FIN701 Finance

Student ID – AS1744
Anurag Soni
28/08/2022

Q: 1 (a)

Optimal capital structure

The optimal capital structure of a firm is the right combination of equity and debt
financing. It allows the firm to have a minimum cost of capital while having the
maximum market value. The lesser the cost of capital, the more the market value of the
company. Debt financing may have the lowest cost, but having too much of it would
increase risks to the shareholders. So, firms need to find a balance between both to
benefit from it entirely.

Why is the Optimal Capital Structure Important?

Firms that can manage to have an optimal capital structure would benefit from having
more market value while having the minimum cost. Firms need to have it because no
firms want to be paying too much money for less value.

Photograph reference: Investopedia.com

Checklist for capital structuring

Many factors influence capital structure decisions and determining the optimal capital
structure is not an exact science. Capital structure is the composition of a company’s
sources of funds, a mix of owner’s capital (equity) and loan (debt) from outsiders. It is
used to finance its overall operations and investment activities.
A company would want its capital structure to be flexible. As times change, the company
should be able to change its capital structures with market demand. For example, if the
government announces a decrease in tax deductions allowed for debt finance,
companies might want to reconsider their capital structure.

Consider the following factors when making capital structure decisions:

1. Sales stability - firm whose sales are relatively stable can safely take on more debt and
incur higher fixed charges than a company with unstable sales. Utility companies,
because of their stable demand, have historically been able to use more financial
leverage than industrial firms

2. Asset structure- firms whose assets are suitable as security for loans tend to use debt
rather heavily. General-purpose assets that can be used by many businesses make
good collateral, whereas special-purpose assets do not. Thus, real estate companies are
usually highly leveraged, whereas companies involved in technological research are not.
3. Operating leverage - other things the same, a firm with less operating leverage is better
able to employ financial leverage because it will have less business risk.
4. Growth rate - faster-growing firms must rely more heavily on external capital. Further,
the flotation costs involved in selling common stock exceed those incurred when selling
debt, which encourages rapidly growing firms to rely more heavily on debt. At the same
time, however, these firms often face greater uncertainty, which tends to reduce their
willingness to use debt.
5. Profitability. One often observes that firms with very high rates of return on investment
use relatively little debt. Although there is no theoretical justification for this fact, one
practical explanation is that very profitable firms such as Intel, Microsoft, and Coca-Cola
simply do not need to do much debt financing. Their high rates of return enable them to
do most of their financing with internally generated funds.
6. Taxes. Interest is a deductible expense, and deductions are most valuable to firms with
high tax rates. Therefore, the higher a firm's tax rate, the greater the advantage of debt.
7. Control. The effect of debt versus stock on a management's control position can
influence capital structure. If management currently has voting control (over 50 percent
of the stock) but is not in a position to buy any more stock, it may choose debt for new
financings.

8. Management attitudes. Because no one can prove that one capital structure will lead to
higher stock prices than another, management can exercise its own judgment about the
proper capital structure. Some managements tend to be more conservative than others,
and thus use less debt than the average firm in their industry, whereas aggressive
managements use more debt in the quest for higher profits.
9. Lender and rating agency attitudes. Regardless of managers' own analyses of the
proper leverage factors for their firms, lenders' and rating agencies' attitudes frequently
influence financial structure decisions. In the majority of cases, the corporation
discusses its capital structure with lenders and rating agencies and gives much weight to
their advice.
 10. Market conditions. Conditions in the stock and bond markets undergo both long- and
short-run changes that can have an important bearing on a firm's optimal capital
structure.
11. The firm's internal condition. A firm's own internal condition can also have a bearing on
its target capital structure. For example, suppose a firm has just successfully completed
an R&D program, and it forecasts higher earnings in the immediate future. However, the
new earnings are not yet anticipated by investors, hence are not reflected in the stock
price.
12. Financial flexibility. Firms with profitable investment opportunities need to be able to fund
them.

Important conclusion:
A firm's optimal capital structure is that mix of debt and equity that maximizes
the stock price. At any point in time, management has a specific target capital
structure in mind, presumably the optimal one, although this target may change
over time.
Several factors influence a firm's capital structure. These includes
(1) business risk
(2) tax position
(3) need for financial flexibility
(4) managerial conservatism or aggressiveness
(5) growth opportunities.

Business risk is the riskiness inherent in the firm's operations if it uses no debt.
A firm will have little business risk if the demand for its products is stable, if the
prices of its inputs and products remain relatively constant, if it can adjust its
prices freely if costs increase and if a high percentage of its costs are variable
and hence will decrease if sales decrease. Other things being the same, the
lower a firm's business risk, the higher its optimal debt ratio.

Financial risk is the additional risk placed on the common stockholders

resulting from the decision to finance with debt or financial leverage .Financial
leverage is the extent to which fixed-income securities (debt and preferred
stock) are used in a firm's capital structure. Financial risk is the added risk
borne by stockholders as a result of financial leverage.

Operating leverage is the extent to which fixed costs are used in a firm's
operations. In business terminology, a high degree of operating leverage, other
factors held constant, implies that a relatively small change in sales results in a
large change in ROIC.

An alternative theory of capital structure relates to the signals given to

investors by a firm's decision to use debt versus stock to raise new capital. A
stock issue sets off a negative signal, while using debt is a positive, or at least a
neutral, signal. As a result, companies try to avoid having to issue stock by
maintaining a reserve borrowing capacity, and this means using less debt in
"normal" times than the MM trade-off theory would suggest.

Q: 1 (b)
Financial risk is the risk placed on the common stockholders resulting from the
decision to finance with debt or financial leverage. Whereas Business risk
represents the amount of risk inherent in the firm’s operations even if it uses
no debt financing.
The uncertainty caused due to insufficient profits in the business due to which
the firm is not able to pay out expenses in time is known as Business Risk.
Financial Risk is the risk originating due to the use of debt funds by the entity.
Business Risk can be evaluated by fluctuations in Earning before Interest and
Tax. On the other hand, Financial Risk can be checked with the help of
leverage multiplier and Debt to Asset Ratio.

Business Risk is linked with the economic environment of business. Conversely,

Financial Risk associated with the use of debt financing.

Business Risk can be disclosed by the difference in net operating income and net cash
flows. In contrast to Financial Risk, this can be disclosed by the difference in the return
of equity shareholders.

Business risk is influenced by a number of different factors including:

 Consumer preferences, demand, and sales volumes, market behavior

 Per-unit price and input costs
 Competition
 The overall economic climate
 Government regulations
 Technology changes
 Management Strategies
 Financing
 Production, Quality and sales
 Capital Expenditures and Fixed Cost Ratio

Factors influencing Financial Risk

 Financial risk refers to the risks that businesses run when making investments, planning
for the future and conducting day-to-day operations. All businesses run some risk in
making financial decisions. Some of these risks are external, depending on outside
factors and decisions made by other organizations and consumers. Other risks are
internal and deal with the chance that the strategies and actions the business leaders
choose may have negative effects on operations.
  MARKET RATES Market rates are one of the most pervasive types of external factors when it
comes to financial risk. The market changes based on consumer interest, supply and
demand and new elements like technology. When the economy speeds up or slows
down, interest rates for bonds and loans change. These changing rates can make it more
expensive for a business to get a loan, or require it to make higher payments on bonds it
uses to generate capital
 REGULATION Government regulation is another important factor in all financial planning.
Governments create tariffs (or taxes on imports and exports), changing existing tax laws
and put new financial regulations into place constantly. Some changes are beneficial,
such as creating tax deductions for certain business actions. Others can make it more
difficult for a business to make a profit, such as lowering treasury bond rates and adding
new requirements to tax reports.
 CREDIT Credit is halfway between being an external and internal factor. In many ways,
business credit is an external factor of risk, because it depends on what outside lenders
are willing to loan, and the rates or requirements lenders choose for the business. On the
other hand, credit depends on the past decisions the business has made, what lenders it
approaches and its current financial position -- internal factors.
 LIQUIDITY Liquidity is simply how easy it is for a business to turn securities into cash. Cash
is the most liquid type of fund, but it also makes the least amount of money. Businesses
must balance how much cash they hold for emergencies with less liquid securities like
bonds or shares.
 CASH FLOWS Cash flow refers to the daily revenues and expenses of the business. This is an
internal factor of risk that depends on what expenses a business choose to pay and how
much revenue is directed to specific areas of the business.

What Is Operating Leverage?

Operating leverage is a cost-accounting formula that measures the degree to which a firm or
project can increase operating income by increasing revenue. A business that generates  sales
with a high gross margin and low variable costs has high operating leverage.

 Operating leverage is used to calculate a company’s break-even point and help set
appropriate selling prices to cover all costs and generate a profit.
 Companies with high operating leverage must cover a larger amount of fixed costs each
month regardless of whether they sell any units of product.
 Low-operating-leverage companies may have high costs that vary directly with their
sales but have lower fixed costs to cover each month.
The higher the degree of operating leverage, the greater the potential danger from forecasting
risk, in which a relatively small error in forecasting sales can be magnified into large errors
in cash flow projections.

The Operating Leverage Formula Is:

Degree of operating leverage=Contribution margin/Profit

Operating leverage defines a company's break-even point, reports Accounting Tools. The break-
even point is the point at which costs are equal to sales; the company "breaks even" when the
cost to produce a product equals the price customers pay for it.
The importance of operating leverage is that it drives a company's pricing strategy. To make a
profit, the price must be higher than the break-even point. A company with a high operating
leverage, or a higher ratio of fixed costs to variable costs, always has a higher break-even point
than a company with a low operating leverage. The company with a high operating leverage, all
other things being equal, must raise prices to make a profit.
Example, a company with low operating leverage might own no assets, just buy products and
sell them at a slightly higher price. That has little business risk. If revenues fall 10%, the company
just does 10% less business and has 10% lower operating profits. With no assets it doesn’t need
debt, so there’s no danger of the business failing. The owners just make 10% less money.
Another company might have borrowed a lot of money to build a plant that produces the
goods. Each item costs less, so its profit from each item sold is much greater. But it needs to sell
a certain number of items just to cover the costs of running the plant, plus servicing the debt. If
revenues rise 10%, its operating profit might increase by 20% or 50% or more. But if revenues
fall 10%, its operating profit could turn negative, or anyway fall below the level necessary to
service the debt. That could put it into financial distress.

The second company also has more risk if things change. Perhaps a different version of the
product becomes popular, and the plant cannot be adapted to it. The first company can just find
suppliers for the new version.

On the other hand, the second company has more control over its business. The first company
might be put out of business if suppliers raised prices. The second company might be able to
innovate in its production.

So high operating leverage by itself increases business risk, and it often means more assets that
could change in value, and more debt. But it can also offer more control and flexibility so it can
adapt to changing circumstances and exploit opportunities.

Real life Example of Airline companies: The airline industry exhibits high operating leverage.
Their fixed costs include aircraft leases and wages for staff for their routes. These high fixed
costs make profit (or loss) extremely sensitive to sales volume. Aside from operating leverage,
competition within the industry is very intense. These factors make air travel a tough business
that suffers periods chronic losses and sometimes drives airline companies into bankruptcy.

Leverage refers to the use of debt (borrowed funds) to amplify returns from an
investment or project. Investors use leverage to multiply their buying power in
the market. Companies use leverage to finance their assets—instead of issuing
stock to raise capital, companies can use debt to invest in business operations
in an attempt to increase shareholder value. There is a range of financial
leverage ratios to gauge how risky a company's position is, with the most
common being debt-to-assets and debt-to-equity. Misuse of leverage may
have serious consequences, as there are some that believe it played a factor in
the 2008 Global Financial Crisis.

Q 1 (c)

Yes in my views both decisions are very much interrelated. For business growth being an
employee of construction field, I would like to advise my company to go with fully automatic
production process with an appropriate capital structure for financing. As it will help to grow at
a faster rate, and shall leg behind some manual intervention.
In today’s scenario process automation is must, rather to get stick with old manual ways to
operate industries.
My business is deeply needs to change into automation, in right from raw material supplies to
make it usable through random samplings, which can be avoided by providing robotics, this will
also reduce error chances and complete manual intervention.
Material supply issue can also be overcome by adopting automation process, by in-time
tracking of vehicles and managing things.
Whereas some processes still can be effectively done by semi automatic process.
Overall it should be a good combination of both with an appropriate capital financing.
There are three main financial decisions that a company takes, both in normal course of
business as well as part of expansion plans: Investment decision, financial decision &
Dividend decision.

The asset investment and the financing decisions should be jointly determined
due to the inter-correlation between those two decisions. The financing
decision would affect the cost of capital in analyzing the profitability of the
asset. The value of the asset would affect the volume of required capital. The
combination of those two decisions would help the management team seek an
optimal capital structure to maximize the asset's earnings.

The leverage concept refers to the use of debt to finance an asset or a project that
would increase the total return at the end of the project. This concept can explain the
firm's strategy in financing the expansion by debt, but not the equity. Or, instead of
issuing new stocks, the use of debt will reduce the cost of capital since the cost of equity
will be usually higher than the cost of debt. Besides, the savings on tax liability by the
interest expense will contribute more value to the shareholders.

Q 2 (a)

NPV is sensitive to the discount rate (or cost of capital) more so for projects with higher
proportion of cash flows at the end of the project compared to a similar project with the
same cash flows occurring earlier in the project lifecycle. This phenomenon is illustrated in
the example below: The long term project is more sensitive to discount rate changes as a
larger proportion of cash flows are discounted multiple times at the discount rate,
reducing the overall NPV value. The cash flows generated from the project as assumed (by
the NPV method) to be reinvested at the discount rate. Higher cash flows earlier in the
project's life allows more re-investment income to be generated and thus higher NPV.

In addition, if two mutually exclusive projects are being compared, the short-term project
might have the higher ranking under the NPV criterion if the cost of capital is high, but the
long-term project might be deemed better if the cost of capital is low. Mutually exclusive
projects are also affected by this phenomena and high cost of capital can make short term
projects attractive and similarly low cost of capital can make long term projects attractive.
The reason for this is the same, i. e. high cash flows are assumed to be reinvested at the
cost of capital and thus compounded over the remaining life of the project.

Finally, would changes in the cost of capital ever cause a change in the IRR ranking of two
such projects? No! IRR depends on the cash flow patterns and not the cost of capital. Thus
changes in the cost of capital shall not have any impact on the IRR. However, during
project selection, only projects with IRRs higher than their cost of capital are considered,
otherwise the project would have a negative NPV (i. e. unprofitable project).

Q 2 (b)

Sunk costs should not be included in capital budgeting decision making

because such costs are already incurred and cannot be recovered. Sunk
costs are independent of any event and should not be considered when
making investment or project decisions. Only relevant costs (costs that relate
to a specific decision and will change depending on that decision) should be
considered when making such decisions. All sunk costs are considered fixed
costs. However, it is important to realize that not all fixed costs are considered
sunk costs. Recall that sunk costs cannot be recovered. Take, for example,
equipment (a fixed cost). Equipment can be resold or returned at a determined
price. Therefore, it is not a sunk cost. Sunk cost is also known as past cost,
embedded cost, prior year cost, stranded cost, sunk capital, or retrospective
cost.

Opportunitycosts are relevant for decision making because they represent the
revenue foregone by missing out on other alternatives. Externalities are also
relevant for the capitalbudgeting decisions because they affect the cash flows
of the firm and are not included in the project. Externalities can have both
negative and positive effects.

Examples of negative production externalities include

Air pollution: A factory burns fossil fuels to produce goods. The people living
in the nearby area and the workers of the factory suffer from the deteriorating
air quality.
Water pollution: a tanker spills oil, destroying the wildlife in the sea and
affecting the people living in coastal areas.
Noise pollution: People living near a large airport suffer from high noise levels

Examples of negative consumption externalities are:

Individual education: The increased levels of an individual’s education can
also raise economic productivity and reduce unemployment levels.
Vaccination: Benefits not only the person vaccinated but other people in the
community because the probability of being infected decreases.

Q3 (a)
What is the Cash Conversion Cycle
The cash conversion cycle (CCC) is a metric that expresses the time
(measured in days) it takes for a company to convert its investments in
inventory and other resources into cash flows from sales. Also called the
Net Operating Cycle or simply Cash Cycle, CCC attempts to measure how
long each net input dollar is tied up in the production and sales process
before it gets converted into cash received.

This metric takes into account how much time the company needs to sell
its inventory, how much time it takes to collect receivables, and how much
time it has to pay its bills.

The CCC is one of several quantitative measures that help evaluate the
efficiency of a company's operations and management. A trend of
decreasing or steady CCC values over multiple periods is a good sign while
rising ones should lead to more investigation and analysis based on other
factors. One should bear in mind that CCC applies only to select sectors
dependent on inventory management and related operations.

Cash Conversion Cycle Formula

The cash conversion cycle formula is as follows:

Cash Conversion Cycle = DIO + DSO – DPO

Where:

 DIO stands for Days Inventory Outstanding

 DSO stands for Days Sales Outstanding
 DPO stands for Days Payable Outstanding
DIO and DSO are associated with the company’s cash inflows, while DPO is
linked to cash outflow. Hence, DPO is the only negative figure in the
calculation. Another way to look at the formula construction is that DIO
and DSO are linked to inventory and accounts receivable, respectively,
which are considered as short-term assets and are taken as positive. DPO is
linked to accounts payable, which is a liability and thus taken as negative.
Calculating CCC
A company’s cash conversion cycle broadly moves through three distinct stages

The first stage focuses on the existing inventory level and represents how
long it will take for the business to sell its inventory. This figure is
calculated by using the Days Inventory Outstanding (DIO). A lower value of
DIO is preferred, as it indicates that the company is making sales rapidly,
implying better turnover for the business.

DIO, also known as DSI, is calculated based on the cost of goods

sold (COGS), which represents the cost of acquiring or manufacturing the
products that a company sells during a period. 

The second stage focuses on the current sales and represents how long it
takes to collect the cash generated from the sales. This figure is calculated
by using the Days Sales Outstanding (DSO), which divides
average accounts receivable by revenue per day. A lower value is preferred
for DSO, which indicates that the company is able to collect capital in a
short time, in turn enhancing its cash position.

The third stage focuses on the current outstanding payable for the
business. It takes into account the amount of money the company owes its
current suppliers for the inventory and goods it purchased, and it
represents the time span in which the company must pay off those
obligations. This figure is calculated by using the Days Payables
Outstanding (DPO), which considers accounts payable. A higher DPO value
is preferred. By maximizing this number, the company holds onto cash
longer, increasing its investment potential.

Interpreting the Cash Conversion Cycle

The CCC formula is aimed at assessing how efficiently a company is
managing its working capital. As with other cash flow calculations, the
shorter the cash conversion cycle, the better the company is at selling
inventories and recovering cash from these sales while paying suppliers.

In addition, comparing the cycle of a company to its competitors can help

with determining whether the company’s cash conversion cycle is “normal”
as compared to industry competitors.

Show how a reduction in CCC can increase company’s profitability

The traditional view on Cash Conversion Cycle (CCC) and profitability highlights that
the shorter the CCC, the superior the firm profitability. The firm can shorten its CCC by
improving the inventory turnover, collects cash from receivables more quickly, and
slowing down the payments to suppliers. This will increase the efficiency of the firm
internal operation and result in greater profitability.

On the other hand, shortening the Cash Conversion Cycle (CCC) could harm the firm’s
profitability as reducing the inventory conversion period could increase the shortage
cost, reducing the receivable collection periods could make the company’s losing its
good credit customers, and lengthening the payable period could damage the firm’s
credit reputation. Therefore, shorter cash conversion cycles associated with high
opportunity cost, and longer cash conversion cycles associated with high carrying
cost. By achieving the optimal levels of inventory, receivable, and payable will
minimize both carrying cost and opportunity cost of inventory, receivable, and
payable and maximizes sales, and profitability of firms. In this regard, an optimal cash
conversion cycle a more accurate and comprehensive measure of working capital
management.

Measures to shorten the CCC

1. Improve Your Cash Flow Management: Tracking the timing and amounts of

cash inflows and outflows is an important part of cash flow management. Cash
inflows arise from cash sales to customers, conversion of accounts receivable
to cash, loans and borrowing, and asset sales. Cash outflows come from cash
payments for expenses, conversion of accounts payable to cash via bill
payments, and principal and interest payments on debt.

2. Collect Your Accounts Receivables Faster: How quickly customers pay has a

significant impact on cash cycle. Companies can shorten this cycle by
requesting upfront payments or deposits and by billing as soon as information
comes in from sales.

3. Improve Your Accounts Receivables Process: Several people generally have

a hand in a company’s billing and invoicing process. One way is to automate
invoice creation process in order to ensure maximum efficiency in the billing
process. This will lead to faster turnaround times on pay received from those
who owe us money.

4. Disburse your accounts payable more slowly: While it’s beneficial to us if

our customers pay early, our cash on hand increases if we disburse our
accounts payable later. While it’s recommended we pay invoices according to
terms we had negotiated with our suppliers, we receive no benefit from paying
early. To increase our cash on hand, need to work with our accounting
department to set up a payables management system where all invoices are
paid as close to the due dates as possible.

5. Manage your inventory more efficiently: Companies can reduce their cash

conversion cycles by turning over inventory faster. The quicker a business sells
its goods, the sooner it takes in cash from sales and begins its accounts
receivable aging. Consider implementing a just-in-time – or JIT – inventory
management, where supplies are delivered as they’re needed, not weeks – or
 even months – early. Also, consider cutting our losses on slow-moving
inventory items, even if this means selling them at a big discount.

Q3 (b) Dividend Irrelevance Theory

Modigliani and Miller, famous for their capital structure theories, advanced the
dividend irrelevance theory.

They suggested that in a perfect world with no taxes or bankruptcy cost, the dividend
policy is irrelevant. They proposed that the dividend policy of a company has no effect
on the stock price of a company or the company’s capital structure.

According to them if an investor gets a dividend that’s more than he expected then he
can re-invest in the company’s stock with the surplus cash flow. If the expected
dividend is too small, then he can sell a part of his shares and replicate the same cash
flow he would get if the dividend was what he expected. In both cases, investors are
irrelevant to what the company’s dividend policy is because they can create their own
cash flows.

Higher returns are what investors care about. They can have that return through re-
investing or selling a part of their shares. If the market conditions are perfect, then
they don’t care if the return is from dividends or from stock price appreciation.

Assumptions of the Theory

Some of the assumptions for this theory are:

 Taxes do not exist: Personal income taxes or corporate income taxes

 When a company issues a stock, there are no flotation costs or transaction
costs
 When a firm decides its capital budgeting, dividend policy has no impact on it
  Information is readily and freely available to all investors. Information about
the firm’s future prospects is available to the company’s manager as well as
investors
 Leverage has zero impact on the cost of capital of the company

The Theory in Real Life

In reality, none of these assumptions stand true. Taxes are a certainty for all of us.
Companies have to deal with flotation costs while dealing with issuances. Information
is readily available to everyone, but the tools and sophistication with which
institutional investors analyze securities is far better than what a retail investor might
use. The information that a company’s manager might have is still superior than what
an institutional investor might have in spite of the sophisticated tools that they
possess.

MM believe that it’s only the company’s ability to earn money—and how risky that
activity is—that has an impact on the value of the company. MM’s conclusions might
stand true theoretically but they do not stand true in the practical world.

Q3 (c) As a company CEO, would you ever borrow money to pay cash dividends?

There may be two cases, in which first one if company isn’t earning profit, in that case
there shall not be any dividends to irrespective of market value and stock price.

Whereas in another case if company earning higher profit with a higher rate ie more
than 30-40% than I would like to invest this amount in business growth and would like
to borrow money from market/bank for a lower interest rate say 10%.