Impact of Debt Upon the Value of the Firm

To: CEO

CC: CEO

From: Hillbrandt

Subject: Impact upon Firm’s Value due to Change in Capital Structure

1. Impact of Debt upon the Value of Firm: ABC Golf Equipment Corporation has raised $ 2.5 million of debt at the rate 9% resulting in the valuation of the company at $20.78 million as compared to $22.93 million earlier. The back up working of the valuation is as follows:

Cost of Equity after recapitalization	13%
Value of Equity (A)  (EAT/Cost of equity)	18.28
Value of Debt (B)	2.50
Value of the company (A+B)	20.78

 

Recommendation: Present value of the firm that is $22.93 million is greater than the value of firm after taking the impact of debt (i.e. $22.93). It is suggested that Debt should not be employed in firm as it decreases the value of the firm. 

2. EPS of ABC Golf Equipment Corporation after recapitalization: After raising the debt, an annual interest cost of $.23 million will arise which be resulting in EPS of $5.83 per share as compared to $5.04 per share under the existing zero debt structure. The tax benefit on the interest cost has resulted in increase in EPS. The EPS has reached as follows:

EBIT	$3.88
Interest Cost	0.23
EBT	$3.66
Tax @ 35%	$1.28
EAT	$2.38
No. of Shares after recapitalization	0.41
EPS after recapitalization	$5.83

 

Recommendation: EPS of ABC Golf Equipment Corporation has increased to $5.83 million from $5.04 million. According to the EPS, it is beneficial for the firm to recapitalize its capital structure.

3. New Stock Price of ABC Golf Equipment Corporation after recapitalization: The new capital structure has resulted in the favorable manner for the company and resulted in the hike in the share price of the company to $ 44.86 from $ 27.

New Stock Price =	Value of Equity
	No. of Equity Shares
=	44.86

 

Recommendation: Stock price of ABC Golf Equipment Corporation has increased to $44.86 from $27 million. According to the stock price of ABC Golf Equipment Corporation, it is beneficial for the firm to recapitalize its capital structure.

4. EBIT derived from probability distribution: As EBIT derived from probability distribution is same as it is provided, that is $3.88 million.

Probability Distribution	EBIT
0.05	(1.00)	(0.05)
0.25	2.30	0.58
0.40	4.00	1.60
0.25	5.80	1.45
0.05	6.10	0.31
EBIT on the basis of Probability Distribution		3.88

5. Interest earned ratio at each level of probability: Interest earned is calculated by dividing EBIT from interest for each level of probability.

Interest earned ratio =	EBIT
	Interest
Probability	0.05	0.25	0.4	0.25	0.05
EBIT	-$1.00	$2.30	$4.00	$5.80	$6.10
Interest	$0.23	$0.23	$0.23	$0.23	$0.23
Interest earned ratio (In times)	(4.44)	10.22	17.78	25.78	27.11

 

Recommendation: The value of the firm has go up after raising the debt funding , EPS has also go up because of the tax savings on the interest on debt. It is suggested that ABC Golf Equipment Corporation should recapitalize its capital structure.

Yours faithfully,

Mr. Hillbrandt

Introduction: Factors that should be considered by company while selecting or changing capital structure are Risk exposure of the firm, financial flexibility of the firm, company’s tax bracket, Growth rate, management of company , last but not the least is market conditions. These all are factors which should be considered by company before taking any decision regarding the restructuring of capital structure.

Risk exposure of company: It is the basic risk of firm’s activities. If the ratio of business risk will be high then debt ratio of the company will be low: Hanif, Mohammed (2001)

Financial Flexibility: It can be defined as the capability of the company to raise its capital during its bad period. If the debt level of company will be low then the financial flexibility of the company will be high.

Company’s tax bracket: Payments to debts are deductible. If company falls under high tax bracket then it will be beneficial for the company to employ more debts and vice versa will also be applicable.

Growth rate: It is also another important which should be considered by company for restructuring of capital structure. If company’s revenue is stable then less debt will be employed in capital structure of the company and vice versa will also be applicable.

Management of the company: whether management of the company is aggressive or conservative. If company’s management is aggressive then it will employs more debt and if management of the company is conservative then it will employs less debt and more equity in capital.

Market conditions: Company’s market condition should be considered. For example, if wants to purchase a new machinery then it is beneficial for firm to raise the fund from equity rather than employing debt- Mallin (1993)

Conclusion: It can be concluded that company should consider Risk exposure of the firm, financial flexibility of the firm, company’s tax bracket, Growth rate, management of company ,and its market conditions before taking any decision regarding capital restructuring.

References

Hanif, Mohammed (2001). Capital restructuring (3rd ed., Vol. 2). New York: Blackwell.

Riad, Janet Hontoir (2001). Financial Management (4th Ed., Vol. 3). London: Oxford University.

Mallin (1993). Techniques of Financial Management (1^st Ed, Vol. 2). London: Penguin.

Reek (2011). Dividend payout ratio Factors (1^st Ed, Vol.2). New York: Pearson Hall.