Capital Structure & Dividends

Capital Structure and Dividends

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 Capital Structure & Dividends

Introduction

According to Hikent Baker & Gerald S. Martin (2011), Capital structure refers to the

sources of financing employed by the firm. Therefore; it is considered to be a critical factor that

is considered by both the management of the organization as well as shareholders of the

enterprise. Any decision that is made by the administration concerning the capital structure of the

firm has a direct effect on the owners of the business hence Mr. Hillbrandt can be seen to be an

efficient manager being that he seeks advice before making a change in capital structure of ABC

Golf Equipment Corporation. These also show that he has it in mind that the operations of the

firm should be in line with the improvement of shareholders wealth. He is an agent of

shareholders hence the need for him to make a decision that will be considered to have a positive

impact on shareholders wealth. Therefore the aim of this paper is to critically evaluate capital

decisions that are about to be made by Mr. Hillbrandt. This evaluation will ensure that he can see

the effect of moving from debt-free capital structure to a mixed capital structure of 75% equity

and 25 % debt. Our evaluation, therefore, will involve the use of numerical figures to arrive at a

conclusion and also provide recommendations for the CEO. He will be able to see the effects of

his decision on shareholders wealth.

The initial capital structure is made of 100% equity capital hence the value of the investment

is equivalent to the outstanding ordinary shares multiplied by the price of each share 1.e.

(500,000 x 27) giving you $13,500,000 as the total amount invested in the company. Therefore;

introduction of 25% debt capital means that the proportion on equity will be (75% x 13,500,000)

= $ 10,125,000 whereas debt will be $ (25% x 13,500,000) = 3,375,000.

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 Capital Structure & Dividends

From the analysis, the introduction of debt leads to increase in the value of the firm, hence;

the CEO needs to rethink about his decision. Due to this. There has been an increase in the

WACC of the company from 11% to 12 %, and this is a clear indication that the company will be

exposed to more risks.

EPS of the company is derived from the division of the profit attributable to ordinary

shareholders of the company hence, the introduction of debt capital results into the dilution of

EPS i.e. a decrease in the earnings per share which is as a consequence of a decline of profit

attributable to the ordinary shareholder. This also has an effect on the value of the share since

investors will prefer to invest in firms that are promising higher dividend. For this reason, the

CEO will be seen not to be working for the benefit of his principal.

The new share price of the firm is obtained through the division of the total capital raised

through issue of the shares divided by the number of shares. From the analysis that was carried

out, this value reduced from $ 27 to $ 20.25. This shows a negative impact on shareholders

wealth hence it is not advisable to introduce debt capital.

Times Earnings interest ratio indicates the number of time a firm can cover its interest

expense using its net operating income. According to Jerry J, Weygandt, Donald E. Kieso & Paul

D. Kimmel (2010 Pg. 678), it measures the ability to meet interest payments as they come due.

From the analysis of different EBIT provided, it was clear that as the amount of earnings before

interest and tax increases, the firm’s ability to cover its interest expense also increases. The

increase has been from -3.25 times to 20.08 times hence can be interpreted to mean that the

company was not able to cover its interest expense at the initial stages. This inability was up to -

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3.29 times but as time passed; they were able to cover these costs up to 20.08 times which is

considered to be good for the firm and the shareholders.

Conclusion

Mr. Hillbrandt should not consider implementing his decision since it has an adverse

impact on the value of the firm, share prices as well as earnings per share. They may repurchase

the shares of the business but not introduce debt capital in its structure. According To G. Ramesh

Babu (2012 Pg. 125) the value of the firm can be stimulated with the help of available cheaper

sources of finance .therefore the CEO should consider an optimum debt to equity mix.

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Reference

Baker Hikent & Martin S. Gerald (2011) Capital structure and corporate financing decision;

Theory, evidence, and practices

Babu Ramesh G. (2012) financial management; Concept publishing company PVT LTD new

dechi-110 059

Weigandt J Jerry, Keiso E. Donald & Paul. D. Kimmel (2010) financial accounting; IFRS

Edition generally accepted accounting Principles

Stickney P. Clyde, Weil L.Roman & Schipper Katherine (2009) financial accounting; an

introduction to concept, methods, and uses

Paramasiva,c & Subramanian ,T (2012 ) Financial management, New age international

publishers.