CAPITAL STRUCTURE AND COST OF CAPITAL ASSIGNMENT

The purpose of this assignment is to enable students to evaluate the capital structure and cost of capital of a selected company and its possible impact on shareholders wealth.

Company is selected when there is significant change in the capital structure (debt-equity) over 2-3 years.

The student is expected to do the followings:

1. Identify the rationale for capital structure changes
2. Compute the debt equity ratios for the relevant period
3. Assuming a constant tax rate of 30%, compute the cost of debt to the company
4. Using any of the suggested model as per notes, compute the required return
5. Determine the WACC or weighted average cost of capital
6. Determine the degree of Financial Leverage and related financial risk
7. If information is available on fixed cost, determine the degree of Operating Leverage
8. Prepare a report on the efficiency of the cost of capital and evaluate the performance of the company
9. Please state any limitations or assumptions of your analysis

SUMMARY

In financing their assets, an organization has the option to either use debt or equity. The appropriate combination of debt and equity would result in an optimal capital structure decision. Hence examining the capital structure of an organization is very important as it will have implications of shareholders’ wealth, market analyst’s evaluation of the company’s state of financial health and the long term survival of the company. We will discuss these in turn later.

In this assignment, the team has chose to analyze the capital structure of Malaysia Airlines System for the last 2 financial years, i.e. Year 1 which covers the financial period of April 1, 1999 to March 30, 2000 and Year 2 which covers the financial period of April 1, 2000 to March 30, 2001. (Refer Appendix I and II). The reason for the selecting Malaysia Airlines is because it has appeared from the balance sheet that there has been a significant change in the capital structure which will provide a very meaningful analysis.

In analyzing the relevant information, the team has agreed to approach it in the following way:

(1) DEFINITION AND CONCEPT

Understand the concept of capital structure and factors that determine the capital structure in an organization, the effect of capital structure on stakeholders’ wealth, the rationale behind capital structure changes

(2) ANALYSES OF THE CAPITAL STRUCTURE

The analysis of the capital structure of Malaysia Airlines for the last 2 consecutive financial years and the interpretation of the data according to the concept of capital structure as explained in (1)

(3) EVALUATION OF COMPANY PERFORMANCE BASED ON COST OF CAPITAL

Discuss the efficiency of the cost of capital and evaluate the performance of the company

(4) LIMITATIONS AND ASSUMPTIONS

Discuss the underlying limitations and assumptions of the information

(5) CAUSAL AND IMPACTS OF THE CHANGES IN CAPITAL STRUCTURE

This section discussed the factors that affect the capital structu8re and its impacts on the sharehoders wealth

(6) THE ALTERNATIVE.

Evaluate and suggest alternative solution.

(7) CONCLUSION.

(1) DEFINITIONS AND CONCEPT

Gallagher defines capital structure as the mixture of sources of funds a firm used such as debt and equity and this includes debt, preferred stock, common stock and bond.

When raising funds for the organizations, the firms must first analyze the cost and return associated with each sources of fund. All capital raised has a cost associated with them. Hence, a firms’ cost of capital affects the firm’s financing and investment decision.

Costs associated when raising for debt and equity can be summarized as follows;

(1) The cost of debt

Type of Cost	The after tax cost of debt (AT kd)
Purpose	Compute the cost to the company of obtaining debt funds
Indications	Because the interest paid is tax deductible, hence the cost of debt after tax is less than the required return of the suppliers of debt capital

(2) The cost of equity

Type of Cost	The cost of preferred stock (kp)
Purpose	Rate of return investors require on a new company’s new preferred stock
Indications	The value of kp is the minimum return the firm’s managers must earn when they use the money supplied by the preferred stocks.

Type of Cost	The cost of common stock (ks)
Purpose	The required rate of return in funds supplied by existing common stockholders
Indications	There are 2 methods in computing ks and there are (1) Dividend growth methods (2) The CAPM approach

Type of Cost	The cost of equity from new common stock (kn)
Purpose	The cost incurred by a company when new common stock is sold by considering the amount of dividend expected, the expected growth of dividend and the floatation cost per share
Indications	If the cost of new common stock equity is higher than the cost of on internal common equity, the cost of preferred stock and cost of debt, then issue fo new common stock may be a last resort to raise capital

Furthermore, raising capital based on each option has its advantages and disadvantages as outline below..

	Debt	Equity
Advantages	§ Interest is tax deductible, which lowers the effective cost of debt § Debt holders are limited to a fixed return so stockholder s do not have to share profits if the company does exceptionally well § Debt holders do not have voting rights, so stock holders can control a business with less money than would otherwise be required	§ Corporations need not pay interest and are not legally obligated to pay dividends to common stock holders. § Dividends payments to stockholders do not reduce earnings § Issuance of new stock to raise capital could help bring the firm’s debt ratio down to more normal industry level and hence make it easier for firm’s to borrow in the future.
Disadvantages	§ The higher the debt ratio, the greater the risk and hence the higher the interest rate § At some point, interest rates overwhelm the tax advantages of the debt § If a company falls on hard times, and if the operating income is insufficient to cover interest charges, hence stockholders have to make up on the shortfall or the company can be declared as bankruptcy. § Payment of interest reduce firm’s earnings § High debt may result in difficulty in obtaining more borrowings in the future	§ When new common stock is issued, the ownership position of the existing shareholders can be diluted. The dilution may result in a lower earnings per share § When new share are issued, the floatation costs associated with new common stock issues are normally higher than those associated with debt § Issuing new stocks, may also send the wrong signals to investors and analyst that the by issuing new stocks that the organization wants more ‘partners’ with whom to share bad times.

However, in determining capital cost structure of an organization, there are other factors that may have bearing on the decision such as the followings:

(1) The cost of raising the debt as explained above. Issuance of new common stock may relate to the floatation costs

(2) The impact on shareholders’ wealth. As explained above, the issuance of new common stock may send the wrong signals to the market that the organization wants more ‘partners’ with whom to share bad times

(3) Market conditions – if the stock market is strong, a company may decide that it is a good time to issue common stock

(4) Timing and period of debts – Raising debts when interest rates are high may effect earnings because the firms will have to pay bondholders a higher interest rates to obtain debt capital.

(5) Business risk – A firm that has relatively low business risk –small sales variability, low operating leverage and so on – can take on more debts that can firms with nigh business risk.

(6) Asset Structure – Firms whose assets are suitable as security for loans tend to use debt rather heavily. Thus, real estate companies, which have marketable assets, tend to be highly leveraged versus a company which involved in technological research employ relatively little debt

(7) Foreign Exchange risk – the borrowings are made with an overseas instituition may result in increase cost of borrowings when the interest rates are sensitive to fluctuations of the exchange rate.

(8) Capital Structure policy – Change in the capital structure may can affect the cost of capital.

(9) Dividend Policy – If a firm’s payout ratio is so high that it must issue new stock to fund its capital budget, this will force it to incur flotation costs and this will affects its cost of capital

(10) Agency Problem- Higher debt forces managers to be more careful with shareholders’ money and wealth versus too much cash in hands which may result in them to be more delinquent in their expenditures. If too little debt is used, management runs the risk of a takeover.

1. Hence, the rationale for capital structure changes are as follows:

(1) Maximization value of stock – firm must always choose the capital structure which maximizes the value of stock. If the stock prices is maximized, then the cost of capital will simultaneously be minimized.

(2) Change in the level of interest rates which resulted in cost of debt became more costly than floatation costs when issuing new common stocks.

(3) Using leverage involves a risk/return trade off – higher leverage increases expected earnings per share, but it also increase the firm’s risk. It is this increasing risk that causes cost of common stocks and interest rates of all debts to increase at higher amounts of financial leverage.

(4) Growth rate- - firms which plans to grow faster in the industry tend to use more debt than slower-growth companies

(5) Corporate tax- should there be any changes in the corporate tax structure may influence the capital structure change. The higher a firm’s corporate tax rate, the greater the advantage of using debt

(6) Market conditions – During recent credit crunch, the bond market may not be very attractive and it was impossible for forms to issue lower quality debt at reasonable interest rates. Hence low-rated companies in need of capital were forced to issue stock or use short term debt, regardless of their target capital structures. As conditions eased, companies may readjust and to be in line with the target

In the MAS context, the airline is known as cyclical, hence it exposes the company to higher risks.

(2) ANALYSES OF THE CAPITAL STRUCTURE

(2.1) The debt equity ratios

Purpose: The debt equity ratio expresses the relative equities of owners(stocks) and creditors (debt)

The Formulae: Debt

Common Equity

(2.2) Implication of debt equity ratio:

- It is one of the debts ratios used to assess the relative size of MAS debts load and the ability of the company to pay such debts. When the ratio increased significantly, the risk to lenders and bondholders increased significantly.

-

	2001	2000
Current Liabilities	5,404, 204	4,911,463
Long Term Borrowings	7,829, 873	9,388, 594
Other Long Term Liabilities	433, 887	518,981
Total Debt	13,667,964	14,819,038
Minority Interest	12,347	11,111
Total Equity (Shareholders Fund)	1,888,453	3,222,276
Debt Equity Ratio	7.24	4.60

Source: Consolidated Balance Sheet.

Observation:

Data has indicated that the firm total debt has increased in 2001 compared to the year before, from 4.59 to 7.23. It is also noted that the actual debts had reduced from 14.8 million to 13.6 millions, representing reduction of 7.8%. The increased in ratio is contributed by the reduction of equity from 3.2 billions to 1.9 billions representing a reduction of 41.39%.

(2.2) Qc. Computation of the cost of debt to the company assuming a constant tax rate of 30%

Purpose: The after tax cost of debt (AT k_d) is the cost to the company of obtaining debt funds.

For computation purposes, we shall assume that kd = 2.1%

Formulae for the After Tax Cost of Debt

AT k_d = k_d (1- T)

Where k_d = the before-tax cost of debt

T = The firm’s marginal tax rate

The cost of debt is equal to the interest of borrowings.

a. Interest on borrowing before tax adjustment for FY 2000 = 563,304

2001= 582,342

Kd for Fy 2000 = interest payment/ total debts

=563304/ 14,819,038

= 3.8%

AT Kd Fy 2000 = 3.8(1- 0.3)

= 2.66%

Kd for 2001 = interest payment/total debts

= 582,342/ 13,667,964

= 4.26%

AT Kd for 2001 = Kd (1-tax)

= 4.26 % (1- 0.3)

= 2.98 %

b. Minority interest

Fy 2000, payment to minority interest = 2,871, minority interest value = 11,111

Cost of minority interest = 25.84%

Fy 2001, payment to minority interest = 4,109, minority interest value = 12,347

Cost of minority interest = 33.28%

	2001	2000
Interest on borrowings before adjustment for tax	582,342	563,304
Total Debt	13,667, 964	14,819,038
Cost of Debt after tax (%)	2.98	2.66
Minority interest value	12,347	11,111
Minority interest payment	4,109	2,871
Cost of minority interest (%)	33.28	25.84

Analyses:

After applying 30% tax deduction on the total debt, we can conclude that the cost of obtaining debt funds has reduced by 7.76% in year 2001

(2.3) (Qd) Computation of the required return, based on the suggested model

Cost of Equity

(1) CAPM formulae for the cost of common stock equity

Purpose: to calculate the rate of return that investors require for holding common stock according to the degree of non-diversifiable risk present in the stock

K_s = k_RF + (k_m – k_RF) x β where

K_s = The required rate of return from the company’s common stock equity

k_RF = The risk free rate of return

k_m = The expected rate of return on the overall stock market

β = the beta of the company’s common stock, a measure of the amount of non-diversifiable risk

For computation purposes, we have made the following assumptions:

Beta for 2001 = .96 taken from Risk Return Analysis on 15Jul 2001.

2000 = 1.0 ,considered equal to the market risk.

Krf = 3% based on the Malaysian Treasury rate.

Km changed from 10% in the year 2000 to 12% in 2001 assuming that there was a market growth.

	2001	2000
km	12%	10%
kRF	3%	3%
β	.96( from internet	1.00
Computation	Ks = kRF + (km – kRF) x β = 0.03 + (0.12 – 0.03) x .96 = 0.03 + 0.0864 = 0.1164 or 11.64%	Ks = kRF + (km – kRF) x β = 0.03 + (0.10 – 0.03) x 1.00 = 0.03 + 0.07 = 0.10 or 10%
The required rate of return from the company’s common stock equity	11.64%	10%

(2) D₁/(ks-g) cannot be applied as there has no dividend declared for the year 2001 for us to compare with

(2.4) Determine the Weighted Average Cost of Capital (WACC)

The Weighted Average Cost of Capital is computed to estimate a firm’s overall cost of capita. To compute the WACC, we need the following information

K_a = (WT_d x AT k_d) + (WT_p x k_p) + (WT_s x k_s)

Type of Capital	2001		2000
	Capital Amount	% capital composition(WT)	Capital Amount	% capital composition(WT)
Debt	13,667,964	87.79	14,819,038	82.09
Common Sock	1,888,453	12.13	3,222,276	17.85
Minority Kminority	12,347	0.08	11,111	0.06
Total	15,568,764		18,052,425

K_{a 2001} = (WT_d x AT k_d) + (WTm x km) + (WT_s x k_s)

= (0.8779x 0.0298) + ( 0.0008x 0.3328) + (0.1213 x 0.1164)

= 0.02616 + 0.00027 + 0.014119

= 0.0405

= 4.05%

K_{a 2000} = (WT_d x AT k_d) + (WTm x km) + (WT_s x k_s)

= (0.8209 x 0.0266) + ( 0.0006 x 0.2584) + ( 0.1785 x .10)

= 0.02184 + 0.00016 + 0.01785

= 0.03985

= 3.985 %

Observation:

The weighted average cost of capital had increased from 3.985% in the year 2000 to 4.05% for the year 2001.

Where

K_{a =} WACC

WT_{d =} The weight or proportion of debt used to finance the firm’s assets

AT k_{d =} The after tax cost of debt

WTm ₌ The weight or proportion of minority interest being used to finance the firm’s assets

km ₌ The cost of minority interest.

WT_{s =} The weight or proportion of common equity being used to finance the firm’s assets

k_{s =} The cost of common equity

(2.5) Determine the degree of financial leverage and related financial risk

Page 334153

To compute the degree financial leverage = DFL = %change in NI/ % change in _EBIT

or DFL = EBIT/ (EBIT-1)

	2001	2000
Earning Before Interest and Tax (P&L – 2(a)	**-722,958	235,502*
Interest Expense	582,342	563,304
Financial Leverage	0.5539	-0.7184

-* EBIT (2000) = 1,883,270 – 1,647,768

= 235,502

-** EBIT(2001) = 679,491 – 1402,449

= - 722,958

Refer to Chapter 7, pages 153 -155

(2.6) Determine the degree of operating leverage, assuming that fixed assets as a proxy of fixed cost

To compute the degree operating leverage, the followinf formulae may be used:

a. DOL = % changed EBIT/% change in Sale

b. (Sale –VC)/( Sales- VC-FC)

The second formula is chosen because of the data availability. The first formula requires the price and variable cost per unit to be constant and the fixed cost to be constant.

	2001	2000
Sales	8,956,145	8,160,737
VC	1,126,355	842,652
FC	9,439,826	7,773,423
Degree of operating Leverage	-4.863	-3.449

VC is taken from the Group Cost Components pie chart. Assumptions were made to calculate the variable and fixed cost. Fuel- 20% variable and 80% fixed. Aircraft Maintenace , 15% variable and 85% fixed. Commission 100% variable. All other costs are taken to be fixed.

(3) EVALUATION OF COMPANY PERFORMANCE BASED ON COST OF CAPITAL

(4) LIMITATIONS AND ASSUMPTIONS

(5) CONCLUSIONS

(6) REFERENCES

1.Gitman Lawrence, Managerial Finance, Pearson Education International Ninth Edition.

2. Gallagher, Financial Management, Prentice Hall

(7) APPENDIX I