Companies use various methods to raise capital from different sources of financing. The most common sources of financing are the equity and debt financing. Most companies mix sources of finance to come up with a capital structure that is ideal for them. Such companies incur some costs in order to acquire finances from different sources or instruments. However, the companies always face a challenge in determining the optimal debt/equity ratio. This report will identify and analyze some of the financial components of the three companies, that is, EBay, Clorox, and Darden Restaurants Inc, and determine the optimal financial structure of the company. From this analysis, the report will determine some of the advantages of using debt to finance the organization over the use of equity.
EBay is an American multinational corporation that manages the eBay.com, an online auction and shopping website for the businesses and people who buy and sell goods and services worldwide (Yahoo Canada Finance, 2012a). It provides online platforms and tools that enable individuals and businesses to make online payments in both the United States and the rest of the world. It also has several shopping sites, classified sites and advertising services.
EBay’s current assets for the previous financial period that ended 30th December 2011 totaled to US$12,661,454,000. On the hand, the total long-term assets totaled to USD14, 658,764,000 and the total company assets stood at US$ 27,320,218,000 (Yahoo Canada Finance, 2012a). The current liabilities of eBay for the previous financial year that ended on 30th December 2011 were US$ 6,734,204,000 and the total long term liabilities were at US$ 2,656,135,000.
EBay’s market capitalization in the previous financial year that ended on 30th December 2011 was at a total of US$11,651,654,000 which was much high than the preceding financial periods (Yahoo Canada Finance, 2012a). The company’s total debt/equity ratio for the latest full quarter ending March 2012 was at 0.11. However, the long term debt to capital ratio was at 0.08. The company’s revenue margin for the same period was as follows; gross profit margin was 75.9%, the EBIT margin was at 32.7%, the EBITDA was at 28.2% and Pre-Tax margin was at 32.5%. The company’s return on assets for the latest full quarter was 11.8% and return on equity capital was at 16.4% (Forbes 2012).
The company’s current beta is at 1.01 and this implies that the company stocks are slightly riskier but they provide higher returns and the security of the company will turn 1.01 times that of the market return (Forbes, 2012) One of the reasons why the company has a beta which is slight higher than that of the market is its high debt/equity ratio. However, the company generally is not that risky to invest in.
Clorox Company is a US based manufacturing firm that produces a variety of food and chemical products. The company manufactures and markets consumer and institutional products worldwide and operates in four segments such as cleaning, lifestyle, household and international product segments (Yahoo Canada Finance, 2012b).
The Clorox Company total current assets for the financial year ending 29th June 2011were US$ 1,279,000,000 and the total long-term assets were US$ 2,884,000,000. The total current liabilities for the company were US$ 1,365,000,000 and the total long term liabilities were at US$ 2,884,000,000. Clorox Company also had total revenue of US$ 5,231,000,000 for financial period that ended on 30th June 2011. There was a slight drop in revenues compared to the previous period that ended on 30th June 2010. The debt equity ratio was at approximately 20.0 (Yahoo Canada Finance, 2012b)
The company’s gross profit margin for the latest quarter that ended March 2012 was at 42.33% slightly higher than the previous quarter that ended December 2011 (Forbes, 2012). However, the gross margin for the financial year ending June 2011 was 43.5% and the operating margin was at 12.6%. Its return on assets for the same period was at 12.78% and there was a slight drop from the previous quarter that ended in December 2011 which was 13.38%. The company’s return on equity for the period that ended 30th September 2011 was at 1.48K%.
The company’s latest beta is 0.46; the beta for the company is below that of the market. This implies that the company’s stocks are less risky compared to the market and the returns are also low (Forbes, 2012). Those who invest in the company’s stock will incur fewer risks but generate lower returns.
Darden Restaurants Inc
Darden Restaurants, Inc is a Multi-brand restaurant operator that operates several restaurants in the United States and Canada. The company operates its restaurants under different brand names such as Red Lobster, Olive Garden, Steakhouse, Bahama Breeze, Capital Grille, LongHorn and Season 52 (Yahoo Canada Finance, 2012c). The company by February 2012 operated approximately 1900 restaurants and its headquarters is in Orlando, Florida.
Darden Restaurant Inc’s total current assets for the financial year ending 28th May 2011 were US$ 663,800,000 and the total long-term assets for the same period was at US$ 4,802,800,000 (Forbes, 2012). The total current liabilities were US$ 1,286,800,000 and the total long term liabilities were US$ 2,243,600,000.
Darden Restaurant Inc had total revenue of US$ 7,500,200,000 for period that ended on 28th May 2011. It had an increase compared to the financial years of the previous monetary periods. The company had a return on asset of 8.01 according to the data released by February 2012 and the return on equity was at 25.02%. The return on Capital was at 12.12%. The gross margin stood at 22.91% and EBITDA margin was at 13.37%. The data also shows that the company has total debt/equity ratio of 122.8 (Forbes, 2012).
The current beta factor of Darden Restaurant Inc is 0.86 and this implies that the company is slightly less risky than as compared to the market or industry risk. It also implies that the returns are also slight lower than that of the industry. The investors who invest in the company stock are likely to incur fewer risks and generate fewer returns.
Use of Bond in Financing the Firm
The bond financing is where the borrower obtains finance against a security and obligates the borrower to pay an interest on the amount of the loan (Choudhry, 2004). The principal, which the borrower is given by the lender, is paid in full at the maturity date. However, before the bond or debt matures, the borrower has to pay the periodic interest also known as coupon. In cases where the borrower is not creditworthy, the borrower will pay the lender or the bond holder a higher yield to obtain the bond (Choudhry, 2004).
Advantages of Debt Financing Over Equity Financing
The company that uses debt finance benefits a lot as the lenders or the owner of the debt capital does not have any claim over the equity that exists in the business. This implies that the ownership of the company will not be diluted (Brigham & Houston 2009).
The lender is also only entitled to principal amount that has been lent and the interest agreed upon. In cases where the company generates larger profits, the owners normally get a huge share of the profits (Shakespeare, 2011). The companies that use debt financing can plan for the loans that they use to finance the business. To raise debt capital is easier as the company does not have to comply with some of the state and federal regulations (Shakespeare, 2011). The company avoids incurring a lot of costs such as costs on communicating to a large number of shareholders.
Disadvantages of Debt Financing Over Equity Financing
When the company uses debt to finance its operations, it has to pay the interest unlike in cases where it uses equity debt (Shakespeare, 2011). When the company uses equity finance, it may sometimes avoid paying the dividends and reinvest the earnings. The interest rate is often fixed and it raises the company’s break even points and this can sometimes increase its risk of insolvency (Brigham & Houston 2009).
In cases where the company uses debt finance, it will be restricted from undertaking some operations due to some agreements that have taken place between the lenders and the company. For example, the management may be restricted from disposing some of the assets of the company to secure the loans (Shakespeare, 2011). When the company uses more debts than equity, it is considered more risky by the investors and this can lower its stock values.
Optimal Capital Structure
Companies are considered to have an optimal capital structure when the ratio of debt to equity maximizes the value of the firm (Brigham & Houston, 2009; Harvey, 1995). The company has to balance between the use of debt finance and equity finance such that it is able to minimize the cost of capital. The cost of debt capital is normally lower but debt capital normally increases the risk that is associated with the company (Shakespeare, 2011). Therefore, an optimal capital structure requires the company to use both the debt and equity capital in a proportion that will lower the cost of capital.
The companies have to do thorough financial analysis in order to be able to determine the optimal structure of the firm. They should ensure that the kind of financing used lowers the cost of funding and that it maximizes the value of the firm. The proportion of debt to equity should maximize the value of the firm.
Brigham, E. F., & Houston, J. F. (2009). Fundamentals of financial management. Mason, OH: South Western Cengage Learning.
Choudhry, M. (2004). Fixed income markets: Instruments, applications, mathematics. Clementi Loop: Wiley & Sons Ltd.
Forbes. (2012). EBay Inc (NASDAQ:EBAY): Ratios and Returns. Web.
Harvey, C. R. (1995). Capital structure and payout policies. Web.
Shakespeare, K. (2011). Trade for good – the essential guide to business and finance in UK and international trade. Herts, AL: Ecademy Press.
Yahoo Canada Finance. (2012a). EBay profile: eBay Inc stock. Web.
Yahoo Canada Finance. (2012b). The Clorox Company (CLX): Profile. Web.
Yahoo Canada Finance. (2012c). Darden Restaurants, Inc. (DRI): Profile. Web.