Optimum Capital Structure For Competition Bikes example essay topic

Abstract Capital structure refers to the way a firm finances or rather services its chattels. This can take several forms some of which include debt financing, equity financing or an amalgamation of both also referred to as hybrid securities. Marketable securities include bonds, notes and stocks. Therefore capital structure is a constitution of a company's liabilities. The forms of capital structures mentioned above can also be referred to as capital structure approaches. Introduction In this summary paper I will recommend a capital structure approach that maximizes shareholders returns on equity.

I will also proceed to discuss the capital budget areas that raise concern in relation to Net Present Value and Internal Rate if Return. I will also proceed to discuss how working can be properly obtained and managed to correspond with the plans of expansion to Canada. I will also weigh in the options of merging and acquisition of Canadian Bikes, Inc. facility. Definitions The main objective of a firm is to maximize its returns. This notion forms the basis of my summary report. Definitions Capital budgeting- Basically refers to the method in which a firm establishes which investment opportunities need to be given priority.

Capital budgeting looks at an investment's timeframe and assesses whether the income it amerced meets an adequate goal yardstick. Can also be referred to as Investment appraisal. Internal rate of return- In summary it is a form of discounting that makes the Net Present Values of a future investment equal Zero. A project with a high internal rate of return should be given considerations over the others if all factors are kept constant in all the investments.

The IRR is also referred to as the Economic rate of Return ERR. Net present value- This value gives the distinction between the current value of cash in and the current value of cash out. This analysis is mostly relevant to the consistencies of future cash inflows that a venture will capitulate. Working Capital- This is a measure of a company's ability to meet its short term obligations.

It is gotten by subtracting Current liabilities from its current assets. It can also be referred to as the networking capital or the working capital ratio. The Summary In my quest to recommend a suitable capital structure approach I need to evaluate both the merits and demerits of debt financing and equity financing and suggest the most suitable option for competition bikes, Inc. Both equity financing and debt financing have a valid defense to put forward. Some of the advantages of debt financing include; Debt financing permits you to have control of your business from every aspect. All the profits made are yours.

Interest on loans to be repaid are treated as tax deductibles Some of the disadvantages of debt financing include; It is easy to ruin your credit rating if loan repayments are not made on time. Even if Competition Bike made a mistake by investing in Canadian biking and it ends up shutting down the whole operation they are still obligated to pay the money they borrowed. There is need to put collateral in case of default In case a company goes bankrupt lenders will have priority in repayments over equity owners The equity financing option has the following characteristics: Advantages; Firm can get on with its operations without the load of debt trailing it Investors understand if a venture fails after adequate explanations in the prospectus Investors offer valuable business support that maybe the management does not have all for the purpose of safeguarding their investment Some of the demerits of equity financing include; You tend to lose control of your business as investors own a part of your business and how much control they get depends on how much you rely on investors. Due to the fact that they own your business they expect a share in the profits. They are risks of being sued if the management of a company does not act in the best interest of the investors. However the Capital markets Authority which is the regulation body has made some recommendations to big companies to separate ownership and management so that managers can operate with clarity in order to do what is best for the company as compared to individual investors.

Based on the above evaluation I would advise Competition Bikes, Inc. to adopt debt financing option. This is because they have a lot of options on this form of financing. Justification 1. The company can decide to issue bonds only. The capital structure will look as follows; Bonds 600000 Preferred 0 Common 0 Total 600000 EBIT 181546 Interest on Bonds 54000 Income before tax -54000 Income Tax -13500 Net Income -40500 Preferred Stock Dividends 0 Total income from common stock -40500 Common stock shares outstanding 975000 Earnings per common stock share -0.042 Given that the interest rate for the bonds is 9% and the marginal tax rate is 25%.

1. Computation of capital structure by issuing a 5 Year bond with 9% interest for 50% and preferred for 50%, it will look as follows; Bonds 0 Preferred 300000 Common 300000 Total 600000 EBIT 181546 Interest on bonds 0 Income before tax 0 Net income 0 Preferred stock dividends 15000 Total income from common stock -15000 Common stock shares outstanding 1275000 Earnings per common stock shares -0.012 2. The company also has the option of issuing bonds at 9% for 5 years for 20% and common stock for 80%. The capital structure computation will look as follows; Bonds 120000 Preferred 0 Common 480000 Total 600000 EBIT 181546 Interest on bonds 10800 Income before Tax -10800 Income tax -2700 Net income -8100 Preferred stock divided Total income from common stock -8100 Common stock shares outstanding 1455000 Earnings per common stock shares -0.006 3.

The 4th option that competition bikes, Inc. can employ is issuing a bond at 9% for 40% and common stock for 60%. The capital structure will look as follows; Bonds 240000 Preferred 0 Common 360000 Total 600000 EBIT 181546 Interest on bonds 21600 Income before tax -21600 Income tax -5400 Net income -16200 Preferred stock dividends 0 Total income from common stock 1335000 Earnings per common stock share -0.012 4. There is also another option that the company can use to compute its capital structure. It can issue a 5 year bond at 9% bonds for 60% and common stock at 40%. The computation will look as follows; Bonds 360000 Preferred 0 Common 240000 Total 600000 EBIT 181546 Interest on bonds 32400 Income before tax -32400 Net Income -24300 Preferred stock dividends 0 Total income from common stock -24300 Common stock shares outstanding 121500 Earnings per common stock shares -0.02 The above five computations give the optimum capital structure for Competition bikes, Inc. The best capital structure to adopt is one that has the highest earning per share (Don, D. 2002) From the computations above the EBIT is the same for all the options but optimally it is advisable to go for the one that yields the highest returns which is option 3.

This is my final recommendation to Competition Bikes management. This is because the earnings per common stock shares is the highest of the five capital structures hence provides the optimal capital structure approach that maximizes shareholders returns. The data above in the Capital structure approach was all collected from the excel sheet that was provided to me. The Canadian expansion was slated to take effect in year 13 hence the EBIT figures remain the same for all the approaches to capital structure since they are all for the same year.

The capital budget areas that raise concern Capital budgeting is done with projected sales values. These values do not represent the actual sales volume more often than not the protracted values are usually more than the actual values of sales volume. This is one of the areas that raises concern in capital budgeting. The reason behind this is that both the NPV and IRR cannot be accurately calculated.

For instance in year 9 the projected sales figures were 3510 units but the actual unit sales amounted to 3400 units. Total sales amounted to $5083000 for Carbon lite bikes. In year 10 the projected sales units were 3660 units but the actual sales units amounted to 4000 units giving a total sales figure of $5980000 and for year 11 the sales forecasts were 3800 units and the actual sales amounted to $4485000 if the sales projection were used for year 9 the sales amount would have been $5247450, for year 10 the sales volume would have been $5471700 and lastly for year 11 the sales would be $5681000. These figures would completely alter the whole capital budgeting structure hence it is advisable to use actual sales to compute for capital budgeting structure. From the competition Bikes, Inc.

Budgeted Contribution Margin Income statement for year 9 if the projected sales figures were used the operating income would have been $79962 but when we use the real sales figures we get the operating income amount to be $34142 giving rise to a difference of $45820 a considerable amount that would blow the budgeting structure out of proportion. A change in the contribution margin for any company would result in a change in the projected income statements for any company not excluding Competition Bikes, Inc. This is because the Net cash flows are used in tabulating NPV and IRR figures. Another area of concern in capital budgeting is in the variance analysis. From the definition of variance analysis it compares two or more variables or components in our case projected sales units and actual sales units (Colston 1997). The main advantage of variance analysis is that it increases the chances of assigning a variety or a blunder which impacts on decision making (Satish 2007).

Some of the decisions include decisions to invest or not to invest. This decision is relevant to Competition Bike, Inc as they are looking to invest with or on Canadian Biking in their expansion options. The impacts of variance analysis can be negative if the attributes are false this would give a wrong assessment for Competition Bikes, Inc forecasted Canadian Operations and the error would be reflected in the comparative income statements. If errors on the attributes go undetected the NPV and IRR analysis would be rendered useless as they do not portray the true needed to make an investment decision (Satish 2007) which at the moment is relevant to Competition Bikes, Inc since like I said earlier is looking to expand its operations to Canada.

Another important area of concern in the Capital budgeting of Competition Bikes, Inc. is on the cost of carrying risk. Majority of monetary policy decisions in capital budgeting tend to build on the importance and cost of a firm retaining the risk. On the up side since Competition Bikes, Inc is a nonfinancial corporation risk pricing are not done often. However they are still risks associated with the expansion move to Canada that will raise concern in the Capital budgeting area, examples are the cost of setting up the new manufacturing plant in Canada, this cost is two pronged there is the cost of setting up the factory and also working Capital sourcing and management costs. The cost to build the facility is $400000 and the working capital for operation support is $200000 the total make up the Capital or investment cost for the Canadian expansion.

The Company can be able to come up with the money adequately but some areas of capital budgeting that raise concern may slow down the investment. At the risk of repeating me the risk associated with cost is another area of concern. Other areas of Capital budgeting that raise concern and are related to cost include inflation, replacement and closure. Other considerations include; Skilled labor force Labor costs Land cost comparisons Construction cost of new facility Tax incentives for selected locations Reliability in the ferrying of raw materials and related transportation costs Support facilities for employees Obtaining and managing working capital in the Canadian expansion In year eight total current assets amounted to $1606817 and the total current liabilities amounted to $300200 the working capital then comes to $1306617 the working capital for this same year was funded by a total stockholders' equity of $2336617.

Working Capital is obtained from adding all the current liabilities and subtracting the value from total current assets (Colston 1997). Working Capital is basically the funds needed for the day to day running of a firm (Frank 2002). From task 4 of the story line we see the activities that task working capital and they include Working Capital is basically the ease in accessing the liquid assets of a company. Revenue is a key aspect of the business and the main purpose of a business is to keep it flowing. It is not easy to finance working Capital when it is in shortage but a business has several options to chose from some of which include loans, factoring in accounts receivables and business cash advances which do not need collateral. Managing working capital In a nut shell this is the management of receivables, payables and inventories.

Some of the ways in which the above said items can be managed include; Putting measures in place at both levels of operation and process to stimulate optimal performance. This can be done by evaluating financial data critically and doing away with expenses that don't directly compliment the current financial objectives of the firm in the case of Competition Bikes, Inc research funding. A firm would also do itself some good in regards to the management of working Capital if it incorporates information and reporting techniques with forecasting activities. The first point has generally summarized the major areas concerning working Capital management but to conclude this segment a company could also gauge its performance with industrial standards with the purpose of improving its management of working Capital.

Merging option Earnings per share before the merger was $0.056 for Competition Bikes and for Canadian biking was $0.121 after the merger the earnings per share was $0.076. This is good for Competition Bikes, Inc as the earnings per share has increased. The number of shares available in Canadian Biking is 200000 shares giving a value of $15200 which is the total earnings from all shares from Canadian Biking. The NPV values would look something like this. Acquisition Option For this option the offer price per share is $1.43 for 200000 shares which comes to $286000.

The total cash inflows amount to $296019 with a present value of $211193. Conclusion The total cash inflows for the Merging option is $296018 with an expected growth of about 10% for five years the present value is $222193.14. Compared to the acquisition option it is in the best interest for Competition bikes, Inc. to merge with Canadian biking because; Earnings per share is higher for Competition Bikes, Inc at $0.076 as compared to before the merger where the earnings per share was $0.056 The present values from cash flows in the merging option are $222193.84 and for the Acquisition option is $211193. My recommendation to Competition Bikes, Inc management is merging with Canadian Bikes, Inc because of the above mentioned advantages.

Bibliography

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Variance Analysis: Management Accounting Techniques Series. Chicago: Chartered Institute of Management Accountants Don, D. (2002).
Capital budgeting: Financial appraisal of investment projects. Cambridge: Cambridge University press Frank, J. (2002).
Capital budgeting: Theory and practice. London: John Wiley and sons. Harry, M. (2000).
Mean variance Analysis in portfolio choice and capital markets. Satish, B. (2007).