Capital Structure: Use of Debt

Introduction

It should clearly be understood from the onset that no single business operation could be started without a source of fund. The fund required by any business in order to be established is usually referred to as the capital. In most instances, and mostly when dealing with small business, the owner of a business usually injects a certain amount of capital from his own saving in order to get started. In this case, the capital and the owner of the business are usually taken as two different entities, which mean that such a business is indebted from commencement, and the owner became the first business creditor.

Click the button, and we will write you a custom essay from scratch for only $13.00 $11.05/page 322 academic experts available Learn more

While dealing with the theory of classical capital structure, the idea of how a business finances its assets through a combination of debts from different sources, in addition to use of equity emerges. Though there are many theories propagated to oppose the capital structure, others argue on it favor claiming it lowers the cost of capital to a business (Gerstenberg, 1959, p.424). The same author notes that from this concept, capital structure can be said to have an advantage when a business is financed with debt and at the same time pose a disadvantage when the same business is financed with debt.

The positive side of financing a business with debt is in the tax benefits of debt, which means that the business will incur less tax burden than when it is financed with equity. On the other hand, such businesses suffer from bankruptcy costs and the financial anguish cost of debt. According to this theory, the marginal benefit of financing a business with debt increases as the rate or amount of debt incurred by a business declines.

Literature Review

The task of corporation’s administration in capital structure is to increase the value of the business corporation to its shareholders while taking into consideration the stipulated set of laws as well its responsibility. Corporate financing deals with issues such as how the corporation raises and manages its capital, what investment the corporation should be engaged in, in addition to deciding on the amount of profit the company should plough back to shareholders in terms of dividends (Brigham & Ehrhardt, 2010, p.337).

According to Brigham & Ehrhardt (2010, p.337), the management of any corporation is equally supposed to formulate rational decision pertaining the financial standing of a business. By so doing, the company value of its shareholders equity can easily be established through subtracting all the expenses from the corporation assets.

Myer (1984, p.36) echoes similar sentiments to those of Brigham & Ehrhardt (2010), though to some extent advices the management to give priority to internal financing and that financing a business from equity should only be considered as the last result. The author further remarks that it is only after the internal sources is depleted that the company should think of issuing the debt. Myer (1984, p.37) further observes that only when issuing more debt is not sensible should the management turn to equity. On preferring debt to equity, Bierman (2003, p. 5) observes that equity means issuing new shares and consequently bringing in new external ownership into the company.

Only 3 hours, and you will receive a custom essay written from scratch tailored to your instructions Learn more

According to Sharma & Kumar (2002, p.231), in a perfect market the manner in which a firm is financed is of no relevance to its value. However, since not a single corporation operates in an ideal world situation, the capital structure that a company employs become of much relevance and always affects the value of a corporation, when one puts into consideration the imperfect market in the real world situation. This theory brings about issue of whether there exists an optimal capital structure.

Analysis and Discussion

In order to settle on the best way a corporation should seek its source of funding, the company should critically analyze the available sources. In the course of analyzing these sources, the management of a corporation should have some aspects in mind. In order to come up with a true picture of financial decision, a corporation should first be valued to reflect on the expected flow of cash (McKinney, 2010, p.453). Due to inflation and changes in the economy, what a dollar can buy today is of higher value than what one will be able to buy with a dollar in say ten years from now. Over time, money tends to lose exchange value.

One way of dealing with the problems associated with capital structure is capital budgeting. Capital budgeting involves taking decisions on how to assign capital and related accountability measures. Among the analytical techniques developed for evaluating capital expenditure, include the discounted cash flow method and present value method. The discounted cash flow method is an assessment method used to guesstimate the attractiveness of a venturing opportunity. This method uses prospective free cash flow protrusion and discounts them to arrive at a present value, which is used to appraise the prospective for investment. If the resulting value is higher than the present asking price of the investment, the chance may be a good one. However, the method that is more commonly used in capital budgeting is the Net Present Value method.

Present value method

This method is also widely referred to as ‘time adjusted rate of return’ or ‘internal rate of return’. This method is based on the assumption that the future value of say a dollar, cannot be taken to equal the current value of a dollar. In present investments, the financial manager has to seek to ensure that the value of inputs and the value of outputs somehow are the equal. The present value of future cash inflows can be premeditated with assistance of the following method:

PV=S/ (1+I) n

Where: PV = present value of future cash inflow

Get a 15% discount for your first original paper from our academic experts Get it now

I=internal rate of returns

S= future value of a sum of money

N=number of year

Numerical Computation of Net Present Value Method

Under this technique, an essential rate of return is assumed and a similarity is made among the present value of cash inflows at diverse times and the original venture, in order to establish the potential effectiveness. This technique is based on the fundamental standard. If the present value of cash inflows discounted at a particular rate of return equals or go beyond the quantity of speculation, the suggestion ought to be acknowledged.

Present value charts are normally used whenever one wishes to compute the present value in order to make the computation quick. The present value tables also help financial managers to understand the present value of the cash inflows at essential earning portion equivalent to diverse periods. One can however use a formula to make out the present value attainable after a specified period at a known rate of concession.

PV=S/ (1+I) n

For $13.00 $11.05/page, our academic experts will deliver a completely original paper according to your requirements Learn more

Where: PV=present value

R=rate of discount

Illustration

An investment proposal requires an initial outlay of $ 40,000 with an expected cash inflow of $ 1000 per year for five years. Should the proposal be accepted if the rate of discount is a) 15% or b) 6%.

By use of the present value chart, one can promptly land at the present value of the money inflow.

Year
(1)
Cash inflow
(2)
Present value of [email protected] 15% (3) Total present [email protected] 15%(2)*(3) Present value of [email protected]%
(5)
Total present value @ 6%
(2)*(5)
1

2

3

4

5

1000

1000

1000

1000

1000

.870

.756

.658

.572

.497

870

756

658

572

497
3353

.943

.890

.840

.792

.747

943

890

840

792

747
4212

From the above-tabulated computation, one can come up with the following conclusion. Given the present value of $3353 at an interest rate of 15 %, is below $ 4000, which is the sum of the initial investment, the suggestion cannot be established. If one decides to ignore the other non-quantitative deliberations. However, the present value of $ 4212 at a concession rate of 6 % exceeds the original investment of $ 4,000, from that fact the proposal can readily be acceptable.

Conclusion

From the above considerations on business capital, it is clear that capital structure is one of the very essential things that a corporation should put serious consideration on, as it entail the practicability of its daily business operations. From the way a corporation makes decision on the most prudent means of financing a corporation, capital structure cannot be undermined since the business finances are interrelated with its operation.

Similarly, as long as a corporation is operating on real world situation and not on a perfect market, it is of absolute necessity for any corporation to decide on the most optimum capital structure to put in use. From the analysis given above, it is clear that the management need practical evaluation of its sources of finance, before it finally settle on the best according to its needs. This analysis finally makes it clear that no matter the source of capital, taking into account the net present value of inflows helps towards better future prospects.

References

Bierman, H., 2003. The Capital Structure Decision. Routledge publishers: New York.

Brigham, E., F., & Ehrhardt, Michael, C., 2010. Financial Management Theory and Practices. Cengage Learning: London.

Gerstenberg, C., W., 1959. Financial Organization and Management of Business. Prentice-Hall Publishers: California.

McKinney, J., B., 2004. Effective Financial Management in Public and Non-Profit Agencies. Greenwood Publishing Group: Pittsburgh.

Myers, S., 1984. Corporate Financing and Investment Decisions. University of California: California.

Sharma, R., & Kumar, A., 1998. Managerial Economics. Atlantic Publisher: New York.

Cite this text

Pick the style

Reference

NerdyTom. (2022, March 24). Capital Structure: Use of Debt. Retrieved from https://nerdytom.com/capital-structure-use-of-debt/

Work Cited

"Capital Structure: Use of Debt." NerdyTom, 24 Mar. 2022, nerdytom.com/capital-structure-use-of-debt/.

1. NerdyTom. "Capital Structure: Use of Debt." March 24, 2022. https://nerdytom.com/capital-structure-use-of-debt/.


Bibliography


NerdyTom. "Capital Structure: Use of Debt." March 24, 2022. https://nerdytom.com/capital-structure-use-of-debt/.

References

NerdyTom. 2022. "Capital Structure: Use of Debt." March 24, 2022. https://nerdytom.com/capital-structure-use-of-debt/.

References

NerdyTom. (2022) 'Capital Structure: Use of Debt'. 24 March.

Copy this

We received this text from a student and added it to our database in order to facilitate your research. You can reference it in your writing assignment by using our citation generator.

Send us a request to withdraw this paper if you are the original author and no longer want to see it published on NerdyTom.

Find out your order's cost