Corporate Finance: Critical Examination of Company’s Capital Structure

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.