Solutions to Assignments
IBO-06 - INTERNATIONAL BUSINESS FINANCE
Master of Commerce (M.Com) - 1st Year
Question No. 4
a) Discuss the factors that influence the design of world wide corporate capital structure.
Some of the major factors influencing capital structure are as follows: 1. Financial Leverage or Trading on Equity 2. Expected Cash Flows 3. Stability of Sales 4. Control over the Company 5. Flexibility of Financial Structure 6. Cost of Floating the Capital 7. Period of Financing 8. Market Conditions 9. Types of Investors 10. Legal Requirements.
1. Financial Leverage or Trading on Equity:
The word ‘equity’ denotes the ownership of the company. Trading on equity means taking advantage of equity share capital to borrowed funds on reasonable basis. It refers to the additional profits that equity shares earn because of funds raised by issuing other forms of securities, viz., preference shares and debentures. It is based on the premise that if the rate of interest on borrowed capital and the rate of dividend on preference capital are lower than the general rate of company’s earnings, the equity shareholders will get advantage in the form of additional profits. Thus, by adopting a judicious mix of long-term loans (debentures) and preference shares with equity shares, return on equity shares can be maximized.
Trading on equity is possible under the following conditions:
(i) The rate of company’s earnings is higher than the rate of interest on debentures and the rate of dividend on preference shares.
(ii) The company’s earnings are stable and regular to afford payment of interest on debentures.
(iii) The company has sufficient assets which can be used as security to raise borrowed funds.
2. Expected Cash Flows:
Debentures and preference shares are often redeemable, i.e., they are to be paid back after their maturity. The expected cash flows over the years must be sufficient to meet the interest liability on debentures every year and also to return the maturity amount at the end of the term of debentures. Thus, debentures are not suitable for those companies which are likely to have irregular cash flows in future.
3. Stability of Sales:
Stability of sales turnover enhances the company’s ability to pay interest on debentures. If sales are rising, the company can use more of debt capital as it would be in a position to pay interest. But if sales are unstable or declining, it would not be advisable to employ additional debt capital.
4. Control over the Company:
The control of a company is entrusted to the Board of Directors elected by the equity shareholders. If the board of directors and shareholders of a company wish to retain control over the company in their hands, they may not allow to issue further equity shares to the public. In such a case, more funds can be raised by issuing preference shares and debentures.
5. Flexibility of Financial Structure:
A good financial structure should be flexible enough to have scope for expansion or contraction of capitalisation whenever the need arises. In order to bring flexibility, those securities should be issued which can be paid off after a number of years. Equity shares cannot be paid off during the life time of a company. But redeemable preference shares and debentures can be paid off whenever the company feels necessary. They provide elasticity in the financial plan.
6. Cost of Floating the Capital:
Cost of raising finance by tapping various sources of finance should be estimated carefully to decide which of the alternatives is the cheapest. Prevailing rate of interest, rate of return expected by the prospective investors, and administrative expenses are the various factors which affect the cost of financing. Generally, cost of financing by issuing debentures and preference shares for a reputed company is low. It is also essential to consider the floatation costs involved in the issue of shares and debentures, such as printing of prospectus, advertisement, etc.
7. Period of Financing:
When funds are required for permanent investment in a company, equity share capital is preferred. But when funds are required to finance expansion programme and the management of the company feels that it will be able to redeem the funds within the life-time of the company, it may issue redeemable preference shares and debentures.
8. Market Conditions:
The conditions prevailing in the capital market influence the determination of the securities to be issued. For instance, during depression, people do not like to take risk and so are not interested in equity shares. But during boom, investors are ready to take risk and invest in equity shares. Therefore, debentures and preference shares which carry a fixed rate of return may be marketed more easily during the periods of low activity.
9. Types of Investors:
The capital structure is influenced by the likings of the potential investors. Therefore, securities of different kinds and varying denominations are issued to meet the requirements of the prospective investors. Equity shares are issued to attract the people who can take the risk of investment in the company. Debentures and preference shares are issued to attract those people who prefer safety of investment and certainty of return on investment.
10. Legal Requirements:
The structure of capital of a company is also influenced by the statutory requirements. For instance, banking companies have been prohibited by the Banking Regulation Act to issue any type of securities except equity shares.
b) Describe adjusted present value method?
The adjusted present value is the net present value (NPV) of a project or company if financed solely by equity plus the present value (PV) of any financing benefits, which are the additional effects of debt. By taking into account financing benefits, APV includes tax shields such as those provided by deductible interest.
The Formula for APV Is:
Adjusted Present Value = Unlevered Firm Value + NE
where:
NE = Net effect of debt
The net effect of debt includes tax benefits that are created when the interest on a company's debt is tax-deductible. This benefit is calculated as the interest expense times the tax rate, and it only applies to one year of interest and tax. The present value of the interest tax shield is therefore calculated as: (tax rate * debt load * interest rate) / interest rate.
How to Calculate Adjusted Present Value (APV)
To determine the adjusted present value:
- Find the value of the un-levered firm.
- Calculate the net value of debt financing.
- Sum the value of the un-levered project or company and the net value of the debt financing.
The adjusted present value helps to show an investor the benefits of tax shields resulting from one or more tax deductions of interest payments or a subsidized loan at below-market rates. For leveraged transactions, APV is preferred. In particular, leveraged buyout situations are the most effective situations in which to use the adjusted present value methodology.
The value of a debt-financed project can be higher than just an equity-financed project, as the cost of capital falls when leverage is used. Using debt can actually turn a negative NPV project into one that’s positive. NPV uses the weighted average cost of capital as the discount rate, while APV uses the cost of equity as the discount rate.
Example of How to Use Adjusted Present Value (APV)
In a financial projection where a base-case NPV is calculated, the sum of the present value of the interest tax shield is added to obtain the adjusted present value.
For example, assume a multi-year projection calculation finds that the present value of Company ABC’s free cash flow (FCF) plus terminal value is $100,000. The tax rate for the company is 30% and the interest rate is 7%. Its $50,000 debt load has an interest tax shield of $15,000, or ($50,000 * 30% * 7%) / 7%. Thus, the adjusted present value is $115,000, or $100,000 + $15,000.
The Difference Between APV and Discounted Cash Flow (DCF)
While the adjusted present value method is similar to the discounted cash flow (DCF) methodology, adjusted present cash flow does not capture taxes or other financing effects in a weighted average cost of capital (WACC) or other adjusted discount rates. Unlike WACC used in discounted cash flow, the adjusted present value seeks to value the effects of the cost of equity and cost of debt separately. The adjusted present value isn’t as prevalent as the discounted cash flow method.
Limitations of Using Adjusted Present Value (APV)
In practice, the adjusted present value is not used as much as the discounted cash flow method. It is more of an academic calculation but is often considered to result in more accurate valuations.
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