Competition Bikes, Inc.: Financial Analysis

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Capital structure

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Competition Bikes, Inc has an opportunity to expand its operations in Canada and thus it is better to evaluate Competition Bikes’ financial position and ensure that the firm is using the best option to fund the proposed expansion. The firm has six options available to deal with this expansion; these options are considered as the best on grounds of the current situation accompanied by the present market conditions. The main objective of the capital structure analysis is to locate the $600,000 amount needed to fund the project within the timeline of 5 years that is from the 9th year to the 13th year. The options available are as follows;

1 Bank loan at 6% requiring a compensating balance of $150,000 (receiving 1%)
2 Wholly financed by 9% bonds for 5 years
3 5%, $50 par, preferred stock and common stock with equal proportion (50%)
4 9% bonds for 5 years and common stock with a proportion of 20% and 80% respectively
5 9% bonds for 5 years and common stock with a proportion of 40% and 60% respectively
6 9% bonds for 5 years and common stock with a proportion of 60% and 40% respectively

Each of the above alternatives has disadvantages and benefits, and I will analyze each one of them as follows.

Option 1

Some creditors or banks require compensating balances as stipulations to the firm for extension of the loan or credit by the bank since the firm is required to increase or maintain a certain deposit balance. The nature and the total amount required as a deposit varies from one arrangement to the other and most of the time the borrowing firm receives low rates on the amount deposited. The main aim of this type of arrangement by the bank is to offer security and worthiness to the credit and also to increase returns to the bank as a result of differences between loan rates and deposits (Stuber and Kinkel, 1985).

In this case, Competition Bikes is to receive 1% per annum as returns with a requirement of $150,000 as deposit balance. Based on the Time Value of Money this means that it is worth investing in other projects that would return more earnings than meeting the bank’s minimum requirement as a stipulation for the loan extension. From now on, option 1 is removed since it does not add any value and I will concentrate on the remaining options as we know for a firm to achieve an optimal capital structure that will maximize shareholder’s value it must combine equity and debt.

Option 2

Theoretically, debt funding commonly provides the least cost of capital as a result of tax deductibility. But it is hardly the optimal capital structure since the firm’s risk usually rises as debt rises. High leverage maximizes the EPS but it also raises risk. From the calculation given it is evident that this option gives the highest EPS and it also raises risk due to 100% debt financing. Therefore, a higher stock price cannot be attained by maximizing the EPS. An optimal capital structure normally consists of debt but should not be 100% debt, therefore this option cannot offer the optimal capital structure.

Also from Table 2 (Low-demand) and 3 (Moderate-demand), use of 100% debt yield the highest WACC of 83.91% and 61.41% respectively compared with the other options (3, 4, 5 and 6). The increase in the cost of capital is a result of high cost of equity as well as the cost of debt; cost of equity depends on the required return rate on the company’s asset, cost of debt as well as debt-equity ratio. The firm’s debt-equity ratio will be increased if the firm uses 100% debt this means that the risk to equity and thus the required return on the cost of equity will increase. Higher cost of debt will put owners’ capital at risk and thus shareholders will demand high returns thus increasing WACC and that is the reason why this option will yield high cost of capital.

This option also gives the highest firm’s value when leverage is included based on the MM’s (1963) model that included corporate taxes, which says that the value of a levered firm is equal to the value of an unlevered firm plus the value of the tax shield (Sherman, 1997). The value of tax shield will be high due to the use of more debt thus increasing the firm’s value to the advantage of the shareholders but still the risk is very high and shareholders would not go for this as a result of increased bankruptcy costs which will arise if the firm fails to meet its long-term obligations and as a result reduce the firm’s value.

Option 3

This option gives the least WACC of 16.01% and 15.15% for low and moderate demand respectively. Therefore, this capital structure will have the minimal cost of capital and thus it will maximize the market value of firm’s stock but it will not maximize EPS this means that the firm’s stock price will attain its highest point because the share price is not increased by maximizing EPS. The firm’s value will be increased as shown in Tables 2 and 3, compared with other options (4, 5 and 6); this option gives the highest firm’s value, lowest WACC, and also the highest EPS. Therefore, it increases the shareholders’ value.

Option 4

Option 4 offers the second-best option in terms of WACC since it will be at 27.45% and 22.95% for low and high demand respectively and EPS but the firm’s value will be lower than options 5 and 6. Shareholders in this option will demand lower returns as a result of low risk occasioned by the use of less debt and that is why cost of equity is very low compared to all other options. Therefore, we can say that the use of debt increases the firm’s value due to the value of the tax shield which is added to the firm’s value when it is not levered. The management should thus make use of debt in order to increase the shareholders’ value.

Option 5

In terms of WACC, this option is the third best and the firm’s value will be higher than option 4 because the firm will have more debt compared to option 4. This is a result of the higher value of the tax shield. But as debt increases the shareholders’ capital is exposed to high risk and owners will demand higher returns and that is why the cost of equity is high which eventually increases the WACC.

Option 6

As a result of the high use of debt the firm’s debt-equity (60%/40% = 1.5) will increase and thus the firm will be facing financial risk. The increase in risk increases the cost of equity which eventually increases the WACC. If the firm will fail to meet its long-term obligations then it will have to pay bankruptcy cost to be declared bankrupt these cost reduces the value of the firm. Assuming that it will meet the long-term obligations therefore the firm’s value will be higher than option 5 which has lower debt. This option also gives the second-best firm’s value compared to other options but the risk will still be high.

EBIT-EPS can also be used to determine optimal capital structure; the effect of the options on EPS. The main aim is to discover the EBIT level that EPS will not change (EBIT Breakeven). Based on the EBIT-EPS analysis shown in Table 4 option 3 gives the highest EPS i.e. option three is the EBIT breakeven and if implemented it will produce the highest EPS. Generally, using debt will generate higher EPS where the EBIT will be greater than EBIT Breakeven. Utilizing less debt will generate higher EPS where the EBIT will be below EBIT Breakeven. Therefore, option 3 will minimize the WACC, maximize the EPS and still manage financial risks within tolerable ranges. Therefore, Competition Bikes, Inc’s optimal capital structure that will maximize shareholders’ returns is that which has 5%, Preferred stock of $50 par and common stock in equal proportion of 50% (Option 3).

Capital budgeting

When making a capital budgeting decision the firm must consider risk, replacement, inflation, and closure which mostly help in determining the best option when using valuation techniques like NPV and IRR (Newbould and Carroll, 1986).

IRR and NPV at times lead to incompatible decisions in evaluation of the mutually exclusive investments. The major reason for this possible issue is the cash flows timing of the investments (Stolze, 1997).

The major concern for capital budgeting is the capital structure the firm is going to use therefore the firm should use an optimal capital structure that minimizes WACC. This is because WACC is normally used to discount the cash flows during the determination of the NPV. The calculation uses a hurdle rate of 10% to discount future cash flows; the 10% is the cost of funds used to finance the project. The discount rate (10%) is normally deemed to be consistent with yield-to-maturity on the bond even if the future is uncertain and may lead to incorrect cash flows and normally superior rates are evaluated when cash flows are withdrawn for a larger time period. Although consistent discounting rates may be utilized to produce correct NPV, finance literature has a tendency of simplifying the assessment process through the use of constant discount rates rather than a dynamic one. This oversimplification of the assessment process is disingenuous since it disregards the concept that future cash flows are uncertain and the anticipated cash flows in the distant future are normally more uncertain compared to near cash flows. Therefore, the firm should use different hurdle rates after maybe two years. Similarly, IRR uses cash flows to determine the rate of return and it may be affected by the incorrect cash flows projection as a result of risk affecting the firm but the risk has been taken care of by considering low and moderate demand situations.

Based on the calculation, during periods of low-demand and moderate demand the project will lead to a negative and positive NPV respectively while based on IRR, low-demand and moderate-demand will have 8.2% and 10.4% respectively. Generally, a project is accepted if it has a positive NPV and rejected if it has a negative NPV while using IRR a project is accepted when it is higher than the hurdle rate. In this case we have only one project which is being affected by fluctuations in cash flows. The more constant is the demand for a company’s products, the lesser the business risk. Considering that the firm will be operating in different nations it will be able to diversify these business risks assuming that there will be no international recession, thus this diversification will reduce demand inconsistency. The company’s sales will not vary widely, and then the capability to pay fixed costs and firm’s cash flows will also not vary widely. This means that the firm’s sales will be somewhat secure. Therefore, the NPV will not vary much with the calculated ones same case with IRR. This means that the New Canadian Plant should be undertaken since during moderate risk the NPV is positive and IRR is higher than the hurdle rate and in case of high demand the NPV will still be positive and IRR will be higher than 10%.

Raising working capital

The firm may have excess net current assets (positive working capital) this means that the firm is very successful and may use the excess current assets over current liabilities to finance the expansion. Thus they may use the excess inventory, cash, prepayments as well as short-term loans; excess net current assets show that the firm is able to meet its short-term obligations. Thus, a firm is said to be exposed to liquidity risk if it is not able to pay short-term obligations on time and this may lead to loss of confidence from the creditors’ point of view. Thus, firm needs to manage such assets in what is known as working capital management (Investingaswers.com, 2010).

The firm can manage account receivables by making sure that the debtors pay on time this is through the use of credit management policy in that the firm may opt to give discounts to debtors who pay on time and penalize those who pay late. The company should not pay its bills in advance this is because the amount paid may be used in other types of investments to earn returns; marketable securities like treasury bills. Sometimes the firm may have excess cash which should be used wisely and avoid keeping idle cash, this idle cash may be invested in short-range marketable securities. The firm may also increase the amount of inventory it keeps this is by manufacturing more of the bikes and keeping them as inventory but these inventories should be managed wisely through the use of inventory management techniques like LIFO and FIFO.

These inventories may also be sold on account to customers but this will not have an effect on the current assets but will increase the total amount of liquid current assets. On the other hand, the firm may use an overdraft facility if it does not have enough current assets the firm should be able to negotiate for the overdraft facility or short-term loan (Investingaswers.com, 2010).

The company should comprehend the timing of payments, collection policies, purchases and the possibility of writing-off bad debt as they can produce varying needs for working capital for the same firms. Working capital requirements are different for each industry and looking for methods of smoothing out payments to maintain working capital constant is specifically hard for manufacturers as they require huge amounts of initial costs. Therefore, Competition Bikes should compare its working capital within similar industries in Canada and define the ‘low” or “high” ratio in this circumstance (Investingaswers.com, 2010).

Merger or Acquisition

To build a new plant the firm will incur $400,000 as capital expenditure and it will take longer for the firm to start earning income thus this is not a better option. The firm can also buy the Canadian Biking facility at $400,000. Under purchase decision, the firm will use the loan from the bank to fund the outright purchase and the NPV of the loan payments is $333,999. Comparing the purchase decision NPV with the lease decision NPV, which has a lower NPV of $321,660, the firm’s decision should be the leasing option because the NPV difference is negative as shown below;

  • NPV∆= NPV of loan payments under outright purchase – outright purchase – NPV lease option
  • NPV∆= $333,999 – $400,000 – $321,660
  • NPV∆= -$387,661

The negative NPV shows that leasing is favorable to the outright purchase. Therefore, in this case, a very huge variation exists between buying outright and leasing the Canadian Bikes facility.

References

Investingaswers.com. (2010). Working capital. Web.

Newbould, G. and Carroll, J. (1986). Inflation, risk, replacement, closure: concerns in capital budgeting. Journal of Healthcare Financial Management, 40(12): 64-8.

Sherman, A. (1997). The Complete Guide to Running and Growing Your Business. New York: Times Business.

Stolze, W. (1997). Start Up Financing: An Entrepreneur’s Guide to Financing a New or Growing Business. Franklin Lakes, NJ: Career Press.

Stuber, M. and Kinkel, J., (1985). Administrative interpretation no. 3.107-8501. Web.

Appendix

Table 1: EBIT and unlevered firm value

EBIT Market Value of unlevered firm Vu ((EBIT (1 -0.25)/WACC (10%))
Year Low Moderate Low Moderate
9 74,816 109,816 561,120 823,620
10 84,714 128,814 635,355 966,105
11 94,501 148,160 708,758 1,111,200
12 106,872 169,568 801,540 1,271,760
13 109,200 181,546 819,000 1,361,595

Table 2: Low-demand (WACC and firm’s value)

Low (Year 9)
Option 2 Option 3 Option 4 Option 5 Option 6
The market value of common stock – 38,880 261,120 441,120 321,120 201,120
Cost of equity – 0.54 0.29 0.15 0.17 0.21
Cost of debt 0.75 0 0.75 0.75 0.75
Cost of preferred stock 0 0.05 0 0 0
WACC 83.91% 16.01% 27.45% 50.01% 55.68%
Market Value of levered firm (Vu +(0.25*debt) 711120 636120 591120 621120 651120

Table 3: Moderate-demand (WACC and firm’s value)

Moderate (Year 9)
Option 2 Option 3 Option 4 Option 5 Option 6
Market value of common stock 223,620 523,620 703,620 583,620 463,620
Cost of equity 0.25 0.21 0.14 0.15 0.17
Cost of debt 0.75 0 0.75 0.75 0.75
Cost of preferred stock 0 0.05 0 0 0
WACC 61.41% 15.15% 22.95% 57.55% 42.18%
Market Value of levered firm (Vu +(0.25*debt) 973620 898620 853620 883620 913620

Table 4: EBIT-EPS analysis

EPS (Moderate-demand)
Option 2 Option 3 Option 4 Option 5 Option 6
No. of shares after the plan 975000 1275000 1455000 1335000 1215000
EPS =(EBIT – interest) x (1-t)/no. of shares 0.043 0.065 0.051 0.050 0.048
EPS (low-demand)
Option 2 Option 3 Option 4 Option 5 Option 6
No. of shares after the plan 975000 1275000 1455000 1335000 1215000
EPS =(EBIT – interest) x (1-t)/no. of shares 0.016 0.044 0.033 0.030 0.026

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