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Capital Structure Approach

Essay by   •  December 5, 2013  •  Research Paper  •  1,988 Words (8 Pages)  •  1,643 Views

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A. 1. The capital structure approach recommended that maximizes shareholder return is the EBIT-EPS capital structure approach. This approach centers on looking for a capital structure with the highest EPS (earnings per share) over the expected scope of EBIT (earnings before interests and taxes). The one recommended for this company will be the 50% preferred and 50% common stock. The two components that will need to be analyzed are the debt capital and equity capital.

a. The justification for this recommendation is as follows: This structure allows the company to attain the vital goals of the enterprise, which is to maximize the shareholders' wealth by getting the most out of its stock price. The two key variables for this approach are risk and return. This approach concentrates on making the most of earnings rather than making the most of wealth. The 50% preferred and common stock has the overall highest EPS over the years. It also shows a higher net income even though there are higher income taxes. The mix of these 2 stocks will maximize the shareholders wealth (Boricki, 2010). When using this structure, you can see a greater amount of equity versus debt, which is a sign of how good the company is doing. It becomes an important measurement for a company to consider before a sale or merger, with the higher EBIT being thought as a measure of a company's financial health. It can be one of the most significant indicators of a company's profitability from possible shareholders, the EPS that is (Klonsky, 2010). The other options given for Competition Bikes or its shareholders are not at all better alternatives. The last alternatives given, proposing 9% bonds and common stock or the 12% bonds and common stock, means a decrease in net income because of the increased interest paid. This would mean there could be less funds obtainable for allotting common stock and decreased EPS. There becomes a threat of reducing dividends and decreasing earnings, by deciding to propose bonds with common stock. There is also a danger of not being able to reimburse dividends to stakeholders if the company does not meet expected budgets. Earnings per share for stockholders are low, between 0.002 and 0.042, compared to the suggested alternative, where earnings per share array from 0.027 to 0.057. The other alternatives also have greater interest payments which ends in less income before taxes related to offering the preferred and common stock without bonds. These are also a form of debt, rather than an equity. With the last option of offering 20% or 40% common stock and 9% bonds, while they are higher common stock shares outstanding, the earnings per share is higher, with the recommended alternative in the long term and equal to or higher than the last options in the first 2 years. Choosing the 50/50 the company is able to have the highest EPS in years 1, 2, and 5, also equaling the next alternative of 20% with 9% bond in years 3 and 4. Despite an increase in taxes for all 5 years, net income is higher, as the EBIT is as well. The total income available for the 5 years in regards to the common stock and common stock shares outstanding, is less than the other options as well. The other options are not best for the shareholders either. Offering the 9 or 12% bonds, means a decrease in net income because of the increased interest paid. Earnings per share are lower as well. This means less common stock shares outstanding and less equity for the company and fewer shares for stockholders. By only offering bonds, is that if predictions are less than projected, there could be a damaging effect on shareholder earnings. The other alternatives also offer higher interest payments which means less income before taxes compared to the preferred and common stock without bonds. Using stocks as an equity tool over bonds as a debt tool, is more beneficial with the moderate earnings because Competition Bikes will draw in more shareholders, especially since Canadian Bikes has displayed development and consistency.

2. Areas that raise concern for this approach are that it ignores or does not consider financial risk. As the company obtains more debt, the risk also increases and shareholders may require higher returns to adjust for the bigger financial risk. This approach also does not allow the company to know the place where weighted average cost of capital is at the lowest and where stock price is at the highest. Other areas that raise concern are that the NPV over the 5 years is significantly negative. Also, the moderate demand model is not being met, therefore causing the IRR to go below the hurdle rate. These things could result in not only cash flow problems, but entire project problems (Boricki, 2010). It is key to see that Competition Bikes does not know which situation will come out or what the investment will do over the five year term, being that the low and moderate demand models are only probable estimates of what will transpire. The NPV is considerably negative at $26,740, after 5 years in the low demand model. The expansion plan will not be cost-effective since Competition Bikes will not be able to entice any new stakeholders, if the IRR does not meet the hurdle rate and the NPV is negative. The NPV is hardly positive at $2,243 with the moderate demand model. The concern in this is if the moderate demand model is not accomplished, even by a slight amount, the company could have a negative NPV. The moderate demand model is 10.1%, that meets the hurdle rate, but just hardly, which becomes an additional fear. If the moderate demand sales projections are not accomplished, even by a slight part, this could decrease the IRR to under the hurdle rate. The stockholder will most likely not invest if the necessary rate of return is not met. Also, in order to not upset the capability of the company to entice investors in backing this growth, management should be very careful in continuing with this plan since it would take only a slight variation in the projections to fail. Competition Bikes might want to contemplate creating a NPV profile in order to find the IRR that would be suitable and the slightest risk since the IRR is the discount rate at which the NPV equals zero. Collection procedures should also be more effective to prevent overages of funds and debts. Also, by having good working relationships with suppliers, the more likely they are

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