Recommendation

The overall effect of this new capital structure will land the company with increased cost of capital and decreased market prices of shares because the investors, if not compensated for the increased risk, will lose interest in such stocks. This will lead to a lower demand and consequently lower prices. However, they will earn higher dividends per share after lesser outstanding stocks. The nutshell effect of the proposed capital structure will not help in creating sustained value for the stock holders.

The insights from Modigliani and Miller theories do, favor the execution of the proposed capital structure since they suggest no effect of gearing on the prices of stock calculated through dividend growth model and the inclusion of maximum debt in the capital structure since it is not subjected to tax. Nonetheless, the Traditional theory of capital structure is considered more relevant and applicable since it outlines the existence of an optimal capital structure where the decreased cost of capital yields higher value of a firm as the future cash flows are not discounted heavily as expected by the business.

Reference

  • Matthew R. Morris. (2001).Creating Shareholder Value through Capital Structure Optimization.

 

http://www.valueinc.com/press/files/optimalcapitalstructure.pdf

 

 

Pre-Capital restructuring era
D/V 0%
E/V 100%
Tax rate 0%
   
Ke 8%
Kd 0%
WACC 8%
   
Shares outstanding 62.5
Shares repurchase 20.0
Repurchase price $500
Price/share $25
   
Rm – Rf 5%
β-unlevered 0.8
Rf 4%

Appendices

 

  • Appendix-1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  • Appendix-2

 

Post-Capital restructuring era
Debt issue $500
Share outstanding 42.50
Amount of outstanding shares $1,062.50
D/V 32%
E/V 68%
Tax rate 20%
   
Kd 4%
   
β -levered 1.10
Rm – Rf 9%
Rf 4%
Ke 13.91%
   
WACC 10.48%

 

 

 

The keen talent is eager to play his part in making the business more profitable, and simultaneously increasing the value of the company to provide investors with the incentive of capital gains through elevated stock prices. The probability for him to achieve this was found in restructuring the capital structure by allowing the relatively less expensive mode of financing that is debt financing.

The business, having no debts issue till date, is considered in need to have an optimal capital structure with reasonable portion from all the available mixes i.e., debt and equity. Such structure provides for the management to have higher value of the firm obtained primarily through the least weighted average cost of capital (WACC). The lesser the WACC, the higher is the sum reading of all the discounted free cash flows that account for the increased anticipated value of stock prices.

With all these objectives in mind, the business is to analyze if the proposed restructuring is worthwhile. The company has a cost of capital equivalent to cost of equity in the present scenario. The management looks forward to a less expensive financing mode that debt financing in which case the rate is just half the rate of the former option. Additionally, it has shown less responsiveness to the market, thus, it has a beta of 0.8. The new managing director intends to exercise a capital structure that would have around F$500M of new debt issues making up 32% of the debt proportion and 68% of equity part amounting to over F$1050. The inclusion of debt in the business will uplift the business risk and the investors will be more likely to demand a higher return in exchange. Surprisingly, the country is expected to implement a corporate tax rate of 20% that will certainly provide incentive to move to debt (a tax deductible mode of financing). However due to the newly incorporated risk component, the beta tends to increase beyond 1 and the resultant cost of equity is certain to elevate…………………….

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