BUS FPX 4070 Assessment 8 Capital Structure and Financial Health

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Capella university

BUS-FPX4070 Foundations in Finance

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Date

Problem 1: Optimal Capital Structure

XYZ Inc. is in the process of determining its target capital structure. The Chief Financial Officer (CFO) believes that the optimal debt-to-capital ratio lies between 25 percent and 60 percent. After analyzing various projections, the following data was obtained:

Debt/Capital Ratio	Projected EPS	Projected Stock Price
25%	$4.20	$40.00
35%	$4.45	$41.50
45%	$4.75	$41.25
60%	$4.50	$40.59

Assuming the firm utilizes only debt and common equity, determining XYZ’s optimal capital structure and the debt-to-capital ratio at which the company’s Weighted Average Cost of Capital (WACC) is minimized is essential.

According to Corporate Finance Institute (CFI), capital structure refers to “the amount of debt and/or equity employed by a firm to fund its operations and finance its assets,” with the optimal structure being the proportion resulting in the lowest WACC.

Optimal capital structure: Based on the data, XYZ’s optimal capital structure would be at a debt-to-capital ratio of 45%, coinciding with the higher projected stock price.
Minimized WACC: The debt-to-capital ratio yielding the minimized WACC for XYZ is also 45%. At this ratio, the projected EPS is relatively higher, indicating a favorable balance for the cost of capital and lower debt for the company.

Problem 2: Break-Even Analysis

XYZ Inc. sells photo frames at $20 each, with fixed costs amounting to $60,000 and variable costs of $7 per photo frame.

Gain or Loss at Different Sales Levels:
- At 6,000 photo frames: Gain = $18,000
- At 15,000 photo frames: Gain = $135,000
Effect of Selling Price Increase to $25:
- Break-even point at $25 selling price: 4,615 units
- The analysis highlights the significance of break-even point as the minimum units to cover production costs, with fixed costs remaining constant.
Effect of Selling Price Increase with Variable Cost Rise:
- Break-even point with selling price at $25 and variable costs at $13: 5,000 units
- The increase in variable costs alongside the price hike escalates the break-even point.

Problem 3: WACC and Optimal Capital Structure

XYZ Inc.’s finance department provides debt cost data at various levels of debt-to-capital ratio. Additionally, using the Capital Asset Pricing Model (CAPM), XYZ estimates its cost of common equity.

WACC at Optimal Capital Structure: With an equity/asset ratio of 60% and a debt weight of 40%, XYZ’s WACC is 13.8%.
Effect of Anticipated Increase in Business Risk: Anticipation of increased risk would likely prompt XYZ to adjust its working capital, minimizing debts until the risk is mitigated.
Effect of Congressional Tax Rate Increase: A significant increase in corporate tax rate would alter XYZ’s target capital structure, reducing debt due to its tax-deductible nature and subsequently lowering WACC.

Problem 4: Cost of Trade Credit and Bank Loan

XYZ Inc. purchases $10 million of materials with credit terms of 3/5, net 60. Analysis of forgoing discounts and obtaining additional credit reveals the nominal and effective cost.

Additional Credit Analysis:
- Additional credit amount without discounts: $1,506,849.32
Nominal and Effective Cost of Credit:
- Nominal cost: 20.57%
- Effective cost: 22.22%
Effective Cost of Bank Loan:
- Effective cost of bank loan at 8% interest, paid monthly: 7.8%

Conclusion:

Based on nominal and effective rates, utilizing a bank loan appears to be the most cost-effective option for XYZ.

References

Brigham, E. F. (n.d.). Fundamentals of financial management. Retrieved from https://capella.vitalsource.com/reader/books/9780357088562/epubcfi/6/62[%3Bvnd.vst.id ref%3DM31]!/4/528/1:621[199%2C4.]

Corporate Finance Institute. (n.d.). Capital structure. What is capital structure? Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/finance/capital-structureoverview/

Edspira. (2018, September 9). Youtube.com How to calculate cost of equity using CAPM. Retrieved from https://www.youtube.com/watch?v=JyUBm9M7Wyw