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Final Project I Milestone I

/in /by

Southern New Hampshire University

Final Project Milestone Two


The capital structure

The company capital structure composes of the equity and debt as sources of finance of the company. The most recent capital structure compose of the debt of $193,437, leases of 7,627, common stock of 31,251, common stock add in capital of $25,000  and retained earnings of $96,364. This capital structure amounts to $353,679. The weighted cost of capital that represents the percentage of compensation the company gives to the investors for risking to invest into the company is 12.6%. This also represents the cost of capital that is used in the computation of the cost of borrowing (Harris & Raviv, 2014).

When we categorize the components of the capital structure, we get that the total debt including the preferred stock and leases amounts to $201,064 which translates into a percentage proportion of 56.8%. On the other hand, the total equity of the company amounts to $152,615.0 which translates to 43.2%. The debt to equity ratio which measures the amount of debt that is used to finance the company assets is 1.3 meaning that most of the company assets are fundamentally financed by external borrowing. The debt to the capital ratio for the company is 0.6 and this stipulates that the company has a high debt capacity which further shows that the company’s financial leverage is high.

The company has been maintaining a constant dividend payout to the investors. In this type of the dividend policy, the company is said to have been keeping a certain percentage of retained earnings to be the respective investors as the dividends. The ratio has been remaining constant all through a number of years. Through this policy, the investors have been receiving an increase in the dividends given that the company net income generation has increased and conversely receiving a decrease in the dividends if at all the retained earnings have reduced significantly.

There exists a direct relationship between the capital structure and the cost of capital. Additionally, there is a direct relationship between the cost of capital and the risk level of the company. It can be seen that the company has a high debt level than the equity amount. Since it has been noted that the debt has a tax shield advantage, the effect has translated into lowering the cost of capital to as low as 12.6%. This therefore, means that a high debt level in the capital structure results into a low cost of capital (Miller & Modigliani, 2012). The low cost of capital of the company shows that the company has low risk and can therefore, borrow more debt due to good credit worthiness. The low risk level of the company further shows that the company is a good investment as more returns are anticipated to be generated in the near future due to high returns anticipated.

Valuation

It can be noted that the main objective of any company to exist is basically to maximize the shareholders wealth. To maximize the shareholders’ wealth, it is advisable that the company should consider using low cost of capital and high proportion of the equity amount in its capital structure. This will reduce the financial leverage of the company and on the other hand increase the required rate of return of the investors hence increasing their respective wealth.

The current market value of the company is approximately $2,193,403. The market value is high due to the anticipated increase in the net income of the company over the period forecasted. Nevertheless, the company has high cash flows being anticipated to be generated in the future.

Assumptions

The revenue was assumed to increase at a growth rate of 15% per year for the forecasted period of time. This is due to the probable increase in the production capacity of the company. It will be noted that the increase in the sales will not be pursuant to the increase in the price of the products sold but will be due to the increase in the units produced. 

The operating income of the company is assumed to be at the rate of 27.8%. This is due to a number of expenses that are related with the production and distribution of company products. The relationship between the company sales and the operating income will remain constant through the period of ten years. The net present value was computed by discounting the respective cash flows by a discount rate of 10%. This rate was relevant as it represents the average rate of discount to the medium risk companies in the industry.

The economic value addition of the company is $2,193,409, the net present value of the company at a discount rate of 5% is $1,069,401, at a discount rate of 10% is $755,291 while at a high risk of 18% is $457, 833. This shows that the higher the risk level, the lower the Net present value of the company can be (Shrieves & Wachowicz Jr, 2016). The internal rate of return equates the cash inflows to the initial capital outlay of the project. The internal rate of return for the company is 8.5% while the modified internal rate of return for the company is 8.549%.

References

Harris, M., & Raviv, A. (2014). The theory of capital structure. the Journal of Finance, 46(1), 297-355.

Miller, M. H., & Modigliani, F. (2012). Dividend policy, growth, and the valuation of shares. the Journal of Business, 34(4), 411-433.

Shrieves, R. E., & Wachowicz Jr, J. M. (2016). FREE CASH FLOW (FCF), ECONOMIC VALUE ADDED (EVA™), AND NET PRESENT VALUE (NPV):. A RECONCILIATION OF VARIATIONS OF DISCOUNTED-CASH-FLOW (DCF) VALUATION. The engineering economist, 46(1), 33-52.

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