Head of strategic planning with Superior Living
Today we will be discussing our strategic plan on how using more debt could impact our firms capital structure, as well as what the trade-offs would be between incremental and IPO proceeds in debt financing. We will also be looking at Superior Living balance sheet and how this could be impacted by debt financing vs. using cash. Lastly how Superiors return equity would be impacted if they decide to use more debt.
Using more debt can impact a firm’s capital structure; there are many factors that could impact a company’s capital structure (“CFA Level 1- Corporate Finance”, 2011, p. 1).
‘¢ Business Risk
‘¢ Company’s Tax Exposure
‘¢ Management
‘¢ Market Conditions
‘¢ Financial flexibility
‘¢ Growth Rate
When researching the business risk we will find that many company’s basic risks are the company’s operations. When we have a bigger business risk then the lower our debt ratio will be.
When comparing the tax liability for the company all tax payments are tax deductible, one example is if Superior Living has a high tax rate, we would be able to use the debt as a means of financing a new project because the tax deductibility of the debt payments protects some income from taxes (“CFA Level 1- Corporate Finance”, 2011, p. 1).
When our Management is more conservative the less inclined it will be to our debt to increase profits. If we used a more aggressive management approach it could grow the company quicker using up debt to ramp up the growth of the company’s earnings per share (“CFA Level 1- Corporate Finance”, 2011, p. 1).
As long as sales are growing and earning strong, then raising capital would not become a problem. This is in regards to our company’s financial flexibility.
Companies that are in the growth stage of their cycle typically finance that growth through debt, borrowing money to grow faster.
As long as Superior stands stable with their growth rates then the debt to finance growth will generate the cash-flow needed to finance new projects for Superior Living.
Market Conditions can play a significant impact on a Superior’s capital-structure condition. If we need to borrow funds for a new project and the market is struggling, this will show us that investors are limiting companies’ access to capital because of market concerns, the interest rate to borrow may be higher than a company would want to pay (“CFA Level 1- Corporate Finance”, 2011, p. 1).
Superior’s long term success will depend on how they invest their earning at a good rate of return. In order for Superior to succeed it will be necessary for them to show a high rate of return. Superior’s capital structure is the amount of debt and equity that will be weighted at the average cost of capital (WACC).
The tradeoff between the IPO will proceed as long as the IPO is less than the initial cost of the debt. We will need to take a look at the companies’ balance sheet to see if the debt is increasing. Superior’s return will increase with the use of the amount of debt it will incur.
Superior’s assets are financed by either debt or equity. The WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances (“Weighted Average Cost of Capital- WACC”, 2011, p. 1).
The discount rate to use for cash flows with risk that are similar to those of the overall firm while debt reduces Superiors tax liability, interest payments are deductible expenses, increasing amounts of debt raise both the cost of equity capital.
The higher amounts of debt that arise, the financial risk of Superior Living’s, debt risk will be reflected on the cost of capital that Superior uses (“Weighted Average Cost of Capital- WACC”, 2011, p. 1).
References
CFA Level 1- Corporate Finance. (2011). Retrieved from http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/capital-structure-decision-factors.asp
Weighted Average Cost of Capital- WACC. (2011). Retrieved from http://www.investopedia.com/terms/w/wacc.asp