Corporate Finance: Capital Structure, Investment Process, and Strategy

This document explores the different aspects of corporate finance, including capital structure, investment process, and strategy. It discusses arguments for and against the company's overall cost of capital, factors to consider when choosing between preference shares and debentures, and major factors influencing additional debenture finance. It also provides insights into the process and strategy of investment in corporate finance.

CORPORATE FINANCE

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................1
Question 1 Capital structure.............................................................................................................1
(a)Arguments for and against the company overall cost of capital.............................................1
(b) Factors need to be considered when making choice between preference shares and
debentures as a means of raising long term fund........................................................................2
©Major factors that influence the amount of additional debenture finance that Newham plc
will be able to raise.....................................................................................................................3
Question 2........................................................................................................................................4
a. process and the strategy of an investment...............................................................................4
b. capital budgeting or investment appraisal techniques.............................................................6
CONCLUSION................................................................................................................................9
REFERENCES..............................................................................................................................10

INTRODUCTION
Corporate finance referred as the division of the finance which deals with the financing,
investment decisions, structuring and the capital. It is primarily concerned to maximising wealth
of the shareholders by way of short and the long-term planning and an execution of the several
strategies. In other words, it an area of the finance which deals with the sources of the funding,
capital structure of the company, actions that the managers takes for increasing firm's value to
shareholders and an analysis or the tools for allocating the financial resources appropriately. The
current report is based on the different aspects of the corporate finance that includes evaluation
of the capital structure, investment process and the strategy. Furthermore, the study presents a
computation of the net present value and the profitability indexes with an application of an
investment appraisal techniques.
Question 1 Capital structure
(a)Arguments for and against the company overall cost of capital
Table 1Value of levered firm
Vu 3,500,000
Tc 20%
D 2,600,000
Vl 4020000
Proposition 1 (M&M 2) of MM model state that value of levered firm is always greater then
value of unlevered firm. This because firm receive tax deductions on the debt amount and due to
this reason, its value increase. It can be said that tax deductible interest payments positively
affect company cash flow and this is the main reason due to which levered firm value is always
greater then same of the unlevered firm. In the above table it can be said that value of the levered
firm is $4020000 which is very high. Hence, it can be said that debt up to certain limit benefit
business firm.
Table 2Debt equity ratio
Value Proportion
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D 2600000 42%
E 3640000 58%
Debt equity
ratio 0.714286
Debt equity ratio value is 0.71 which is indicating that debt is almost nearby to equity value.
Proportion of debt in the capital structure is 42% and same of equity is 58%. Hence, it can be
said that firm capital structure is balanced.
Capital structure is the one of the most important part of finance management for the
business firm. This is because capital structure clearly determines the combination of equity and
debt that will be used to finance entire business. Combination of the equity and debt clearly
determine the cost of capital of the business firm. If in the capital structure majority of portion
will be of equity then in that case cost of capital will be high because rate of dividend is always
higher then rate of interest. On other hand, if in the capital structure majority of portion is
covered by debt then in that case cost of finance will be low because rate of interest is always
smaller then rate of dividend on equity (DeAngelo and Stulz, 2015). Thus, it can be said that cost
of capital always affected by the capital structure of the company. Modigliani and Miller’s
(M&M) in their capital structure theory state that there may be two conditions one in which tax
is imposed by the Government on the business firms and other situation where there is no tax
from the Government side (Modigliani and Miller Theories., 2019). Latter condition seems not
existed in the real world. However, there is possibility that in order to assist industry to grow
Government may take decision not to levy tax on relevant company revenue. Modigliani and
Miller’s believed that both these situations affect enterprise value in different manner (Acaravci,
2015). If there is situation where no income tax is charged then in that case they believed that
cost of capital will remain same as if cost of equity declines then firm will take debt and cost of
debt will increase by the percentage by which cost of equity reduced. In case if cost of debt
decline then in that case also same thing will be observed. Thus, it can be said that if no-tax is
imposed cost of capital remain same and enterprise value remain unaffected.
Opposite to this, in case tax is imposed by the Government then in that case cost of debt
will be low because Tax department give rebate on the interest that is paid by the firm to the
banks. Thus, cost of debt decreases but cost of equity remains high in each situation. Hence, in
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this case cost of capital can be minimized by adding more and more debt in the capital structure.
Enterprise value also increased in case tax is charged by the Government and more loan is taken
by the firm. This is because due to tax rebate less amount will be deducted from the cash inflow
amount which ultimately lead to traction in the net cash flow which means that enterprise value
will increase. Thus, it can be said that capital structure greatly affects cost of capital for the firm
and by taking more debt it can be reduced to large extent.
(b) Factors need to be considered when making choice between preference shares and debentures
as a means of raising long term fund
There are both positive and negative sides of the preference shares and debentures and it
depend on the conditions firm is facing and other factors that which source of finance firm think
is more appropriate for it. Cost of capital: Cost of capital is the one of the main factor that affect company a lot and
it become very important for the firm to ensure that it have optimum capital structure. In
case any company cost of equity is already high then it must opt for debt because if there
will be higher amount of debt then in that case cost of capital will be low. On other hand,
if there is situation where in the capital structure majority of portion is cover by debt then
in that case company go for equity (Vătavu, 2015). This is because if in the capital
structure there is high amount of debt then in that case burden of debt increased on the
company. In such situation if profitability of the firm is low then in that case burden
further increase. Thus, in such kind of scenario it is better for the firm to issue equity in
the market because by doing so burden of interest payment can be reduced. Necessity of payment: In case of debt it become necessary for the firm to pay interest
amount to the banks or bond holders or debenture holders irrespective of the company
profitability. If firm is already earning less profit then in that case further payment of debt
will affect its business performance. Such kind of thing is not observed in case of equity
as it depends on the company whether it feel appropriate to pay dividend to the
shareholders in the particular year (Faccio and Xu, 2015). Thus, in terms of payment of
cost of finance there is flexibility in case of equity and if proportion of preferred stock is
less in equity then company can go for it. Current capital structure: State of the current capital structure greatly affect choice of
equity and debt. If in the capital structure debt have 70% share then firm must go for
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equity so that interest burden can be reduced. On other hand, portion of equity in the
capital structure is 70% then in that case firm must take debt from the market so that
capital structure can be balanced and cost of equity can be minimized. Economic conditions: Economic conditions of the nation greatly affect business firm. If
the global economy and domestic economy is in recession then in that case people make
less investment. Hence, in that situation if IPO or FPO is launched by the business firms
less shares are subscribed and firm receive less amount of capital they intend to receive.
Thus, in such kind of situation it become better for the firm to issue debentures. However,
in such situation if firm interest payment capability is not strong then in that case it must
go for preferred stock.
©Major factors that influence the amount of additional debenture finance that Newham plc will
be able to raise
In case Newham PLC already have debt in the capital structure it is very important to take
into account number of factors to decide whether firm must further take debt from the market.
Further taking debt through debenture may prove risky for the firm and may create extra burden
on it Current interest payment liability: In case Newham already have very high amount of
interest payment liability then in that case it must abstain from further issue of debenture
(Pindado, Requejo and de La Torre, 2015). This is because issue of debenture will
increase interest payment liability which may prove dangerous for the company. If
interest payment liability is less then in that case firm can Newham can think about
further issue of debenture in the market. Debt burden: Current debt burden must also be taken into consideration by the
mentioned business firm. In case debt burden is already high then in that case it may not
be wise decision to further issue debenture in the market. Thus, consideration of the
existing debt burden is very important while firm is thinking about financing its business
through debt. Economic conditions: Economic condition of the nation greatly affect firm’s financial
conditions. Not only firm people economic condition also severely gets affected due to
economic condition of the nation (Allen, Carletti and Marquez, 2015). In such scenario
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people often prefer to make investment in safe financial instruments like debt so that they
can receive fixed rate on interest on debt. Thus, in case of economic turmoil if firm
financially is strong it can think about further issue of debentures in the market. Industry condition: Industry condition greatly affect firm financial condition. If in
industry there are already large number of well set players then in that case it become
hard for any firm to capture market and differentiate itself from the rivals. Thus, firm can
not earn substantial amount of profit in the business. In such kind of situation further
issue of debenture prove risky for the firm.
Question 2
a. process and the strategy of an investment
Characteristics of the FM system in order to evaluate, control and monitor the
capital expenditure of the projects are as follows-
Estimating capital requirements of an enterprise- Under the system of FM, finance
manager exercise maximum care in respect of anticipating financial requirement of the company.
For doing this effectively, they make use of the long range techniques as every business
organization needs funds not for the long run purposes for an investment in the fixed assets and
also fro the short term in order to have adequate working capital. This acts as the most important
measure in properly evaluating and determining the capital expenditure accurately so that
suitable investment decisions could be taken.
Determining capital structure of firm- It relates with the proportion and the kind of the
different securities. Financial manager should decide the proportion and the kind of the several
sources of the capital after the need of the capital funds has been assessed (Warren and Jack,
2018). Under this decisions are taken relating to mix of the debt and an equity in respect of
raising the funds from several sources. This feature helps in striking out an ideal balance between
the debt and the own funds. Finalising choice in relation to sources of the finance- capital
structure that is finalised by a management decides final choice between several sources of the
finance. The most important sources are considered as the shareholders, financial institution and
the debenture holders. The final choice depends on the careful evaluation of costs and the other
conditions that are included in these sources.
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Deciding pattern of investing the funds- The finance manager should prudently invest
funds procured in several assets in such judicious manner for the purpose of optimising return on
an investment without the jeopardising long run survival of an entity (Schnupp and Möller,
2018). He make use of the two main techniques that is capital budgeting and the opportunity cost
analysis which guides him in finalising an investment of the long run funds through clear
assessment of the different alternatives.
Procedure that the company needs to follow for reviewing their larger capital expenditure
proposals is as follows-
Identifying projects- the first and the foremost step is generating the proposal for an
investment. There can be several reasons in taking up for an investments within the business. It
can relate with an addition of the new line of product or making expansion in the existing
business. It could relates with the proposal for wither increasing production or reducing an
output cost.
Screening and an evaluation of the project- In the next step, it includes selection of all
the correct criteria in judging desirability of the project. This matches with an objective of an
enterprise that is maximising the market value (Roy, Rudra and Prasad, 2017). In this step the
tools in relation time value of the money concept is been used for the purpose of reviewing the
proposal in an effective way. Under this, estimation regarding benefits and the cost has to be
made along with the total of the cash outflows and inflows with an uncertainties and the risk
attached with proposal need to be assessed thoroughly and an appropriate provisioning is been
done.
Selection of the project- The capital expenditure proposal is been approved on the basis
of the selection criteria and the process of screening that is been defined for each firm with
keeping in mind an objectives of an investment that is being undertaken. Once a proposal is been
finalized, different alternatives in raising and procuring the funds has to be explored by finance
team (Srithongrung, Yusuf and Kriz, 2019). This known as the capital budget in which detailed
process for the periodical reports and tracing of the proposal for lifetime required to be
streamlined in an initial phase. Final approvals are taken on the basis of market conditions,
profitability, viability and an economic constituents.
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Implementation- Different responsibilities such as execution of the proposal, project
completion within the specified time frame and a reduction of the costs are been allotted.
Thereafter the management takes up a task in monitoring and containing an execution of
proposals.
Review of performance- the last and the final step is to make comparison of the actual
figures with that of standard one (Alkaraan, 2017). The results that are unfavourable is been
identified and by removing the several difficulties of a proposal enables for the future selection
and an execution of projects.
b. capital budgeting or investment appraisal techniques
Net present value- It is defined as present value of future cash flows from an investment
proposal. It is the most suitable technique in evaluating the success of an investment and is used
as the capital budgeting tool in analysing profitability of an estimated investment. Positive NPV
reflects that projected earnings that is generated by the project or a investment exceed an
anticipated cost (Kolawole, 2016). By this it has been assumed that an investment with the
positive NPV seems to be profitable whereas an investment with the negative net present value
leads to losses.
Profitability index- It is the method that divided a an anticipated capital inflows with that
of the project cash outflows in determining project's profitability. It makes use of the present
value of all the cash inflows and an initial investment for representing the project. It acts as the
financial tool that tells the firm about accepting or rejecting an investment proposal.
Project A
Years Cash flow Discounting factor
Discounted cash
inflows
1 95000 0.87 82608.7
2 110000 0.76 83175.8
3 200000 0.66 131503.2
Sum of discounted
cash flows 297287.75
less: Initial investment 350000
NPV -52712.25
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Profitability index
Present value of the
future cash
flows/Initial
investment 0.85
Project B
Years Cash flow Discounting factor
Discounted cash
inflows
1 45000 0.87 39130.43
2 45000 0.76 34026.47
3 45000 0.66 29588.23
Sum of discounted
cash flows 102745.13
less: Initial investment 105000
NPV -2254.87
Profitability index
Present value of the
future cash
flows/Initial
investment 0.98
Project C
Years Cash flow Discounting factor
Discounted cash
inflows
1 40000 0.87 34782.61
2 25000 0.76 18903.59
3 125000 0.66 82189.53
Sum of discounted 135875.73
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cash flows
less: Initial investment 35000
NPV 100875.73
Profitability index
Present value of the
future cash
flows/Initial
investment 3.9
Interpretation- From the analysis it has been presented that project C is the most suitable
proposal that needs to be selected by the company because it resulted a positive value of NPV
that equates to 100875 which clearly states that the project will be generating higher profits.
Similarly, profitability index that is greater than 1 is seen as better and an investment must be
accepted. Therefore as profitability index of Project C evaluated as higher than 1 that is 3.8
which in turn indicates that this project must be accepted by the firm in order to earn larger
profitability or to attain more and more success in the future periods. This shows that present
value of the future cash flows is higher than the initial outlay which in turn states that the firm
will be earning more and more profits. The other two projects are not considered as appropriate
because it accounted a negative value of NPV and the profitability index of both the projects is
less than 1 which represents that the company will incur losses by selecting project A and Project
B and it will not counted as best for the firm to gain the competitive edge and success within an
industry. By selecting the project C for an investment purpose, an organization could be able to
invest the surplus cash or the profits in money market at the rate of 10% because it depicts a
larger amount of the profitability generation in the future. It also helps the company in limiting
an expenditure and it not have to borrow that is counted as best for its shareholders and all the
stakeholders. This enables the firm in achieving the objective of the profit maximisation and the
wealth maximisation within the market. Thus, among the three projects an entity must opt for
making investment in project C.
CONCLUSION
On the basis of above discussion, it is concluded that there is significant importance of the
finance management for the business firm because it assists it in making effective utilization of
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cash in the business. Capital structure heavily affect business firm cost of capital. Due to high
cost of capital sometimes loss in the business get increased. Thus, business firms must prepare
appropriate capital structure so that cost of capital can be minimized. It is also concluded that
firm must choose project C because its NPV is high and positive.
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REFERENCES
Books and Journals
Acaravci, S.K., 2015. The determinants of capital structure: Evidence from the Turkish
manufacturing sector. International journal of economics and financial issues. 5(1).
pp.158-171.
Alkaraan, F., 2017. Strategic investment appraisal: multidisciplinary perspectives. Advances in
Mergers and Acquisitions. p.67.
Allen, F., Carletti, E. and Marquez, R., 2015. Deposits and bank capital structure. Journal of
Financial Economics. 118(3). pp.601-619.
DeAngelo, H. and Stulz, R.M., 2015. Liquid-claim production, risk management, and bank
capital structure: Why high leverage is optimal for banks. Journal of Financial
Economics. 116(2). pp.219-236.
Faccio, M. and Xu, J., 2015. Taxes and capital structure. Journal of Financial and Quantitative
Analysis. 50(3). pp.277-300.
Kolawole, O. A., 2016. Assessment of the Reliability of Techniques Employed in Feasibility and
Viability Appraisal. Assessment. 7(15).
Pindado, J., Requejo, I. and de La Torre, C., 2015. Does family control shape corporate capital
structure? An empirical analysis of Eurozone firms. Journal of Business Finance &
Accounting. 42(7-8). pp.965-1006.
Roy, D., Rudra, D. and Prasad, P., 2017. Capital Structure and Capital Budgeting: An Empirical
and Analytical Study of the Relationship. Research Bulletin. 42(4). pp.50-60.
Schnupp, C. and Möller, K., 2018. Capital budgeting optimization through process
design. Controlling. 30(6). pp.13-21.
Srithongrung, A., Yusuf, J. E. W. and Kriz, K. A., 2019. A systematic public capital
management and budgeting process. In Capital Management and Budgeting in the Public
Sector (pp. 1-22). IGI Global.
Vătavu, S., 2015. The impact of capital structure on financial performance in Romanian listed
companies. Procedia Economics and Finance. 32. pp.1314-1322.
Warren, L. and Jack, L., 2018. The capital budgeting process and the energy trilemma-A
strategic conduct analysis. The British Accounting Review. 50(5). pp.481-496.
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Online
Modigliani and Miller Theories., 2019. [Online]. Available through:<
https://xplaind.com/161503/modigliani-and-miller-mm-approach>
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