The capital structure of any company is a very important factor that the managers of any organization are expected to manage. Capital structure generally determines the value of the firm in combination with other factors (Moyer, 47). Capital involves a cost to a company and therefore proper management of capital is necessary to ensure that the cost of capital of an organization is not too high. Texas industries Inc is a company found in the United States. This research paper will evaluate the capital structure of the company and recommend how it can change the capital structure if need be to ensure that the cost of capital are as low as possible. In addition, the research will analyze how the capital structure of the company can be manipulated to ensure that the value of the company is high.
There are various sources of capital that is usually used by any company. First, a company can use shares to finance the investments of the company. The cost of the share capital is the costs involved in the sale of the shares and the dividends that are paid to the shareholder every year. The advantage of this source is that it is not an obligation of the company to pay the shares every year. If there are no funds to do so, the company may fail to pay the shares (Grant, 78). The other source of capital is the preference shares. These shares receive a fixed rate of dividends. The shares may demand payment of dividends whether the company makes profits or not. However, the advantage of using the shares is that the company may fail to pay these shares if there are no funds to do so. However, there might be a requirement to pay for the shares due dividends to the preference shares in future years.
Another source of capital for the company is debentures. This is a loan to the public that carries fixed interest rate. In this source of capital, the interest must be paid for whether the company makes profit or not. This is a risky source of capital since failure to pay interest and the amount due can lead to liquidation of the company. The advantage of using this source of capital is the tax shield that the company receives (Grant, 152). By use of this source of capital, less tax is paid and therefore the company is protected from the payment of tax. Retained earnings also form part of capital structure. The advantage of this source is that there are no costs involved. The creditworthiness of the company will be high due to the retained earnings.
WACC = ke(E/V)+ kd(1-T)(D/V)
Ke is the cost of capital.
Kd is the costs of debt.
E is the total value of equity.
T is the tax rate.
V is the total value of debt and equity capital.
D is the total value of the debt.
Tax rate= (tax/earnings before tax)* 100
(41894/106807)*100= 39.22 %
Ke= dividend per share/ price of the shares
Kd= interest paid/debt value
(47.583/654.5)100 = 7.27 %
V = 27.887+ 654.5
WACC = 4.19% (27.887/682.387) + 7.27(1- 0.39)(654.5/ 682.387)
= 0.17+4.25 = 4.42 %
The weighted average cost of capital is not too high hence it is acceptable. There would be various effects of changing the capital structure of the company. First, it can be seen that the company uses a large amount of debt. The company therefore benefits a lot from the shield from taxation. This level of debts however is very high. There is a risk of insolvency of the firm if it increases the debt further. Increasing the amount of debt in this company would generally increase the weighted cost of capital. It is therefore advisable that the company does not increase the debt capital behold this level since it may be unable to pay the interest and the amount due when required.
Increasing share capital would increase the costs of capita of the company. It can be seen that share capital contributes a little share on the total cost of capital of the company. This therefore means that increasing share capital of the company will lead to increase the total cost of the company’s capital (Grant, 57). However, this increase will be very low as compared to the cost that the company incurs in the payment of interest on the debts. A good management decision would be to reduce the amount of debt and increase the share capital since share capital is cheap as compared to the cost of debt.
The other sources of capital that the company could use are the preference shares. Floating of the preference shares would generally increase the costs of capital of the company. However, since the costs of debt are very high, if the debt capital is reduced and preference shares are floated, the weighted average cost of capital would decline (Moyer, 102). This is considering the fact that the costs of capital currently are very high as compared to the cost of share capital.
The company uses retained earnings to a large extent. The problem is that the managers of the company might mismanage the funds considering that it costs nothing to obtain the funds. If there is a guarantee that the funds will be managed wisely, it would be advisable to continue using the source of capital since it costs nothing to obtain it (Grant, 98). Increasing the use of retained earnings as a source of capital will lead to a general reduction in the costs of capital incurred by the company.
Changing the capital structure would also lead to a change in the value of the company in various ways. First, increasing the use of share capital will lead to an increase in the value of the firm. The use of share capital to finance the company would show that the company is committed to improve its performance. This is because, increasing the shares of the company leads to dilution of the earnings per share of the company. To maintain the earnings per share, the company has to increase its performance (Moyer, 147). This is why increasing the share capital leads to improvement of the value of the company. Reducing the share capital of a company can lead to reduced value of the company on the other hand.
Increase in the debt of a company reduces the value of the company. This is because it shows that the shareholders are likely to benefit less from the investment since huge sums would go to the debt providers in form of interest paid. This means that the shareholders will benefit less and hence the demand for the company’s shares will reduce leading to reduce price of the shares. This contributes to the decline in the value of the company.
Retained earnings increase generally can either lead to decline in the value or increase in value of the company. First, the value of the company will decline if the retained earnings are misused by the management (Grant, 132). This is because of the fact that the managers are aware that there are no costs of using the retained earnings. In this case, the management is not motivated to invest in viable projects since they are not required to please the lenders who are to provide them with funds. This misuse of funds can lead to decline in value of the firm.
On the other hand, the retained earnings may be used to purchase investment assets that are to increase the future wealth of the shareholders. It is expected that if the retained earnings are used for viable projects, the value of the shares increases and hence the shareholders benefit from capital gains that are not taxed. In this case, the value of the firm increases.
The use of preference shares can lead to an increase in the value of the company. The reason behind this is that if the company issued preference shares, this would indicate that the management is willing to use the funds collected appropriately so that the dividends that are to accrue from the preference shares are paid. Generally, this is an indicator that the management is committed to improve its profitability to meet its obligations. This will lead to increased demand for the company’s shares hence the price of the shares increase. The value of the firm increases consequently.
Evaluating the capital structure of the company clearly, it can be seen that the cost of capital is reasonable. However, other factors should be considered in determining the capital structure of the company. The value of the company is likely to be very low. This is due to the fact that the dividends paid are very low (Moyer, 169). This makes the potential investors of the company not to demand the shares of the company. In addition, the huge amount of debt means that large amount of interests need to be paid to the lender and the shareholders are not likely to benefit. The fact that there is a very big difference between the weighted cost of equity and the weighted cost of debt means that there is a need to change the capital structure of the company.
The changes in the capital structure would involve reducing the debt amount and increasing share capital amount. This will ensure that the value of the company increases since the company will be required to perform well to meet the dividends need to be paid to the shareholders. In addition, the retained earnings of the company should be reduced so as the dividends paid to the shareholders increases (Grant, 147). This will motivate investors to demand the shares of the company more hence the value of the company will increase. In addition, the management will be motivated to manage the company’s funds better to please the lenders and the shareholders. This will lead to improved performance of the company hence increased value.
A suitable capital structure would be such that share capital of the company increases from 27.887 million dollars to about 327.887 million dollars due to the fact that it costs less as compared to debt. The company should avoid the use of retained earnings due to its disadvantages. This will encourage the management to improve performance hence increasing the value of the firm. The next option is to reduce debt capital from 654.5 to 384.5 million dollars. The debt should remain high to ensure that the company gets tax shield. The company can also issue 2.4 % preference shares of 150 million dollars. This is because the costs of this source of finance will be less as compared to the cost of debt. In addition, the source is less risky since it is not a must that the cost of the capital is paid in a given year. Dividends are paid only when there are profits as opposed to payment of interest. The amount of capital of the company will remain the same but the cost of capital will reduce and the capital structure will change. The cost of capital could be less as shown below.
The value of share capital, preference share capital and debt totals to;
327.887+384.5+150= 862.387 million dollars.
Cost of preference shares;
(2.4/100)*150 =3.6 interest.
Kd= 7.9 (1-0.39)(384.5/862.387)
Cost of ordinary share capital.
WACC= 2.4(150/862.387)+ 7.9(1-0.39)(384.5/862.387) + 4.19(387.887/862.387)
0.41+ 1.9+1.59 =3.9.
The new capital structure reduces the cost of capital. The new weighted average cost of capital reduces to 3.9
The percentage in terms of capital sources is shown below.
Total capital= 150+384.5+387.887= 922.387
(150/922.387)*100= 16.25% preference share capital.
(384.5/922.387)*100= 41.65% debt capita.
(387.887/922.387)*100= 42.1% shareholders capital
In conclusion, the changes in capital structure in Texas industries Inc would involve increasing share capital, and reducing retained earnings and debt capital. This is likely to reduce the costs of the capital for the company and increase its value.
Grant, Tina. International Directory of Company Histories: Volume 100. Detroit, Mich: St. James Press, 2009. Internet resource.
Moyer, R C, and R C. Moyer. Contemporary Financial Management. Mason, OH: South-Western, Cengage Learning, 2012. Print.