TO:Mr.Hillbrandt, CEO ABC Golf Equipment Corporation
SUBJECT: and Decision Making
Thismemo aims at addressing the impact of capital restructuring to thefirm. The immediate impact of capital structure is on the value ofthe firm. Even though most firms have become successful in usingcapital restructuring as a turnaround strategy, the decision may alsoincrease the risk to the company. A thorough analysis of the impactsof capital, reconstruction, is, therefore, much essential beforemaking such decisions.
Theproposed acquisition of 25% debt by ABC Golf Equipment Corporationaffects stock prices and also the earning per share after therecapitalization and therefore, influence the value of the firm. Thenew capital structure will highlight the times interest earned ratioat different probability levels. The value, V of the company, isdependent on debt, D and equity, E (V = D + E), hence, theintroduction of debt in the capital structure will change the valueof ABC Golf Equipment Corporation. Firm’s value is the measure ofthe market worth of a business, and it is one of the fundamentaltools used in evaluating the entity, portfolio analysis, financialmodeling, accounting and risk analysis.
Thecost of capital is influenced by the after-tax cost one of thechanges is that the cost of equity increases from 11% to 13%. Thereis also an increased risk since the firm will now be required torepay the loan plus the interest expenses from its income regardlessof the state of cash flow or earnings. In this case, it is clear thatthis will affect the cost of capital, and the increased risk willlower the EPS. The EPS will be $4.3325 after the recapitalization.
Theinclusion of debt in the firm’s capital structure will decrease thestock price from $27 to $6.232. Recapitalizing the business with 75%equity and 25% debt increases the WACC from 10% to 11.21% and alsoreducing the new stock prices.
Theprobability distribution has been used to estimate the expectedearnings. The probability distribution was designed to account forall the risks and uncertainties involved in the operation of the firmafter the restructuring. The expected EBIT is arrived at bymultiplying EBITs by their probability. The table below shows asummary of the expected earnings at various levels of uncertainties.
Theleverage also has an impact on the times interest ratio due to therisk adjustments. As mentioned earlier, issuance of the bond willincrease the risk in the capital structures. Bonds are associatedwith interest expense charged for compensation of the risk perceivedby the holder. Higher interest expense reduces the times interestearned. The ratio is calculated by dividing the EBIT by the interestexpense incurred. For this case, we have the EBIT of $3.88 millionand an interest expense of 9% of the face value of the bond issued.Times interest expense can therefore, be calculated from the formulabelow
Times Interest Earned =
Earnings Before Interest and Tax (EBIT)
Inconclusion, from the above analysis of changing the capitalstructure, it is evident that the decision will lower the value ofthe firm. The leverage will reduce the value of the company from$22,927,273 to $22,492,754 which marks a margin of $434,519. There isalso an increase in the firm’s capital risk and hence causing theWACC of the corporation to increase. Even though debt is consideredas the cheapest source of capital to finance businesses, therepurchase of shares which intends to reduce the outstanding shareshas to impose an adverse impact on the firm, and therefore, it isrecommended for the top management to reconsider the proposed capitalreconstruction.
Capitalrestructuring refers to the process of modifying the financingsources of a company. The change in the capital structure has animpact on the financial status of the business. The concept ofcapital structure is much essential in decision making. This isbecause the alterations of the firm’s capital structure may haveeither a positive or adverse impact on the general performance of thebusiness. It is also important to analyse the factors that arecritical determinants while making capital restructuring decisions(Marsonet al., 2015). Thisreport provides a highlight of the various factors that are vital inmaking capital changes decision.
Factorsto consider while selecting or changing the capital structure of thefirm
Tradingon Equity– Equity denotes ownership of the company. The trading on equitytherefore refers to the process of taking the advantage of equityshare capital over the debt for reasonable basis. For instance, ABCGolf Equipment Corporation may prefer staying with no debt capitalstructure to avoid the risk associated and also maintain a low costof capital. Trading on equity is much essential especially when theexpectations of the shareholders are high (Marsonet al., 2015).
TheDegree of Control-Another factor that needs to be addressed while selecting or changingthe capital structure of a firm is the authority of the electedrepresentative of equity shareholders (Investopedia, 2015). Forexample, if Mr. Hillbrandt has little powers to restructure thefinancing system of the company, it therefore imposes a challenge onmaking his decision concerning the re-organization. The shareholdershave full control of any organization through their voting rights.There is therefore need to fully involve the shareholders in thedecision-making process to minimize their resistance to change.
TheFlexibility of Financial Plan-All organization operates in a dynamic environment, and it isimportant to execute a capital structure that can accommodate suchchanges whenever a need arises. Debt capital is considered flexibleenough since it can be refunded back as the time requires. Debtcapital can also be raised easily whenever the need arises. On theother hand, equity capital tends to be more rigid since any attemptto refund back through the repurchase of shares by the company willmake the remaining shareholders perceive higher risk (Investopedia,2015). Therefore, if the organization requires flexible capitalstructure, it should go for bonds, debentures, and other loans.
CapitalMarket Condition– The market price of shares may influence the capital structure ofa firm (Investopedia, 2015). At the period of inflation and boons,the recommended optimal capital structure should consist much ofequity shares. If the market condition is during the depressionperiod, then debt capital is more preferable.
FinancingCost– Profit maximization is one the primary goals of the business(Arnold, 2012). The traditional explanation of profit maximization isincreasing revenue while maintaining low costs. Factor cost ofraising security is one of the major factors to be considered whileselecting or changing the capital structure of the firm.
Fromthe above-described factors, we have seen that it is much essentialto analyse the capital structure of the firm before making anysignificant decision. The success of the business depends on thecapital structure used in financing the operations. Examining thebusiness environment is also important as it will help the decisionmakers in developing an optimal capital structure.
ArnoldC. (2012). AnIntroduction to Bayesian Inference in Econometrics,New York: Wiley.
Investopedia.(2015). Factors That Influence the Capital Structure Decision.Retrieved May 05,2016,fromhttp://www.investopedia.com/exam-guide/cfa-level-1/corporate finance/capital-structure-decision-factors.asp#ixzz47mj48NvPMarson, J., & Ferris, K. (2015). Fundamental of Business.Oxford, United Kingdom: Oxford University Press.