Capital Structure of the Companies

This report emphasizes upon the capital structure, market value and valuation methods which could be used to analyze the market price of the shares of two companies. In this report, two companies named, Telstra and Wesfarmers Company have been selected. Each and every company needs to keep its financial leverage low and profitability high if it wants to survive in long run. It will allow company to sustain its business in long run.

Part-A

            Capital structure of the company generally comprises of two elements named as debt and equity. Every firm raises its capital from borrowing the funds and issuing the shares. Therefore, it becomes necessary for them to maintain a balance between its debt and equity portion in order to have optimal capital structure (Robb & Robinson, 2014). In case of Wesfarmers, the company is focused on providing a satisfactory return to its shareholders by managing its capital. Its capital structure consists of Net debt, shareholders’ equity and reserves.

Source of capital	Number in issue Save Time On Research and Writing Hire a Pro to Write You a 100% Plagiarism-Free Paper. Get My Paper	Price per share	Market Value	Proportion to total long term capital
Ordinary shares	2275.4	10	26195	84.82%
Preference shares	0	0	0	0
Long Term Debt#	3441	10	3441	15.12%
			Total	100%

It can be observed from the below table that the debt element of the firm has reduced after 2016 along with the slightest reduction in its equity. It has a high Debt/equity ratio in 2016 at 29.16% which fall to 15.125 in 2018. Repayment of debt for working capital requirements and monitoring the structure as per the group ratings has helped Wesfarmers to reduce its debt portion. Also when compared with the industry average of 24.50%, the ratio of the company was lower in the past years except the 2016. This reflects that Wesfarmers relies more on equity and has less financial obligations which can prove to be an attractive point for the investors. Moreover, the company uses relevant measures to manage its capital so that it can offer high returns with low financial risk (Morningstar. 2018).

Capital structure of Wesfarmers  (Amount in Million $)
	2018	2017	2016	2015	2014
Debt	3441	4400	6692	5817	2998
Equity	22754	23941	22949	24781	25987
Total capital	26195	28341	29641	30598	28985
Debt/equity	15.12%	18.38%	29.16%	23.47%	11.54%
Industry average	24.50%

On the other hand, Telstra’s capital structure comprises of equal amount of debt and equity. The company’s capital has approximately 50% equity and 50% net debt. However, a fluctuating trend can be noticed in the capital structure of the firm over the past five years. It can be observed that in 2015 and 2017, the debt element of the company has increased as compare to their prior years. Talking about the recent year the ratio has declined to 98.17% as compare to 104.95% in 2017. Also it is below the industry benchmark of 116.26%.

The structure reflects that Telstra rely heavily on the outside borrowings which forms major part of its net debt. Also it preserves high financial risk but is trying to reduce its debt portion. Having a ratio lower than the benchmark reflects that company is less risky as compare to the other entities operating in the same sector (Morningstar. 2018).

Capital structure of Telstra Corporation  (Amount in $)
	2018	2017	2016	2015	2014
Debt	14739	15,280	12,459	13,566	10,521
Equity	15014	14,560	15,907	14,510	13,960
Total capital	29753	29840	28366	28076	24481
Debt/equity	98.17%	104.95%	78.32%	93.49%	75.37%
Industry average	116.26%

            There are many factors which influence the capital structure of the firm such as market conditions, timing and flexibility, size of the company, cost of capital, industry benchmarks and many others. In case of Wesfarmers, the one major factor which could have influenced its overall structure is to decide the capital structure for Coles, which has been demerged. According to the report in financial review, it has been believed that net debt for Coles will be between $1.5 billion and $2.1 billion which is half of Wesfarmers’ debt. It also includes the annual lease costs and fixed charges which help in achieving the desired credit rating.

Factors Influencing the Capital Structure

The analysts assume that enterprise value for Coles will be between $16 billion and $19 billion. Such decision may have influenced the structure of the entity in the recent years (Financial Review. 2018). In case of Telstra Corporation, factors which have and could impact its capital structure is the management policies adopted by the company in respect of its capital. Its decisions regarding issuing and repayment of debt, adjustments made in amount of shareholders’ dividend, capital returns to the investors and issue of new shares are some factors which affect Telstra’s capital structure and allow the company to maintain and adjust the same. Moreover, the changes in company’s accounting policies also impact its capital structure (Telstra. 2018).

Capital Structure theories

Trade off theory

This theory reveals how company could set up optimum capital structure theory on the basis of the cost and benefits associated with the same. It set ups relation between the financial leverage and cost of capital of company.

Modigliani-miller approach

The theories of capital structure, one applicable to both the firms are the Modigliani-miller approach stating the proposition II with the presence of taxes. It suggests that the value of the firm can be enhanced by using more debt and reducing the cost of capital. In a way it supports the net income approach where the increment in debt can bring an optimize capital structure for the firm.

Part-B

Weighted Average cost of capital
Wesfarmers Limited
Beta	0.93
Market premium	6.00%
Risk free rate	2.68%
Cost of equity	8%
Finance cost	211
Long term debt	2965
Cost of debt	7%
Tax rate	30%
After tax cost of debt	5%
	Amounts	Weights	Cost of capital	W*COC
Debt	3441	0.13	5.0%	0.7%
Equity	22754	0.87	8.3%	7.2%
Total	26195	1.00
WACC				7.83%
Telstra Corporation
Beta	0.53
Market premium	6.00%
Risk free rate	2.68%
Cost of equity	6%
Finance cost	549
Long term debt	15316
Cost of debt	4%
Tax rate	30.8%
After tax cost of debt	2.5%
	Amounts	Weights	Cost of capital	W*COC
Debt	14739	0.495	2.5%	1.2%
Equity	15014	0.505	5.9%	3.0%
Total	29753	1.00
WACC				4.19%

After assessing all the details, it could be inferred that Company is having 4.19% Weighted average cost of capital.

            Weighted average cos of capital is defined as the firm’s cost of capital under which each category is proportionately weighted. The calculation of WACC includes the tax rate of the company which has a significant impact on it. The taxes enter the calculation in the debt part of the formula. It is observed that a high tax rate would result in lower cost of debt as the debt is tax deductible. The relationship between the tax rates and WACC is defined as when the rate goes up, the WACC reduces and vice versa happens.

The calculation of WACC of both the companies has included the impact of corporate tax rate of 30%. If the same has not been included then the discounting rate would be higher than the calculated one. So it can be said that taxes impact the WACC to a great extent as a minor fluctuation in the same can leave a significant impact on company’s cost of capital (Vélez-Pareja, 2016).

Part-C

How taxes affect cost of capital.

It is analyzed that the level of interest rate of company will affect the cost of debts and potentially the cost of equity. It is analyzed that when the interest rates increases then the cost of the debts increases as well. It is analyzed that if company is having good amount of profitability then it should keep higher debt portion which will not only lower down the cost of capital but also assist company to reduce the tax payment to government. The main reason of lower tax payment in case of high debt portion is related to its interest expenses. All the interest expenses of Telstra Company is deductable tax expenses. Therefore, it could be inferred that higher interest payment is the positive indicator for the future growth and low cost of capital.

Capital Structure Theories

Part-D

Computation of the discounted cash flow method

DCF calculation
Wesfarmers
Current price	44.22
Terminal Growth rate	2%
Growth rate assumption	4.00%
WACC	7.83%
Years	2018 (base year)	2019	2020	2021	2022	2023
FCF	2265	2355.60	2449.82	2547.82	2649.73	2755.72
Discount factor		0.93	0.86	0.80	0.74	0.69
Present values		2184.563397	2106.983327	2032.158346	1959.99	1890.39
Sum of present values						10174.1
Cash flow in 5th year (2023)	2755.72
Terminal Growth in perpetuity	2810.8332
Capitalization rate (Discount rate – terminal growth rate)*(1+Discount rate)^n-1
0.085
Present value of terminal value	33,077.47
Market Value (Sum pf present cash flow + present value of terminal value)	43,252
Number of Shares outstanding	1,133.00
Fair value	38.17
Telstra Corporation
Current price	3.01
Terminal Growth rate	2%
Growth rate assumption	5.00%
WACC	4.19%
Years	2018 (base year)	2019	2020	2021	2022	2023
FCF	3674	3857.70	4012.01	4172.49	4339.39	4512.96
Discount factor		0.96	0.86	0.80	0.74	0.69
Present values		3702.710089	3450.547453	3328.008682	3209.82	3095.83
Sum of present values						16786.9
Cash flow in 5th year (2023)	4512.96
Terminal Growth in perpetuity	4603.222634
Capitalization rate (Discount rate – terminal growth rate)*(1+Discount rate)^n-1
0.027
Present value of terminal value	171,552.80
Market Value (Sum pf present cash flow + present value of terminal value)	188,340
Number of Shares outstanding	11,877.00
Fair value	15.86

Price Earnings Ratio
Relative valuation method
Wesfarmers
Ratios	Company	Industry Average
Price/ Earnings (P/E)	20.53	18.85
Price/ Book Value (P/BV)	2.35	1.83
Price/Sales Ratio (P/S)	0.8	0.2
Return on equity (ROE)	11.15%	9.84%
Telstra
Ratios	Company	Industry Average
Price/ Earnings (P/E)	10.11	19.6
Price/ Book Value (P/BV)	2.4	4.86
Price/Sales Ratio (P/S)	1.39	4.07
Return on equity (ROE)	24.10%	28.65%

Discounted cash flow approach undertakes the free cash flow of the company which is further used to identify the present cash value of company. Under the DCF approach, the value of investment is calculated as per its future cash flows. The present values of the FCFs are determined using a discounting rate and then the intrinsic value of the stock is calculated. If the DCF value is higher than the current value, then the opportunity should be considered. Certain assumptions are made while performing the valuation of Wesfarmers. It is assumed that the FCFs of the company will grow at 4% with the terminal growth rate of 2%.

As per the calculation, the fair value of the stock is $38.17 which is lower than the current share price of $44.22. This means that the share price of Wesfarmers will fall in future. Similarly, the calculation for Telstra has been performed assuming the growth rate of 5% and having a WACC of 4.19%. The fair value of the stock appears to be $15.86 which is way more than its current stock price of $3.01. This reflects that the Telstra’s stocks are going to perform better in future and will give high returns to the investors (Damodaran, 2016).

Under relative valuation method, some financial ratios are considered to value the performance of both the companies. It can be seen that Wesfarmers’ ratios are higher than its industry average but comparatively lower than Telstra. The ROE of Telstra is 24.10% while Wesfarmers has a ratio of 11.15%. Similarly the price to book value ratio of Telstra is 2.4% while it is 2.3% for Wesfarmers. Its P/S ratio is also more, however less than the industry average (Rossi & Forte, 2016).       

Considering the risk and return factors, metrics like standard deviation and beta are used to measure the risks of both the companies’ stocks. It is observed that both the stocks have a standard deviation of 5% (round off) which is more than the market S.D of 3.14%. This indicates that the stocks are more volatile and hence have high level of risk. Beta is another measure of systematic risk and it is said that company having high beta pursues high risk. In case of Wesfarmers and Telstra, it is seen that Telstra has a beta value of 0.53 while Wesfarmers has 0.93. This means that Telstra is comparatively less risky and volatile. Also, it is less volatile than the market. So considering all the factors, it will be suggested to invest in shares of Telstra Corporation as it is less risky and will provide high returns in future.

Part-E

Standard deviation is generally used by the investors to measure the risk of a stock or a portfolio. Basically it is a measure of volatility and it suggests that the stock is more volatile if it has larger standard deviation. Apart from this method, there are other measures also which are been used for measuring the risk of stock. Beta, Value at Risk and Conditional VaR are other statistical measures that are used to assess the level of risk associated with a particular stock of the company or a specific portfolio. Beta is a measure of systematic risk which determines the how much volatile a stock is in comparison to the market. It basically reflects the overall market risk which cannot be diversified. Thus, there are other methods also for calculating the risk which are better than standard deviation (Bollerslev, Xu, & Zhou, 2015). Therefore, it could be inferred that Wesfarmers and Telstra both have equal standards deviation as compared to each other.

Wesfarmers	Telstra	S&p100
Standard deviation	4.49%	4.48%	3.14%
Beta	0.93	0.53

There is below excel work that has been done in this assignment is being embedded

Part-G

Yes, consideration of other qualitative factors will definitely change the decision as it will include the review of several points which are to be considered while making an investment decisions. Factors like market conditions, industry performance, business model, corporate governance and competitive advantages can influence a decision to a great extent. Wesfarmers and Telstra, being operating in different sectors may have different circumstances in external environment which make the companies worth investing. Apart from figuring out the stock value and risk and return, the company may have some favorable market conditions, suitable management style and flexible financial requirements which enhances its performance overall. So, yes it is true that qualitative factors do impact the investment decision of the user.

Conclusion

After assessing the data of these two companies, it could be inferred that Wesfarmers has high profitability but due to the sluggish market condition, it might face high business risk. The financial leverage and profitability of company should be stable and linked to each others. It will not only allow company to survive in sluggish market condition but also increase the overall return on capital employed. As per the investors point of view Telstra Company would give higher return as it has higher return on capital employed and business value as compared to Wesfarmers.

References

Damodaran, A. (2016). Damodaran on valuation: security analysis for investment and corporate finance (Vol. 324). John Wiley & Sons.

Financial Review. (2018). Coles’ capital structure key to success of Wesfarmers demerger. 

Morningstar. (2018). Telstra Corp Ltd. 

Morningstar. (2018). Wesfarmers Ltd. 

Robb, A. M., & Robinson, D. T. (2014). The capital structure decisions of new firms. The Review of Financial Studies, 27(1), 153-179.

Rossi, E., & Forte, G. (2016). Assessing Relative Valuation in Equity Markets: Bridging Research and Practice. Springer.

Telstra (2018). Annual Report. 

Vélez-Pareja, I. (2016). Tax shields, financial expenses and losses carried forward. Cuadernos de Economía, 35(69), 663-689.

Bollerslev, T., Xu, L., & Zhou, H. (2015). Stock return and cash flow predictability: The role of volatility risk. Journal of Econometrics, 187(2), 458-471.