Just a short definition, Capital Structure is a mix of different types of equity and debt that a company has on their balance sheet. It is important to determine how much of the capital or ownership is related to debt and how is the equity. It is also a known strategy how the company raise capital funds on two major components which are equity and long term debt. Different alternatives are available for the company to employ in raising capital funds, it is essential for the company to find out the most feasible combination in order to achieve profitability like for example the company can issue securities or shares at different combinations for maximum efficiency (Mbalectures.com. October 1, 2011).
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Since Competition Bikes Inc. is looking into the possibility of expanding to the Canadian market, financial decisions need to be closely evaluated to identify which of the capital structure options would work best for raising funds. The company needs to raise an amount of $600,000 for the expansion. There are several options that CBI can choose from to raise funds by means of issuing bonds. The company has the following options to choose from: Option 1 A 9% fixed bonds on a five-year period at different percentage rates and common stocks. Option 2 A 9% bond to meet 100% of their financial needs, or combinations of 50% preferred stock and 50% common stock. Option 3 A 20% of the 9% bond plus 80% of common stock. Option 4 A 40% of the 9% bond plus 60% of the common stock Option 5 A 60% of the 9% bond plus 40% of common stock.
These options were plotted into a table to be able to observe how those options can maximize shareholder value based on CBI's 10% requirement on hurdle rate in order to pursue capital investment. By calculating capital structure based on earnings before interest and tax for the next five years we can identify which of the mentioned options would increase investor's wealth. The most optimal capital structure normally involves debt and one form of debt is called bond. In most cases 100% debt is not an ideal approach to capital structure, otherwise the company would suffer the risk of increased liability on top of the current long-term and on-going debt. By calculating capital structure based on earnings before interest and tax for the next five years we can identify which of the mentioned options would increase investor's wealth.
For year 9 a maximum earnings of $109,816 would yield a 0.53 earnings per stock shares on option number two, which appears to be the highest. The lowest yield comes from option number one at only 0.043 based on the same EBIT. In terms of net income option number two also appears to have the highest and option number one has the lowest. From all aspects of the capital sources it comes out that option number two has the highest advantage which is still has the highest yield. Now to calculate EBIT for year 10 at $128,814 EPS option two comes up at 0.640 and $96,611 on net income which is the highest among all options. Options four and five have the same EPS for year 10 EBIT but option two yields higher net income. To calculate year 11 EBIT at $148,160 EPS comes out the same on options three to five at 0.071, but surprisingly option number one which appears to have lower yielding from year nine and ten surpassed options three to five in terms of EPS.
Net income on the other hand is still higher in capital option two with $111,120 and option one still has the lowest with only $70,620 for year 11 EBIT. For year 12 net income option remained the highest at $127,176 although option one has the highest advantage for EPS at 0.089 while option two is only at 0.088. Year 13 with an EBIT of $181,546 provides the highest EPS on capital option number one at 0.098 surpassing option two with only 0.095, but net income stayed the highest on option two with $136,160 while option one only has $95,660. To sum it up, the first three years of EBIT doesn't give so much promise on EPS for options one, three, four and five. But as soon as the business goes on operation for the next fourth and fifth year, EPS appears at the highest for option one, but when it comes to net income capital option two remained consistently high in all EBIT projection. This means the most suitable capital structure for CBI's Canadian expansion is option two.
Based on the earlier assessments and comparisons, the best options to choose from is between capital structure option number one and two. They have two different ranges of advantages. In terms of EPS and net income option number two appears to have a bigger advantage. If the company is aiming to increase EPS for a short period of time them 50% preferred stock and 50% common stocks would be the best option. In general, the company has to think about growth in a long term, because that ensures the company's long term survival. However, the data suggests that in order to reach a 10% hurdle on rate of return, net income has to be constantly high.
So overall, option number two or raising funds 50% from preferred and 50% common stock would be the best choice because of the amount of net income it can provide including a target of 10% hurdle. The net income is a promising indication that the company would not be struggling from a long term debt and would still be able to reach its rate of return targets and maximize shareholder value. The amount of net income does relate much to maximize the value of shareholder's equity and importantly, the value rely on how much each share earns every year and how much it continuously earns on the next consecutive years.
The reason why raising 50% preferred and 50% common stocks is better than any other available options is because of its ability to yield EPS that keeps getting higher together with the net income. Option two or 50% common and 50% preferred has a higher EPS as compared to other alternatives. On year 11 capital option number two is at 0.075 or 0.003 higher than option one on that same year. On year 12, capital alternative number one has an EPS of 0.089 which is 0.017 higher than the previous year. This is also the year when alternative number two was surpassed in EPS yielding only 0.013 more from the previous year or just 0.088.
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Finally, on year 13, alternative number one reached an EPS of 0.098 which leaves alternative number two behind with only 0.095, this is because alternative number was able to increase its EPS by 0.009 while alternative number two only able to increase it 0.007. The reason why capital alternative number two was chosen among other alternatives is because of its ability to increase its EPS every year, although not constantly on a fixed rate but significantly doing well as compared to other alternatives. If alternative number two is chosen, the company can guarantee the shareholders of the value of their investment because of the higher rate of both net income and EPS with minimal obligation to debt.
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