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Capital Structure
Blaine Kitchenware
Mid-sized producer of small Kitchen appliances. Family promoted, Victor Dubinski CEO. Captures 10% of $2.3bn US market. Competitive advantage such as smart technology Brand recognition 2 times borrowed beyond seasonal working capital need
Major Segments
Major Revenue
Food preparation
Cooking appliances
400000 300000
200000
100000 0 Blaine Kitchenware Easy Living System Home & Hearth Design -100000 -200000 -300000 Cash & Securities Net Debt
Main Problem
Lacks of organic growth ROE 11% , below industry average Downward trend in its operating margin Decreasing net margin Dividend payout ratio over 50%
Main Issues
BKI is over liquid and under-levered PE firms purchase all outstanding shares Takeover of BKI Whether to buy-back shares or to pay dividends???
Dilemma
Buy Back
Companies return cash to stockholders in the form of dividends Stock buyback has emerged as an alternative
Capital Structure
380 Ritwa Lokhandwala
Capital Structure
Capital Structure of a firm refers to the combination mix of debt and equity i.e., sources of funds, which a company uses to finance its overall operations and growth A firm's capital structure is then the structure of its liabilities Usually a company more heavily financed by debt poses greater risk, as this firm is relatively highly levered. It is monitored by debt to equity ratio
Example
A corporation that sells $30 billion in equity and $70 billion in debt is said to be 30% equity-financed and 70% debt-financed. Thus, firm's ratio of debt to total financing, 70% is referred to as the firm's leverage.
Capital Structure
Capital Structure
Debt- Capital
Equity-Capital
Long-term debt
Common Equity
Capital Structure
Equity Capital: This refers to money put up and owned by the shareholders. Equity:
Contributed
capital, which is the money that was originally invested in the business in exchange for shares of stock or ownership Retained earnings, which represents profits from past years that have been kept by the company and used to strengthen the balance sheet or fund growth, acquisitions, or expansion.
Capital Structure
Debt Capital in a company's capital structure refers to borrowed money that is at work in the business. The safest type is generally considered longterm bonds because the company has years, if not decades, to come up with the principal, while paying interest only in the meantime. Other types of debt capital can include shortterm commercial The cost of debt capital in the capital structure depends on the health of the company's
Capital Structure
Firstly, the good capital structure will result in a low overall cost of capital for the company Secondly, the only variation in capital structure we will consider is in the overall amount of borrowings which firms use.
To examine the relationship between capital structure and cost of capital the following assumptions are commonly made:
There is no consideration of income tax, corporate or personal. However we consider the implications of tax in some cases. We assume firms policy of paying all of its earning as dividends i.e., 100% dividend ratio is assumed. Investors have identical subjective probability distributions of operating income for each company. It is assumed operating income remains same over period of time. It is assumed that there is no transaction cost incurred if the firm changes its capital structure instantaneously.
Assuming, debt is perpetual: Cost of Debt = Annual interest charges/Market value of debt rD = I /D Assuming, 100% dividend payout ratio and earnings constant: Cost of Equity = Equity earnings/Market value of equity rE = P/E Thus, Capitalization rate of the firm = Operating income/Market value of equity rA = O/V = O/ (D+E) Capitalization rate of the firm = Weighted average cost of capital rA = rD(D/D+E)+ rE(E/D+E) what happens to these rates if D/E changes
This approach, the cost of debt, Rd and the cost of equity, Re, remain unchanged when D/E varies The constancy of Rd and Re with respect to D/E means that Ra, the average cost of capital, measured as Ra=Rd [D/D+E] + Re[ E/D+E]
From the graph it is clear that as D/E increases, Ra decreases because the proportion of debt, the cheaper source of finance, increases in the capital structure.
According to the net operating income approach, the overall capitalization rate and the cost of debt remain constant for all degrees of leverage Ra and Rd are constant for all degree of leverage. Given this the cost of equity can be expressed as: Re=Ra+(Ra-Rb)(D/E)
The critical premises of this approach is that the market capitalizes the firm as a whole at a discount rate which is independent of the firms debt-equity ratio As consequences the division between debt and equity is irrelevant. An increase in the use of debt funds, which are apparently cheaper, is offset by an increase in equity capitalization rate
Traditional proportion
Rd remains constant up to a certain leverage then rises increasingly Re rises gradually up to a certain degree at a constant rate Ra decreases up to a certain point then remains un affected and finally rises beyond the point
Traditional proportion
Implication: Cost of capital depends upon capital structure Optimal capital structure minimizes cost of capital
Before
optimal point: Real marginal cost of debt < real marginal cost of Equity After optimal point: Real marginal cost of debt > real marginal cost of Equity
MM Proposition I
The value of firm is equal to its expected operating income divided by the discount rate appropriate to its risk class. It is independent of its capital structure. V=D+E=O/R V= market value of firm E= market value of equity D= market value of equity O= expected operating income R= discount rate applicable to the risk class to which the firms belongs MM invoked an arbitrage argument to prove this proposition.
MM Proposition II
The cost of equity capital for a levered firm = Re=Ra+(Ra-Rd)(D/E) Expected return on equity= Expected return on assets +[expected return on assets expected return on debt] debt-equity ratio
MM Proposition II graph
FEATURES
Combination at that level of debt equity proportion where the market value per share is maximum and the cost of capital is minimum.
FEATURES
Capital structure should have the following features
Profitability
Risk
Flexibility
Cost Of Capital
WACC = [Rd*(D/V)*(1-Tc)] + [Re*(E/V)] Re = cost of equity Rd = cost of debt E = market value of the firm's equity D = market value of the firm's debt V=E+D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate
Re = Ri + B(EMRP) Ri = Risk Free rate of return = 5.02%(For 10 year Treasury Bond) B = market Risk = .56 EMRP = Equity market risk premium = (6.725.02) = 1.7%
Rd= 0 Re = 5.972 Debt = (230,866) Debt/ Value = -.31 Therefore Equity/Value = 1- (D/V) = 1.31 Therefore WACC = Re*(E/V)] = 5.972 * (1.31) = 7.82
To Reduce Risk
When we make capital structure before actual getting money from money supplier, we can do many adjustments for reducing our overall risk.
For a new business, there will be lower rate of return than the profits. But if the ROI is high in the initial years itself, then the future financing can be done using debt options.
If government of India cuts off his relation with China, from where Company X is getting its fund, it will definitely tough for us to get more money from China. But proper planning of capital structure of future sources will be helpful for us to enlarge our area for getting money. In finance, it is called manoeuvrability. It means to create mobility of sources of fund by including maximum alternatives in planned capital structure.
Suppose, if RBI increases the interest rate, it means your cost for getting debt will be high, at that time, you can choose any other cheap source of fund.
Good planning of capital structure will make versatile to finance manager for getting money from new sources.
two borrowings
Debt free
Cash and securities : $ 230,866,000 Total Debt :$0 Net Debt : $ (230,866,000)
Strong liquidity
Dividends Acquisitions
Average Capital Expenditure = $10 million After-tax operating cash flow more than 4 times
Market Capitalization
Current Stock Price = $16.25 = 59,052,000
Special Dividends
In case the company plans to give out outstanding shares, the amount of the dividends paid per share would be: In case
Excessive
earnings Restructuring
Debt Ratio
Threats
1. Take over threat
Risks
2. Re-investment risks
Dividends ?...
3. Inappropriate policy
Get rid of surplus cash. Decrease the cash carrying cost. Reduce the risk of unattractive re-investments. Increase buying cost of hostile take-overs.
thus by discharging cash BKI can decrease its asset and equity on book and there-by increase its ROE.
Difference Between Proposed sketched of Case Study and Special Dividends Of 4.898/share.
Share repurchase will decrease the number of share outstanding and increase the family ownership.
From investors perspective, instead of being passively given dividend which subject to income tax, they have more flexibility to choose when they want to sell their shares at premium price.
Cont..
In addition, share repurchase might send a signal to the market that the share is undervalued thus boosting the share price
Conclusion
ROE and Earnings/Share both are highest in case of Buyback. Therefore company should go for buyback.
Thank You
Have a nice day