Financial Decision Making Solution Assignment (Doc)

FINANCIAL DECISION
MAKING

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................1
Presenting numerical analysis about impact of capital structure................................................1
Representing graph without tax..................................................................................................2
Proposition of Risk free debt.......................................................................................................6
Proposition of risky debt ............................................................................................................8
Examining problems which impact on financing decision of X firm value.............................10
CONCLUSION..............................................................................................................................11
REFERENCES..............................................................................................................................12

INTRODUCTION
Capital structure could be referred to as method which had been adopted for financing its
operations and growth with implication of various sources of finance. In simple words, it could
be justified by segregating its specific cash flow in two components such as debt and equity. The
capital structure could be termed as optimal when debt and equity proportion would be giving
output in lowest WACC (Weighted average cost of capital) of organization.
It could be justifying by mix of financial securities which is applicable for financing the
particular organization. The main objective is to increase firm's valuation along with expected
wealth of shareholders. The present report is giving brief understanding about firm X’s capital
structure as it has huge requirement of $100000 which is expecting net cash flow of $40000. In
the same series, it is also justifying problems which could impact on financing decisions on
valuation of firm.
Presenting numerical analysis about impact of capital structure
The irrelevance of capital structure proposition had been developed from Miller
Modigliani. It has various assumptions such as absence of bankruptcy and tax cost. Along with
alterations in capital structure, WACC must be constant. If there is no change or advantage with
increment of debt as it would not be influencing stock price where capital structure would be
considered as irrelevant (Arrow, 2017). Trade off theory with context of leverage has
assumptions that leverage would not be benefited in specified capital structure. It also helps in
recognising benefits of tax with reference to payments of interests. It does not make information
asymmetric as investors could lend or borrow at similar rate. In the same series, it is considered
as fixed investment policy through organization.
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Representing graph without tax
100.00%
Debt
Equity
10.00%
90.00%
Debt
Equity
2

20.00%
80.00%
Debt
Equity
30.00%
70.00%
Debt
Equity
3

40.00%
60.00%
Debt
Equity
50.00% 50.00%
Debt
Equity
4

60.00%
40.00%
Debt
Equity
70.00%
30.00%
Debt
Equity
5

80.00%
20.00%
Debt
Equity
Proposition of Risk free debt
The below information had been given to find the impacts of capital structure of firm X
with its valuation.
Investment 100000
Net cash flow 40000
Positive NPV discount rate 15.00%
Corporation tax 40.00%
Risk free debt
Debt Equity Cost of Cost of Debt Equity No tax With tax
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debt (%)
Rd
equity (%)
Re
0.00% 100.00% 5.00% 15.00% 0 100000 100000.00 100000.00
10.00% 90.00% 5.00% 16.20% 10000 90000 111111.11 106666.66
20.00% 80.00% 5.00% 17.50% 20000 80000 124999.99 114999.99
30.00% 70.00% 5.00% 19.30% 30000 70000 142857.12 125714.27
40.00% 60.00% 5.00% 21.70% 40000 60000 166666.63 139999.98
50.00% 50.00% 5.00% 25.00% 50000 50000 199999.95 159999.97
60.00% 40.00% 5.00% 30.00% 60000 40000 249999.93 189999.96
70.00% 30.00% 5.00% 38.50% 70000 30000 333333.22 239999.93
80.00% 20.00% 5.00% 55.00% 80000 20000 499999.80 339999.88
1 2 3 4 5 6 7 8 9
0
100000
200000
300000
400000
500000
600000
Cost of debt (%) Rd
No tax
Capital
If there is presence of alteration in capital structure, then it would not signify for the
overall valuation of an organization. It could be considered that total cash flow had been
produced and is in similar context as total valuation of cash flow is same. The cash flow with
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organization does not matter and its various security holders are referred to as cash flow of debt
or equity (Alti, 2018). The valuation of firm does not impact with leverage. There is increment of
risk and return with reference to stockholders.
The calculation which had been undertaken is extracted from formula Rs = R0 + (B / Sl) * (R0 –
Rb)
Rs Return on equity (levered), cost of equity
R0 Return on unlevered equity, cost of capital
B Value of debt
Sl Value of levered equity
Rb Cost of debt (interest rate)
1 2 3 4 5 6 7 8 9
0
50000
100000
150000
200000
250000
300000
350000
400000
Cost of debt (%) Rd
With tax
Capital
The introduction of corporate tax which causes financing from debt along with positive
advantages to firm's valuation. The main reason for payments of debt interest decreases; and the
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income from taxes as well tax. Along with debt, if there is availability of after tax cash flows
with context of security holders with absence of debt. In the same series, combination of
securities of debt and equity is always greater (Klasa and et. al., 2018). The return and risk of
equity does not raise in quick aspects as ratio of debt and equity is raised due to low risk tax cash
flows are rescued.
It had been calculated by considering formula Rs = R0 + (B /S) * (1-Tax rate) * (R0 – Rb).
Proposition of risky debt
Risky debt
Debt Equity
Cost of
debt (%)
Rd
Cost of
equity (%)
Re Debt Equity No tax With tax
0.00% 100.00% 5.00% 15.00% 0 100000 100000.00 100000.00
10.00% 90.00% 5.00% 16.20% 10000 90000 111111.11 106666.66
20.00% 80.00% 5.00% 17.50% 20000 80000 124999.99 114999.99
30.00% 70.00% 5.00% 19.30% 30000 70000 142857.12 125714.27
40.00% 60.00% 5.00% 21.70% 40000 60000 166666.63 139999.98
50.00% 50.00% 5.00% 25.00% 50000 50000 199999.95 159999.97
60.00% 40.00% 6.00% 30.00% 60000 40000 249999.91 189999.95
70.00% 30.00% 7.00% 39.40% 70000 30000 333333.17 239999.90
80.00% 20.00% 8.00% 57.00% 80000 20000 499999.68 339999.81
9

1 2 3 4 5 6 7 8 9
0
50000
100000
150000
200000
250000
300000
350000
400000
5.00% 5.00% 5.00% 5.00% 5.00% 5.00% 6.00% 7.00% 8.00%
Cost of debt (%) Rd
With tax
Capital
1 2 3 4 5 6 7 8 9
0
100000
200000
300000
400000
500000
600000
5.00% 5.00% 5.00% 5.00% 5.00% 5.00% 6.00% 7.00% 8.00%
Cost of debt (%) Rd
No tax
Capital
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The absence of corporate tax signifies that proportion of organizations equity and debt
does not have any major influence and on its contrary, with taxes, huge proportion of debt is
considered as very valuable due to shield of interest tax. It has been dealt with WACC. It also
signifies debt proportion of organization raises with capital structure, simultaneously return to
equity shareholders had been raised with linear fashion (Capital structure, 2018).
The huge level of debt is existed for purpose of investment in an organization that is
considered as very risky so in this context, high risk premium had been demanded to
shareholders on stock of organization. The capital structure of organization is termed as
irrelevant, alterations in debt equity ratio would not impact WACC. The savings of corporate tax
would be acknowledged by deducting interest tax which concludes alterations in ratio of debt
and equity. Huge proportion of debt decreases WACC of an organization.
Examining problems which impact on financing decision of X firm value
Agency effect on capital structure: The corporate forms with context of ownership that
replicates shareholders as owners of organization. The corporation director had been elected
through shareholders as they would be appointing management of an organization. The
ownership segregation had been controlled with context of corporate form of business entity
which creates agency problems which are existing (Cost of Debt, 2018). The management might
own the best interests of someone instead of shareholders. If there is an occurrence of investors
which might contradict goals for increasing equity's share price of the organization. Generally, it
points out cost which had arisen because of different conflicts with context of manager and
shareholder which would lead to agency problem and related to debt with shape of shifting risk.
Signalling effect on capital structure: The capital structure of organization consists of
various sources of money which had been received by investors. It also comprises of preferred
stock, common stock, bonds and various other items. The financial statement of organization had
been received by investors after release by its organization, but at times, managers are always
aware of the financial position of a company (Signalling effect, 2018). The financing decision
gives signalling impact on investors for recommending that securities of an organization deal in
good aspect or not.
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Examples of signalling effect could be:
 Credibility
 Stock split
 Bond sales
 Stock sales
CONCLUSION
From the above report, it had been concluded that its optimal capital structure is referred
as 40: 60 proportion of risk free and risky debt. It had been articulated from the above report that
without tax, it is more preferred as compared to 40% corporate tax. As per the investment of
100000, it provides proper net cash flow with its expectation. It had also stated that capital
structure should be maintained as huge debt is not preferable because it would be bearing huge
interest which is always fluctuating in risky debt. Usually, risky debt is preferable because of
huge returns but in above scenario, both are similar as interest rate is same as ideal proportion of
debt.
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REFERENCES
Books and Journals
Alti, A., 2018. Capital-Structure Changes Around IPOs: A Comment. Critical Finance
Review. 7(1). pp.81-84.
Arrow, K. J., 2017. Optimal capital policy with irreversible investment. In Value, capital and
growth (pp. 1-20). Routledge.
Klasa, S. and et. al., 2018. Protection of trade secrets and capital structure decisions. Journal of
Financial Economics. 128(2). pp.266-286.
Online
Capital structure. 2018. [Online] Available
through:<https://corporatefinanceinstitute.com/resources/knowledge/finance/capital-
structure-overview/>
Cost of Debt. 2018. [Online] Available
through:<https://corporatefinanceinstitute.com/resources/knowledge/finance/cost-of-
debt/>
Signalling effect. 2018. [Online] Available
through:<https://www.sapling.com/7743194/signaling-effects-capital-structure>
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