Tkacheva, 2016).

THE LAUNCH STAGE
This is the most initial stage in which the business has just initiated. The sales are extremely
low at this stage generally. The business faces difficulties in funding and finding new
financers. The profit is almost negligible, and even some business houses suffer losses in this
stage. This is the stage at which the importance of marketing is realised in order to boost the
sales. There is no scope of savings here, only reinvestments are made in the business, even if
any money is earned (Salamzadeh, and Kesim, 2015). At this stage the business mostly
makes losses because of the new services or product introduced they are yet to be accepted in
the market. At this stage much of the money that is earned is reinvested back in the business
and also to fund new projects this is to ensure that the business survives in the other stages of
business.
GROWTH STAGE
At this stage the business faces a boom growth. The sales are at a level of rise that eventually
increases the company’s profit level. The demand hits high and requires the entity to add
more to its production and product range. The need to expand the business space is felt and
the entity enters new markets. The capital required also rises as he production increases. The
firm has the opportunity to penetrate roots into newer and untapped markets. New offers are
offered to the consumers to keep them retained with the entity (Carnes, et. al 2017). The other
form of growth is diversification where a business ventures into new business, new products.
This requires a lot of capital which can be got from the financial institution. And lastly
growth can be achieved by acquisition thus immediately increasing customers and the market
area.
SHAKE OUT STAGE
Shakeout stage marks the beginning of the maturity stage. It is the stage wherein the
focus of the organisation is on reducing the expenses and bringing a consistency. The
growth tends to slow here in this stage. Many a times business consolidations are also
seen here.
MATURITY STAGE

This is the saturation point at which the firm has achieved highest sales and the growth
becomes stagnant. There is no further rise that can happen until the firm innovates and
expands its horizon (Delgado, Pereira, and Dias, 2015). It is considered that because of high
competition and new entry of similar business. Market share steadily decreases.at this stage it
is easy to access debt finance because at this stage business risk has been fully eliminated.
DECLINE STAGE
Here, the company feels the clutches of tight competition and experiences a reduction in the
sales and the market share. The company is required to gear up here, in order to level back to
maturity stage (Huang, 2016).
TYPES OF BUSINESS FINANCES
In the courtship and launch stage, the company can only resort to self-financing, or can take
loan as finance from family, friends or relatives. The company at this stage has only bloomed
up and it not certain in the eyes of the lenders regarding its creditworthiness. Hence, no
unknown lender is easily ready to finance the capital requirements. It is how the relatives and
friends are left as the best option.
In the growth, maturity and declining stage, the firm has established itself well. So it can try
for equity, and/or debt financing. In this financing money can be taken from external sources
on the basis of credibility of the firm. The cost of finance is also lesser here than what in the
launch stage. This is so because now the company has a varied availability of finances and
could easily harness the finance which provides the company with more benefits and least
cost.
BENEFIT OF DIFFERENT TYPES OF FINANCING
The different types of finances help the organisation to remove its dependency on a single
source of finance. This shall hep he organisation to get funds as and when required. With the
use of digital environment, the company is able to market its business and performance. On
the basis of that new financers could be hacked from the market. Moreover, with the world
being globalised nowadays, it has become easier to tap international finances also. The
dependency on the nation limited sources of finances has vanished. All the benefits if the
international and digital environment has allowed the organisations to decrease their funding

costs at an overall basis. There is no need for the firm now to depend itself on a single and
expensive source of finance.
Conclusion
Financial structure is the mix of both debt and equity finance that is undertaken by a
business to optimize on shareholders wealth. All types of finances have their own advantage
and disadvantages which have to be considered by company while raising funds from the
business. Now in the end, it could be inferred that if proper financing is used then company
may easily overcome the financial sustainability risk. Nonetheless, in case of sluggish market
condition, company should keep the debt funding low and equity funding high so that it could
survive even when business is facing issue in earning profit. The crux of the report is that
equity and debt capital in the capital structure should be determined on the basis of the
internal and external factors of the business.

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