The company may be faced with the need to raise finances from time to time based on the prevailing circumstances. The finances can be accessed through various channels, including banks, financial markets, and investors. The sources of finances are broadly categorized as either equity or debt. Equity constitutes finances sourced mainly through selling a share of the company to investors (Asai, 2021). The company is not obligated to pay back the finances; however, investors expect their funds to grow in value.
The company may also choose to reward the investors by paying dividends to the shareholders. Preference shareholders are mainly interested in the dividends and are therefore given priority in paying the dividends. On the other hand, common shareholders are interested in owning a share of the company and have the right to be considered first when the company is being liquidated (Miglo, 2020). Debt entails finances that are sourced in terms of loans from banks or other financial institutions. The company is expected to pay interest on the amount borrowed in agreed-upon intervals as well as the principal once the loan matures.
The company may engage one or more of the various sources of finances it can be able to access to meet its overall financial necessity. Therefore, the overall amount of capital needed by the company may constitute equity sources and debt sources. Capital, in this case, mainly refers to the long-term sources of finances that the company would prefer, including loans. Capital is therefore sourced depending on the weighting preferred by the company. The capital structure is the constitution of debt and equity in the total capital of a company (Asai, 2021). Capital structure, also referred to as the capital stack, denotes the company’s proportion of debt against the shareholder’s equity.
The case presented by the FCMG Company entails increasing the amount of capital from $500,000 to $1,000,000 both through debt and equity. It is important to consider a proper balance between the two sources based on the company’s current situation. Also, the overall debt-to-equity composition should be considered because an increase in capital will interfere with the current composition. Three scenarios are likely to happen; the debt-to-equity ratio can go up or down or remain the same.
In assessing the appropriate capital structure for the company, the following scenarios are assessed in order to find their effect on the EPS and, therefore, the value of the company. The analysis is based on the assumption that the existing capital constitutes equity only; therefore, interest paid is $0. The current number of shares is $50. Therefore there are 10,000 shares. New shares are issued at the same price. The net income is $50,000, and the interest rate for new debt is 10%. The analysis is presented in three scenarios:
Table 1: Scenario 1 of the New Capital Structure
The first scenario represents a balanced proportion for both equity and debt for the additional capital; both debt and equity are equal to $250,000. In this case, the overall debt-to-equity ratio is 0.33. As indicated in Table 1 above, the first scenario leads to an increase in the EPS from $5 to $6.5.
Table 2: Scenario 2 of the New Capital Structure
The second scenario represents a scenario where the amount of debt acquired is less than the new equity issued in obtaining the additional capital required. The debt component is $200,000, while the equity component is $300,000. Therefore, the overall debt-to-equity ratio is 0.25. As indicated in Table 2 above, the second scenario leads to an increase in the EPS from $5 to $6.39.
Table 3: Scenario 3 of the New Capital Structure
The third scenario represents a scenario where the amount of debt acquired is more than the new equity issued in obtaining the additional capital required. The debt component is $300,000, while the equity component is $200,000. Therefore, the overall debt-to-equity ratio is 0.43. As indicated in Table 3 above, the third scenario leads to an increase in the EPS from $5 to $6.92.
Appropriate Capital Structure
The results in Tables 1, 2, and 3 above show the impact of different capital structure on the firm value (through the EPS), as well as the profitability of the firm. The first scenario can be considered as the base case of evaluation. Under the second scenario, the company chooses to engage more equity capital of $300,000 and borrows a lesser amount of $200,000. Under this scenario, the debt-to-equity ratio is 0.25. Compared to the base scenario, the ratio has gone down from 0.33 found in the first scenario to 0.25. Therefore, acquiring lesser debt will reduce the debt-to-equity ratio. In addition, the company will also have to pay less interest. In the first scenario, the interest paid was $2,500 that went down to $2,000 in the second scenario. The EPS went down from $6.5 to $6.39. This reflects a fall in the value for the company, but profitability increased from $97,500 to $98,000.
Under the third scenario, the company chooses to engage lesser equity capital of $200,000 and borrow more money, $300,000. Under this scenario, the debt-to-equity ratio is 0.43. Compared to the base scenario, the ratio has gone up from 0.33 found in the first scenario to 0.43. Therefore, acquiring more debt will increase the debt-to-equity ratio. In addition, the company will also have to pay more interest. In the first scenario, the interest paid is $2,500 that went up to $3,000 in the third scenario. Also, the EPS went up from $6.5 to $6.93. This reflects an increase in value for the company, but profitability declined from $97,500 to $97,000.
The company needs to choose between higher debt and lower debt. Acquiring higher debt will increase the debt-to-equity ratio as illustrated; also, less debt will reduce the debt-to-equity ratio. The company will also have to pay either higher or lower interest. However, higher debt is preferable if the company is expected to generate sufficient income in order to pay the interest requirement (Miglo, 2020). More debt will also lead to higher earnings per share (EPS) since interest paid on debt is tax-deductible. A higher EPS leads to an increase in the price of shares since it is associated with a higher firm value. However, too much debt in the capital structure will lead to a higher financial risk in case of default in payments. The high debt will also lead to a higher cost of capital that would cause the share price of the company to be depressed.
On the other hand, a higher cost of capital will affect the profitability of the company. The cost of capital and profitability are inversely related; if the cost of capital goes up, profitability will go down, and the reverse is true. The goal is to have an optimal capital structure that strikes a balance between the cost of capital and the value of the firm. There is no formula for determining the appropriate or sound capital structure for any company, either in theory or practice. The best alternative is to have an optimum capital structure that constitutes the minimum overall cost of capital for the company and capitalizes the value of the company (Asai, 2021). The company should aim to reach and maintain the optimum capital structure keeping in mind the value maximization objective of the company.
Debt vs Equity in Raising Additional $200,000
The additional $200,000 that the company seeks to acquire will certainly affect the existing capital structure. There is a need to consider the effect of the additional funding on the debt-to-equity ratio. However, the overall target is to have a capital structure at the lowest cost of capital, and that offers higher value for the company. To achieve a sound capital structure, the additional funding must constitute a sensible combination of debt capital and equity capital. In general, debt capital is the ideal form of capital than equity. The main reason for preferring debt is because it is economical (Asai, 2021). The company is allowed to subtract interest payments from the income generated when working out the amount for tax. Moreover, the cost of debt is usually lower than the cost of equity.
On the other hand, equity capital is money sourced from shareholders. The shareholders have an expectation from the company that they will be paid dividends. Dividends involve dividing the net income generated from company activities to the shareholders. Therefore, dividend payments denote an appropriation of profit. Dividend payments are, however, not deductible when computing the taxable income, which is a disadvantage for the company. Moreover, equity has a higher cost compared to the cost of debt. It is riskier to buy a company’s stock due to constant price variability (Miglo, 2020). The investors will need to be compensated through higher returns and can influence decision-making within the company.
Even though the debt is preferable, it will cause the company’s profitability to decrease. Such a negative correlation between debt and profitability may not be beneficial to the company. Another key problem with debt is when the company takes in a lot of borrowed funds such that it will have to pay more in interest payments. Higher debt may also lead to higher chances of defaulting to pay back the debt (Asai, 2021). Nonetheless, if the company is able to acquire more debt that can have a positive effect on profitability, the decision to acquire more debt will be considered advantageous to the company.
References
Asai, K. (2021). Corporate finance and capital structure: A theoretical introduction. Routledge
Miglo, A. (2020). A new capital structure theory: The four-factor model. Wiley Publishers.