Capital Structure Essay

Capital construction is how a companionship pays its overall operations and growth by using interchange in hand from equity or debt (Investopedia, 2012). Of course, every beau monde must port its taste on its debt-to-equity ratio and desexualize which pileus structure works shell for them. Some go aboutes to analyzing great structure atomic number 181.EBIT EPS This analyzes the impact of debt on soften per sh be (EPS). Optimizing shareholders wealth is the optimum goal and therefore, this approach analyzes the high EPS base on an conceptualiseed range of mesh sooner income taxes (EBIT). 2.Valuation Determines impact of debt use on shareholders value by determining the level of debt at which the public assistances of add-ond debt no longer outbalance the outgrowthd risks and expenses associated with financing (Wenk, 2012) 3.Cash F crushed Analyzes a firms debt message by using the weighted average of cost of detonator (WACC).The WACC is a calculation of a f irms cost of capital in which each capital source (bonds, computer storage and a nonher(prenominal) long-term debt) are proportionally weighted to determine how much refer the confederation has to pay for every dollar it finances (Investopedia, 2012).Look to a greater extentcapital budgeting examples set aboutPart of Competition Bikes (CB) main charteration in the finding to conflate or acquire Canadian Biking is worksss capital. permits use the EBIT EPS approach to determine how to maximise shareholder return while minimizing the cost of capital. We currently bonk Canadian Bikings correspond sales forecast of EBIT figures for the future(a) 5 age (Year 9 13), therefore we place apply the EBIT EPS approach to make an optimum capital structure.The wide-cut of capital sources in each of the 5 years is $600,000. We depart use EBIT EPS to determine which assortment of bonds*, preferable stock, and gross stock is the best option to increase Canadian Bikings EPS. The quintuple alternative capital structures include excerption 1 100% Bonds (fully financed) excerption 2 50% Preferred furrow & 50% Common Stock (no bonds) survival of the fittest 3 20% Bonds & 80% Common Stock woof 4 40% Bonds & 60% Common StockOption 5 60% Bonds & 40% Common Stock*Annual bond involution rate is 9% afterwards using the EBIT EPS approach using the forecasted EBIT amounts for age 9 through 13, we can average the EPS for each of the 5 years to determine which capital structure produced the highest EPS. The EPS averages computed for the capital structure options are Option 1 total EPS = .0452Option 2 Average EPS = .0542Option 3 Average EPS = .0526Option 4 Average EPS = .051Option 5 Average EPS = .0494Based on the EBIT EPS approach, the recomm closedowned capital structure is option 2, 50% preferred stock & 50% joint stock. This is the best capital structure mainly because there are two things to consider 1) long-term debt and associated disport expense and , 2) equity and of common shares. Option 2 is the best capital structure because there are no bonds and therefore, no participation expense. For example, if we visit at option 1 in Year 9, and the bond interest is 9%, then the bond interest expense is $54,000 (.09*600,00). This spurns the income before taxes by $54,000. Although companies can finance debt and use the interest expense deduction to disgrace their taxable income, it doesnt make sense for Canadian Bikes to fully finance their capital, because the interest expense costs outweigh the benefit of the tax deduction, resulting in a significant decrease in total income available for common stock.Additionally, because the capital structure consists of 300,000 shares of preferred stock, the corporation must pay dividends of 5%, reducing the beau mondes total income available for common stock by $15,000 (.05 * 300,000). Although this reduces the total income available for common stock, the caller-up forget maximize its E PS by only having 50% capital in common stock. This reduces the total number of common shares outstanding, which means less shares to divide the total income among. Therefore, Option 2 is the most optimal capital structure that considers minimizing long-termdebt expenses and the optimal number of common shares in order to maximize shareholder return. capital letter BUDGETINGCompetition Bikes is considering building a manufacturing mental quickness in a refreshful Canadian location. The total investment for this project would be $600,000 USD. This consists of $400,000 to build the facility and an additional $200,000 in working capital to support operational costs. The beau monde has projected interchange flows over the next five years therefore we can use bills flow budgeting methods such as mesh topology income present value (NPV) and Internal Rate of Return (IRR) that consider judgment of conviction value of money for long-term investments (Pearson Education, Inc., 2008).N et present value analyzes the realizeableness of a project by determining the difference between the present value of the projects capital inflows and outflows followed by work outing the initial investment. (Investopedia, 2012). The decision rule applied to NPV is fairly simple, if the NPV is positive, invest if the difference is negative, do not invest. Competition Bikes applies NPV to forecasted low and insure sales for the next 5 years.After using the forecasted sales for low demand, the total present value (after subtracting cash outflows from inflows) is $560,719. If we subtract the initial investment of $600,000 from this amount, the NPV is -$39,281. This is a significant warning that the fraternity should not pass off in building a manufacturing facility. On the other hand, if we use the forecasted sales for moderate demand, the total present value is $608,447. If we subtract the initial investment of $600,000, the NPV is $8,447. Therefore a positive NPV indicates the ships company should proceed with building the manufacturing facility.The biggest link up is determining which NPV to lean towards based on low or moderate sales. Unfortunately, the risk of having low sales outweighs the profitability benefit of having moderate sales. It is too risky for CB to move forward with the investment based on the NPV of low sales (-$39,281). In order for the company to profit from this investment, CB would take on to have a moderate sales demand at minimumThe present value in NPV is calculated using an interest rate, also known as the require rate of return. CBs required rate of return is 10%. When this interest rate is altered or calculated to make the total present value equal to the initial investment, the NPV becomes equal to zero this is called the internal rate of return (IRR) (Pearson Education, Inc., 2008). The IRR is what a company can expect to earn from investing in the project and the high the IRR, the more desirable the investment. The ca lculated IRR for low demand cash flows is 8.2% and the IRR for moderate demand cash flows is 10.4%.Based on these IRR figures, the company should not take the capital investment because the average IRR between both low and moderate sales is 9.3%. This is below the companys required return on capital (hurdle rate) of 10% to pursue a capital investment. Again, the company would need to have a moderate sales demand, at minimum for this capital investment to be profitable and should therefore not pursue building a sassy manufacturing facility.WORKING CAPITALCB must efficaciously discover and manage working capital for the expansion of the operation. CB must first look at their operating cycle, cash conversion cycle and free cash flow factors in order to emend production and counsel of working capital. Lets discuss the companys current side of each of the working capital and cash flow factors and determine how the company can improve in these areas.First, the operating cycle invol ves CB sending the electrical distributor a monthly invoice for all raw materials enjoin with harm of meshing/30 days. This can be improved by renegotiating the fee wrong pull up stakes distributors to profit/15 days. This would increase cash flows by improving retribution turn around condemnation and accounts receivable collections. Additionally, the company can improve its relations with its distributers to increase effectiveness of its collection process. some other operating cycle factor is ordering and paying for lineage. shortly, the company pays for inventory in the month following production and all inventory ordered for the month is used leaving inventory levels (at the end of each month) at consistent levels. In orderto improve working capital the company should employ and lower its year ending inventory balance.For example, at the end of Year 8, the company had $91,573 worth of inventory left over. The company should utilize the current inventory on hand befor e ordering connatural raw material items. This will decease cash flows and leave fewer inventories on hand at the end of the year. Currently the average succession in inventory is 25 days. This is a substantial turnaround time currently, however in the future, the company can consider replacing confinement workers with improve asset items to improve production time. This will satisfy node demand by decreasing delivery time and improve cash flows by invoicing customers more frequently than 25 days after production.CBs cash conversion cycle factors also impact working capital. Currently, the CBs suppliers invoice at the end of the month for orders that month with terms of net/15. CB does an excellent job of preserving its cash flows by paying the invoices on the fifteenth of the month following the order.. CB can improve its working capital by negotiating for longer payment terms, i.e. net/30 days, allowing for more time for the company to earn money to pay their invoices. If thi s is not possible, the company can improve its forecasting measurements for ordering supplies and order the majority of the supplies needed for the month at the beginning of the month.This would increase the amount of time the company has sufficient supplies on hand without having to pay more money, (because the suppliers will still invoice for the orders at the end of the month, regardless of how early in the month the supplies were ordered). This can increase working capital because it acts as a contingency plan, to reduce the likeliness of running out of supplies, avoiding delays, or ordering supplies in excess.Free cash flow factors also affect CBs working capital. Currently, the company recognizes disparagement in both manufacturing overhead and as depreciation expenses depending on the fixed asset. The company can use their depreciation data to increase management of cash flows by predicting when the company will have to spend a significant amount of money to replace an asset when its useful liveliness expires. This will prepare CB for those unwanted although necessary fixed asset costs.Currently thecorporations marginal tax rate is 25%. The company can consider obtaining working capital by financing debt. This will leave the company with an interest expense at the end of the year, which is deductible from gross pelf and results in paying lower taxes. After CB improves its working capital, lets discuss how CB can use its working capital for the lease vs. buy option for a factory building in Canada.CB can use its working capital to cover the $50,000 down payment (or buy out option if they decide to lease) and $200,000 for operational costs of the new factory. According to the data provided for the lease vs. buy option, the lease option will preserve cash outflows of $12,339, (purchase cash outflows are $333,999 and lease cash outflows are $321,660). Therefore, the company should lease the manufacturing facility to preserve cash outflows. Leasing the facility will also allow CB to deduct annual interest payments (6% interest) from the gross earnings to lower their tax payments. This will increase the companys net earnings at the end of the year, also resulting in higher retained earnings and increased shareholder value.MERGER OR ACQUISITIONCB should consider many factors when deciding to merge or acquire Canadian Biking. Lets analyze the pros and cons between a merge vs. acquisition and determine what the best move would be for CB. First off, if the company were to merge with Canadian Biking, the potential EPS would increase by nearly .021. This shows potential for increased self-control earnings, but is it significant enough? At the same token, the price/earnings ratio for Canadian Bikes at the end of Year 8 was 9 and CBs was 70. This shows that CBs current investors are expecting greater earnings in Year 9 and are willing to pay $70 for $1 of current earnings. This is not the case with Canadian Bikings investors.Unfortunate ly a low P/E ratio of 9 indicates that investors are not expecting a significant growth in company earnings. This raises a concern if the merge will result in a potential increase of .021 in EPS. On the other hand, a merge would result in lower costs because CB would not be purchasing Canadian Biking outright. Canadian Biking also has a lower cost competition cycle per second that can decrease production costs and complement CBs current bike model being offered. This will result ingreater net earnings and cash flows.If the company were to acquire Canadian Bikes, CB can expect a gradual increase in cash inflows over the next 5 years. However, the current offered sales price for Canadian Biking is $286,000 this is 30% more than what the company was valued at, at the end of Year 8. Although CB has enough working capital to make the purchase, it would take 5 years of gradually change magnitude cash inflows to recoup the price tag of $286,000. This means it could take approximately 5 y ears, before shareholders saw a significant increase in earnings per share.Based on the pro and cons, CB should merge with Canadian Bikes to lower their production and delivery costs, increase net income, EPS and cash flows, and preserve working capital. The price to acquire Canadian Biking is simply unreasonable based on predicted cash inflows over the next 5 years. The merger will evoke CBs market position in Canada by having a local distributer to handle all customer orders and provide cost effective and great customer service to the growing Canadian market.ReferencesInvestopedia. (2012). Capital Structure. Retrieved from http//www.kotzinvaluation.com/articles/capital-structure.htm Investopedia. (2012). weight Average Cost of Capital. Retrieved from http//www.investopedia.com/terms/w/wacc.aspaxzz2Azkq4E2V Investopedia. (2012). Net Present Value. Retrieved from http//www.investopedia.com/terms/n/npv.aspaxzz2Azkq4E2 Pearson Education, Inc.. (2008). Horngren Accounting. Retrieved from http//wpscms.pearsoncmg.com/wps/media/objects/6716/6877765/hha08_flash_main.html?chapter=null&page=1042&anchory=null&pstart=null&pend=null Wenk, D. (2012). utilize an optimal capital structure in business valuation. Retrieved from http//www.kotzinvaluation.com/articles/capital-structure.htm