Capital Structure Decision and the Cost of Capital A-Level Coursework

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Business -- Corporate Finance -- Capital Structure Decisions and the Cost of Capital

Based on the readings of the module and upon reviewing total debt/equity ratios, company betas, profitability ratios, company revenue, assets, and liabilities, and the nature of the operations of the companies, including the nature of their customers and products, what would you recommend to be the capital structure (total liabilities or debt and equity proportions) for each of the three companies?

a) eBay, Inc.

The nature of eBay's business is global online retail connecting more than 124 million buyers and sellers for the sale and purchase of more than 500 million items (eBay, Inc., 2013). As of September 30, 2013, measured in thousands, eBay's: total current assets are $23,476,000 (Yahoo! CA Finance, 2013); long-term assets are $40,067,000 (Yahoo! CA Finance, 2013); current liabilities are $12,028,000 (Yahoo! CA Finance, 2013); long-term liabilities are $17,300,000 (Yahoo! CA Finance, 2013); revenue is $3,892,000 (Yahoo, Inc., 2013); total debt/equity ratio is $17,300,000 (total liabilities)/$22,767,000 (total stockholder equity) = 0.759871744 (Yahoo! CA Finance, 2013); profit margin is $689,000 (net income)/$3,892,000 (revenues) = 0.177029805 (Yahoo! CA Finance, 2013); returns on assets are $2,609,000 (annual earnings)/$37,074,000 (total assets) = 0.070372768 (Yahoo, Inc., 2013); return on equity ratio is $2,609,000 (Net Income)/$20,865,000 (Shareholder's Equity) = -0.125041936 (Yahoo, Inc., 2013); and beta is 0.8 (Yahoo! CA Finance, 2013). EBay is the second riskiest of the 3 companies examined, with a beta of 0.8. Since eBay's return on equity ratio is low

(-0.125041936), eBay appears uncertain about its future and is in a bad position to incur more debt (Damodaran, 2005, p. 18). In order to "get optimal," we would ask: whether the actual debt ratio is greater than the optimal debt ratio, which it is; whether the company is in danger of bankruptcy, which it does not appear to be; whether it has good projections in cost of equity in cost of capital, which it does not; in which case, eBay should pay off its high debt with its retained earnings, reduce or eliminate its stock dividends, issue new sources of equity and pay off its debt (Damodaran, 2005, p. 90).

b) The Clorox Company

The nature of The Clorox Company's business is the global manufacture and sale of cleaning products, home care products, cat litter, charcoal, dressings and sauces, water filtration products, bags, wraps, containers, and natural personal care products (The Clorox Company, 2013). As of September 30, 2013, measured in thousands, The Clorox Company's: total current assets are $1,420,000 (Yahoo! CA Finance, 2013); long-term assets are $4,311,000 (Yahoo! CA Finance, 2013); current liabilities are $1,134,000 (Yahoo! CA Finance, 2013); long-term liabilities are $4,220,000 (Yahoo! CA Finance, 2013); revenue is $1,364,000 (Yahoo! CA Finance, 2013); total debt/equity ratio is $4,371,000 (total liabilities)/$152,000 (total stockholder equity) = 28.75657895 (Yahoo! CA Finance, 2013); profit margin is $572,000 (net income)/$5,623,000 (revenues) = 0.101725058 (Yahoo! CA Finance, 2013); returns on assets are $975,000 (annual earnings)/$4,311,000 (total assets) = 0.226165623 (Yahoo! CA Finance, 2013); return on equity ratio is $572,000 (net income)/$146,000 (shareholder's equity) = 3.917808219 (Yahoo! CA Finance, 2013); and beta is 0.48 (Yahoo! CA Finance, 2013). The Clorox Company is the least risky of the 3 companies examined, with the low beta of 0.48. This company has a relatively high return on equity ratio (3.917808219) and is quite a stable, established company. To determine the optimal capital structure for The Clorox Company, we would ask: whether its actual debt ratio is greater or lesser than its levered debt ratio, which it is not; whether it is a takeover target, which it is not; whether it has good projected cost of equity and cost of capital, which it does; therefore, the company should pursue good projects with debt (Damodaran, 2005, p. 90).

c) Alaska Air Group, Inc.

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The nature of the Alaska Air Group, Inc.'s business is passenger and cargo air transportation spanning 60 cities in 3 countries (Alaska Air Group, Inc., 2013). As of September 30, 2013, measured in thousands, Alaska Air Group Inc.'s: total current assets are $1,935,000 (Yahoo! CA Finance, 2013); long-term assets are $5,862,000 (Yahoo! CA Finance, 2013); current liabilities are $1,650,000 (Yahoo! CA Finance, 2013); long-term liabilities are $4,060,000 (Yahoo! CA Finance, 2013); revenue is $4,657,000; total debt/equity ratio is $4,060,000 (total liabilities)/$1,802,000 (total stockholder equity) = 2.253052164 (Yahoo! CA Finance, 2013); profit margin is $289,000 (net income)/$1,556,000 (revenues) = 0.185732648; returns on assets are $560,000 (annual earnings)/$5,505,000 (total assets) = 0.101725704; return on equity ratio is $316,000 (net income) / $1,421,000 (shareholder's equity) = 0.222378607; and beta is 1.06 (Yahoo! CA Finance, 2013). The Alaska Air Group, Inc. is the riskiest of the 3 companies examined, with the highest beta of 1.06. To find the optimal capital structure for this company, we should ask: whether the actual debt ratio is greater or lesser than the optimal debt ratio, which it certainly is; whether it is a bankruptcy risk, which it is and has been for some time. In this case, the company should quickly reduce its debt by making an equity for debt swap, selling assets and using the cash to pay off debts, renegotiating with its lenders (Damodaran, 2005, p. 90).

d) Debt over equity financing

Companies tend to prefer equity financing over debt financing. First, the investors are making an investment committed to the business and company projects (Peavler, 2013). Secondly, the company can avoid the expenses of business loans, such as interest, which frees up those funds for more capital in the company's activities (Damodaran, 2005, p. 4). Third, the investors can assist in developing and achieving new business ideas. Fourth, some of the investors the company may attract can help with new skills, contacts, strategies and key decisions. Fifth, the investors have a vested interest in the success of the company (Peavler, 2013). Sixth, investors may provide additional funding as the company grows and its goals expand. Simultaneously, there are disadvantages to equity financing (Peavler, 2013). First, it takes considerable time and effort to obtain and maintain equity financing, which could otherwise be spent on the company's essential activities. Secondly, a potential investor will delve into the company's history, forecasts and management. Third, company management may lose some power to the investors and have a reduced share in the business (Damodaran, 2005, p. 20). Fourth, the company and investors will have to deal with laws and regulations governing equity financing. Fifth, the company will not receive the benefits of higher taxes connected with debt financing (Damodaran, 2005, p. 20). On balance, the advantages outweigh the disadvantages of equity financing over debt financing in the view of many companies.

2) What do you perceive you have learned in the Module 4 Case Assignment? Which of the following learning outcomes do you feel you have mastered?

Module 4 has allowed me to obtain a beginner's knowledge about: bonds, which is debt instrument used to raise capital (Damodaran, 2005, p. 4) and other debt instruments, such as bank loans (Damodaran, 2005, p. 4), in capital plans. Module 4 has also taught me about debt financing vs. equity financing, which is discussed in section c, and optimal capital structure, which is a mix of debt and equity tailored to a specific company's needs (Damodaran, 2005, p. 6). Module 4 has also given me.....

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