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Capital Structure MBA
Capital Structure MBA
a) Capital structure describes how a corporation has organized its capitalhow it obtains the financial resources with which it operates its business. Businesses adopt various capital structures to meet both internal needs for capital and external requirements for returns on shareholders investments. A company's capitalization is constructed from three basic blocks: 1. Long-term debt. By standard accounting definition, long-term debt includes obligations that are not due to be repaid within the next 12 months. Such debt consists mostly of bonds or similar obligations, including a great variety of notes, capital lease obligations, and mortgage issues. 2. Preferred stock. This represents an equity (ownership) interest in the corporation, but one with claims ahead of the common stock, and normally with no rights to share in the increased worth of a company if it grows. 3. Common stockholders' equity. This represents the underlying ownership.It is made up of: (I) the nominal par or stated value assigned to the shares of outstanding stock; (2) the capital surplus or the amount above par value paid the company whenever it issues stock; and (3) the earned surplus (also called retained earnings), which consists of the portion of earnings a company retains after paying out dividends and similar distributions. Put another way, common stock equity is the net worth after all the liabilities (including long-term debt), as well as any preferred stock, are deducted from the total assets shown on the balance sheet. For investment analysis purposes, security analysts may use the company's market capitalizationthe current market price times the number of common shares outstandingas a measure of common stock equity. They consider this market-based figure a more realistic valuation.
But, of course, increased debt brings with it higher fixed costs that must be paid in good times and bad, and can severely limit a company's flexibility. Four problems that tend to increase as leverage escalates: (1) a growing risk of bankruptcy; (2) lack of access to the capital markets during times of tight credit; (3) the need for management to concentrate on finances and raising additional capital at the expense of focusing on operations; (4) higher costs for whatever additional debt and preferred stock capital the company is able to raise. Aside from the unpleasantness involved, it is noted that each of these factors also entails tangible monetary costs. Although periodically companies use debt to buy back common shares, a practice that can improve stock performance, most large companies rely heavily on equity financing. The elusive "optimal" capital structure is that which minimizes the total cost of a corporation's capital. In any case, an appropriate capitalization must depend greatly on the nature of the business, prevailing economic and financial conditions, and sundry other shifting factors. Firms with a high degree of management ownership, for instance, are less likely to carry high levels of debt, as are corporations with significant institutional ownership.
Flexibility: The capital structure should be flexible to meet the changing conditions. It should be possible for a company to adapt its capital structure with minimum cost and delay if warranted by a changed situation. It should also be possible for the company to provide funds whenever needed to finance its profitable activities. In other words, from the solvency point of view we need to approach capital structuring with due conservation. The debt capacity of the company which depends on its ability to generate future cash flows should not be exceeded. It should have enough cash to pay periodic fixed charges to creditors and the principal sum on maturity.
4.b) Capital budgeting (or investment appraisal) is the planning process used to
determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures.[1] Components :
Accounting rate of return Net present value Profitability index Internal rate of return Modified internal rate of return Equivalent annuity
These methods use the incremental cash flows from each potential investment, or project. Techniques based on accounting earnings and accounting rules are sometimes used though economists consider this to be improper - such as the accounting rate of return, and "return on investment." Simplified and hybrid methods are used as well, such as payback period and discounted payback period.
The use of the EAC method implies that the project will be replaced by an identical project. Alternatively the chain method can be used with the NPV method under the assumption that the projects will be replaced with the same cash flows each time. To compare projects of unequal length, say 3 years and 4 years, the projects are chained together, i.e. four repetitions of the 3 year project are compare to three repetitions of the 4 year project. The chain method and the EAC method give mathematically equivalent answers. The assumption of the same cash flows for each link in the chain is essentially an assumption of zero inflation, so a real interest rate rather than a nominal interest rate is commonly used in the calculations.Y
Real options
Real options analysis has become important since the 1970s as option pricing models have gotten more sophisticated. The discounted cash flow methods essentially value projects as if they were risky bonds, with the promised cash flows known. But managers will have many choices of how to increase future cash inflows, or to decrease future cash outflows. In other words, managers get to manage the projects - not simply accept or reject them. Real options analysis try to value the choices - the option value - that the managers will have in the future and adds these values to the NPV.
Profitability index (PI), also known as profit investment ratio (PIR) and value
investment ratio (VIR), is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking projects because it allows you to quantify the amount of value created per unit of investment. The ratio is calculated as follows:
Assuming that the cash flow calculated does not include the investment made in the project, a profitability index of 1 indicates breakeven. Any value lower than one would indicate that the project's PV is less than the initial investment. As the value of the profitability index increases, so does the financial attractiveness of the proposed project. Rules for selection or rejection of a project:
If PI > 1 then accept the project If PI < 1 then reject the project