Question

Dear All,

Could you please answer the below question and kindly if there are any further links regarding the similar assignment, kindly send it and this assignment is 2500 word long, I will kindly appreciate a long answer.

"Conduct a comprehensive evaluation of a recently reported corporate event relating to the change in the capital structure of companies Conduct a comprehensive evaluation of a recently reported corporate event relating to the change in the capital structure of companies"

Thank you!

Answer 1

Capital structure refers to the amount of debt and/or equity employed by a firm to fund its operations and finance its assets. A firm’s capital structure is typically expressed as a debt-to-equity or debt-to-capital ratio.

Debt and equity capital are used to fund a business’s operations, capital expenditures, acquisitions, and other investments. There are tradeoffs firms have to make when they decide whether to use debt or equity to finance operations, and managers will balance the two to find the optimal capital structure.

Capital structure by industry

Capital structures can vary significantly by industry. Cyclical industries like mining are often not suitable for debt, as their cash flow profiles can be unpredictable and there is too much uncertainty about their ability to repay the debt.

Other industries, like banking and insurance, use huge amounts of leverage and their business models require large amounts of debt.Private companies may have a harder time using debt over equity, particularly small businesses which are required to have personal guarantees from their owners.

Equity

The equity portion of the debt-equity relationship is easiest to define. In a capital structure, equity consists of a company's common and preferred stock plus retained earnings. This is considered invested capital and it appears in the shareholders' equity section of the balance sheet. Invested capital plus debt comprises capital structure.

Debt

A discussion of debt is less straightforward. Investment literature often equates a company's debt with its liabilities. However, there is an important distinction between operational liabilities and debt liabilities, and it's the latter that forms the debt component of capital structure—but that's not the end of the debt story.

Investment research analysts do not agree about what constitutes a debt liability. Many analysts define the debt component of capital structure as a balance sheet's long-term debt. However, this definition is too simplistic. Rather, the debt portion of a capital structure should consist of: short-term borrowings (notes payable); the current portion of long-term debt; long-term debt; and two-thirds (rule of thumb) of the principal amount of operating leases and redeemable preferred stock. When analyzing a company's balance sheet, seasoned investors would be wise to use this comprehensive total debt figure.

Ratios Applied to Capital Structure

In general, analysts use three ratios to assess the strength of a company's capitalization structure. The first two are popular metrics: the debt ratio (total debt to total assets) and the debt-to-equity (D/E) ratio (total debt to total shareholders' equity). However, it is a third quota, the capitalization ratio—long-term debt divided by (long-term debt plus shareholders' equity)—that delivers key insights into a company's capital position.

With the debt ratio, more liabilities mean less equity and therefore indicate a more leveraged position. The problem with this measurement is that it is too broad in scope and gives equal weight to operational liabilities and debt liabilities. The same criticism applies to the debt-to-equity ratio. Current and non-current operational liabilities, especially the latter, represent obligations that will be with the company forever. Also, unlike debt, there are no fixed payments of principal or interest attached to operational liabilities.

On the other hand, the capitalization ratio compares the debt component to the equity component of a company's capital structure; so, it presents a truer picture. Expressed as a percentage, a low number indicates a healthy equity cushion, which is always more desirable than a high percentage of the debt.

Optimal Relationship Between Debt and Equity?

Unfortunately, there is no magic ratio of debt to equity to use as guidance. What defines a healthy blend of debt and equity varies according to the industries involved, line of business, and a firm's stage of development. However, because investors are better off putting their money into companies with strong balance sheets, it makes sense that the optimal balance generally should reflect lower levels of debt and higher levels of equity.

In finance, debt is a perfect example of the proverbial two-edged sword. Astute use of leverage (debt) is good. It increases the amount of financial resources available to a company for growth and expansion. With leverage, the assumption is that management can earn more on borrowed funds than what it would pay in interest expense and fees on these funds. However, to carry a large amount of debt successfully, a company must maintain a solid record of complying with its various borrowing commitments.

The Problem With Too Much Leverage

A company that is too highly leveraged—too much debt relative to equity—might find that eventually, its creditors restrict its freedom of action; or it could experience diminished profitability as a result of paying steep interest costs. In addition, a firm could have trouble meeting its operating and debt liabilities during periods of adverse economic conditions. Or, if the business sector is extremely competitive, then competing companies could (and do) take advantage of debt-laden firms by swooping in to grab more market share. Of course, a worst-case scenario might be if a firm needed to declare bankruptcy.

Enter the Credit-Rating Agencies

Fortunately, though, there are excellent resources that can help us determine if a company might be too highly leveraged—the credit-rating agencies Moody's, Standard & Poor's (S&P), Duff & Phelps, and Fitch. These entities conduct formal risk evaluations of a company's ability to repay principal and interest on debt obligations, primarily on bonds and commercial paper.

A company's credit ratings from these agencies should appear in the footnotes to its financial statements. So, as an investor, you should be happy to see high-quality rankings on the debt of companies that you're considering as investment opportunities—likewise, you should be wary if you see poor ratings on companies that you are considering.

Methods of recapitalization include:

1. Issue debt and repurchase equity
2. Issue debt and pay a large dividend to equity investors
3. Issue equity and repay debt

Each of these three methods can be an effective way of recapitalizing the business.

In the first approach, the firm borrows money by issuing debt and then uses all of the capital to repurchase shares from its equity investors. This has the effect of increasing the amount of debt and decreasing the amount of equity on the balance sheet.

In the second approach, the firm will borrow money (i.e., issue debt) and use that money to pay a one-time special dividend, which has the effect of reducing the value of equity by the value of the divided. This is another method of increasing debt and reducing equity.

In the third approach, the firm moves in the opposite direction and issues equity by selling new shares, then takes the money and uses it to repay debt. Since equity is costlier than debt, this approach is not desirable and often only done when a firm is overleveraged and desperately needs to reduce its debt.

Tradeoffs between debt and equity

There are many tradeoffs that owners and managers of firms have to consider when determining their capital structure. Below are some of the tradeoffs that should be considered.

Pros and cons of equity:

• No interest payments
• No mandatory fixed payments (dividends are discretionary)
• No maturity dates (no capital repayment)
• Has ownership and control over the business
• Has voting rights (typically)
• Has a high implied cost of capital
• Expects a high rate of return (dividends and capital appreciation)
• Has last claim on the firm’s assets in the event of liquidation
• Provides maximum operational flexibility

Pros and cons of debt:

• Has interest payments (typically)
• Has a fixed repayment schedule
• Has first claim on the firm’s assets in the event of liquidation
• Requires covenants and financial performance metrics that must be met
• Contains restrictions on operational flexibility
• Has a lower cost than equity
• Expects a lower rate of return than equity