# Capital Structure and Dividends

## Introduction

ABC Golf Equipment Corporation is considering changes in its capital structure. The capital structure of a company represents the combination of equity and debt utilized by the company to finance its assets (Brigham & Ehrhardt, 2007). The current capital structure of ABC Gold Equipment comprises of equity only. The company’s total assets are recorded at \$10 million, and it has no liabilities. Therefore, the company’s total equity is also \$10 million. The total number of shares outstanding is 500,000 and the current price per share is \$27. It implies that the market capitalization of the company is \$13.5 million. The cost of equity is 11% that is also the cost of capital (WACC) used for project evaluation. The company is considering altering its capital structure by issuing debt bonds and buying back its shares. The cost of bonds is anticipated to be 9%. When the company issues bonds the existing shareholders expect a higher return on investment. Therefore, the cost of equity is expected to increase to 13%. The additional 2% compensates shareholders for the payments that the company will have to make to debt holders (Gulati & Singh, 2013).

When the company changes its capital structure to 75% equity and 25% debt the cost of capital changes. The cost of capital (WACC) is calculated by using the following formula.

WACC = [Equity/(Equity + Debt)] * Cost of Equity + [Debt/(Equity + Debt)] * Cost of Debt * (1-Tax Rate) (Pratt & Grabowski, 2010).

The levered firm has more risk than the unlevered firm. Therefore, the cost of capital of a levered firm is greater than that of an unlevered firm.

The value of the company is the sum of debt (D) and equity (E), and it is given as follows:

Value of Firm = Value of Debt + Value of Equity (Stowe, Robinson, & Pinto, 2008)

The main objective of companies to borrow is to receive a tax shield. The interest payments are deductible from the firm’s earnings. Therefore, firms prefer to take low-cost loan and adjust their earnings instead of paying a higher tax. The tax shield that firms receive is also considered in the calculation of the cost of capital. The cost of debt is adjusted by the effective marginal tax rate as follows.

Cost of Debt After Tax = Cost of Debt Before Tax x (1 – Tax Rate) (Brigham & Ehrhardt, 2007).

According to Miller and Modigliani’s Proposition I and II, the market value of any firm is not affected by the change in its capital structure. The reason is that the decrease in the cost of capital due to the low cost of debt is offset by the increase in the cost of equity. Therefore, the change in the cost of capital does not affect the value of firm when there is no corporation tax (Ghosh, 2012).

However, other theorists including Stiglitz (1969) and Altman (1984) challenged the assumption of no corporation tax that led Miller and Modigliani to change their assumption regarding the corporation tax. It was suggested that value of the levered firm is different from the value of unlevered firm because the interest payments are tax deductible. The financial risk added to the firm due to the external debt is compensated to shareholders in the form of higher cost of equity. Therefore, the value of the unlevered firm is adjusted by the tax shield received by the firm and the bankruptcy cost that could be incurred by the firm to determine the value of the levered firm (Baker & Martin, 2011).

## Memo

• Date: 18 June 2016
• To: Mr. Hillbrandt
• ABC Golf Equipment Corporation
• From: Finance Manager

## Sub: Changes in Capital Structure of ABC Golf Equipment Corporation

The purpose of this memo is to present findings related to the company’s plan to alter its capital structure by issuing bonds at 9% and buying back its shares at their market value. The findings include the effects of this decision on the company’s cost of capital, the value of the firm, earnings per share, and stock price. Furthermore, the analysis calculates times interest earned at each probability level.

## Value of Firm

The company is current unlevered with zero debt and 100% equity, and its effective tax rate is 35%. The proceeds from the issuance of bonds will be used to repurchase shares at their current market value. Therefore, the decision needs to be carefully analyzed to understand its implications on the firm’s value. The company’s earnings before interest and tax are \$3.88 million. In the current situation, the company’s value is \$22.927 million that is the value of equity. The cost of capital is represented by the cost of equity and is equal to 11%. The company’s plan to replace its equity by 25% of debt will have financial implications for the business. If the company issues bonds of \$4.5 million at 9%, then the company will have to make interest payments of \$0.405 million per year. The interest expense is deductible from the company’s earnings before tax is calculated. Therefore, it will provide a tax shield to the company. The company’s value after utilizing debt will be \$22.493 million, which is less than its current value. The value of equity will decrease from \$22.927 million to \$17.993 million.

## Cost of Capital

The utilization of debt will affect the cost of capital of the company. Although the cost of debt before adjusting for the tax is 9% that is lower than the cost of equity, the shareholders of the company will require a higher return on investment. It will increase the cost of equity to 13%. The adjusted weighted average cost of capital will be 11.21% that is higher than the current cost of capital that is 11%. The increase in the cost of capital is due to the increase in the cost of equity. Although the company can benefit from the low-cost debt, the high cost of equity makes it difficult for the company to keep its cost of capital low. The shareholders of the company anticipate financial risks associated with the company’s decision to issue bonds. The financial risks are because of the company’s inability to generate sufficient cash and earnings to pay interest on the borrowed amount. Also, there is a risk that the company may fail to repay the principal amount to debt holders, and it could face bankruptcy. It must be understood that the company will have to make interest payments to debt holders before any distribution could be made to shareholders. Therefore, the interest of shareholders in the company is affected by its decision to issue bonds. The shareholders may resist this decision. Therefore, the company’s management needs to hold a shareholders’ meeting to seek approval before issuing bonds in the market.

## Recapitalization

Recapitalization refers to the process of restructuring capital structure that is a combination of debt and equity. There are many reasons for recapitalization. In the case of ABC Golf Equipment Corporation, the decision to utilize debt is based on the tax advantage that the company will receive from deductions in its income statement. The utilization of debt affects the company’s earnings. It is highlighted that the company has to pay interest payments to its debt holders before any dividend can be paid to the shareholders. Moreover, the interest payments are deductible before tax is paid. Therefore, it could be noted that interest expense is deducted from earnings before interest and tax in the income statement to determine earnings before tax. The accounting treatment of interest expenses is important to understand as the company will be liable to make interest payments to debt holders under all circumstances and the firm needs to ensure that it has sufficient liquidity to meet its interest obligations each year.

## Times Interest Earned

It is crucial to assess the company’s ability to make interest payments in different scenarios. The times interest earned is a financial ratio that is calculated by dividing the operating income by the amount of interest paid by the company. In the case of ABC Golf Equipment Corporation, there are different estimations of earnings before interest and tax. There is a probability of 0.05 when the company generates negative earnings before interest and tax of \$1 million. In all other scenarios, the company generates sufficient operating income to cover its interest payments. It is an important indicator of the company’s ability to meet its obligations that must be fulfilled before any distribution of earnings to shareholders. The interest amount to be paid by the company provides a tax shield to the firm as it is deducted from the earnings before the tax is calculated. It implies that the company can invest funds borrowed and pay interest on them instead of paying high tax on its earnings. The company can have a substantial saving.

## Summary

It could be noted in the case of ABC Golf Equipment Corporation that the value of the unlevered firm is greater than the value of the levered firm. The difference in the value of both types of the firm is due to the increased cost of capital. The low cost of debt is not matched with the high cost of equity that has increased the cost of capital of the company. The value of equity decreased significantly, and the shareholders of ABC Golf Equipment Corporation would expect a higher return on investment. The management must understand the importance of interest obligations when issuing bonds in the debt market. The interest payments have to be made before any dividend can be paid to shareholders. The interest of shareholders is diluted, and they may resist the company’s decision to utilize debt. However, the management and shareholders of the company need to understand the advantages of utilizing debt including the economic benefits to be derived from debt. The analysis also indicates that the company generates sufficient operating income that will cover the interest payments. It is likely to face a low risk of default. Therefore, it is recommended that the company decides to utilize debt to change its capital structure.

## References

Altman, E. I. (1984). A Further Empirical Investigation of the Bankruptcy Cost Question. The Journal of Finance, 39, 1067–1089.

Brigham, E‎., & Erhardt, M. (2007). Financial Management: Theory & Practice. Boston: Cengage Learning.

Baker, ‎H. K., & Martin, G. S. (2011). Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice. Danvers, MA: John Wiley & Sons.

Ghosh, A. (2012). Capital Structure and Firm Performance. New Brunswick, New Jersey: Transaction Publishers.

Gulati, D., & Singh, Y. P. (2013). Financial Management. New Delhi, India: McGraw Hill Education (India) Pvt Ltd.

Pratt, ‎S. P., & Grabowski, R. J. (2010). Cost of Capital: Applications and Examples. Hoboken, New Jersey: John Wiley & Sons.

Stiglitz, J. E. (1969). A Re-Examination of the Modigliani-Miller Theorem. The American Economic Review , 59 (5), 784-793.

Stowe, ‎J. D., Robinson, T. R., & Pinto, ‎J. E. (2008). Equity Asset Valuation Workbook. Danvars, MA: John Wiley & Sons.

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BusinessEssay. (2022) 'Capital Structure and Dividends'. 15 October.

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