Capital Structure Essay

1459 words - 6 pages

The capital structure of a company is a mix of a company's long-term debt, specific short-term debt, common equity and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of funds. Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure. Equity is mostly supposed to be higher in the firm's capital structure however debt plays an important role as well. Debt is much favourable as it has the lowest cost since the interest paid on it is tax-deductable. Hence if a company has a significant amount of debt it reduces its WACC (Weighted Average Cost Of Capital) therefore generating a higher return for shareholders. However the more the debt the more the interest charged hence an increased chance of bankruptcy in the case of failure to pay the interest and level of risk.As shown by exhibit 3, the assessment of Oceana shows that they are lowly geared with no long term debts. The trade-off theory states that the use of debt will increase the return on equity until bankruptcy costs become overwhelming, hence this company is less likely to be in such a situation. The debt-equity ratio is low which means they bear very low interest rates for their little debts. According to the trade-off theory, they will not have financial distress which includes bankruptcy costs of debt and non-bankruptcy cost e.g. staff leaving.The Signalling theory shows confidence in company. It has got both positive and negative signals. In the case of Oceana, they have a positive signal of high equity and low debt obligations. This is testified by their low gearing ratio. Investors and managers have got the same information available to them.Another capital structure theory is the Agent cost theory. As written in exhibit 3, Oceana is lowly geared with no long term debts and little short term obligations. A relevant type of agent costs is free cash flow. Free cash flows should be given back to the investors otherwise management will have the incentive to destroy the firm value through empire building. Oceana is likely to be careless it has got a low gearing and low risk in its operations.Capital valuationCapital Asset Pricing Model (CAPM) b. Dividend Growth ModelRE= RF+B (RM-RF) KE=DO+(1+G)/P0 +G= 7.41+0.1325 =255.85(1+0.11)/8619+0.11=8.205% =3.624%Over the years the Price/Earning ratio has been increasingly indicating that investors have increased confidence in the business as each rand that they pay is rewarded by a higher earnings per share. This ratio shows how much investors are willing to pay for each R1 EPS that is earned. This is so because the nominal value of earnings is increasing since 2008 to 2012 that is from 237.70 in 2008 to 455.70 in 2012.Dividends per share are the sum of declared dividends for every...

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