Essaycorporate finance 2 topic capital structure

THE FINANCIAL UNIVERSITY OF FINANCE – MARKETING BANKING AND FINANCE DEPARTMENT ESSAY CORPORATE FINANCE TOPIC: CAPITAL STRUCTURE Instructor class DR NGUYEN MINH PHUC Section class 2221702036501 Class CLC_20DTC01 First and last name NGUYEN NGOC YEN NHI Student code 2021000274 TPHCM, THÁNG 08 NĂM 2022 INDEX CHAPTER 1: THEORETICAL BASIS 1 What is capital structure? What is cost of capital? What is the debt ratio? What is optimal capital structure? CHAPTER 2: COST OF CAPITAL & DEBT RATIO Introduce VINAMILK: 2 Determining VINAMILK's cost of capital 2.1 Cost of debt 2.2 Cost of equity 2.3 Weighted Average Cost of Capital (WACC) Debt ratio CHAPTER 3: OPTIMAL CAPITAL STRUCTURE CHAPTER 4: THE DETERMINANTS OF THE COMPANY’S CAPITAL STRUCTURE .6 Profitability Firm size Growth rate Tax rate Business cycle Inflation Control Risk 9 Financial leverage 10 Cost of capital .10 11 Number of years of operation 10 12 Prospects of the capital market 11 CHAPTER 5: CONCLUSION 12 CHAPTER 6: DATA 13 CHAPTER 7: REFERENCE .17 CHAPTER 1: THEORETICAL BASIS What is capital structure? Capital structure describes the mix of a firm's long-term capital, which is a combination of debt and equity Capital structure refers to the amount of money – or capital – that supports a business, finances its assets, and finances its operations Capital structure refers to the amount of money - or capital - that supports a business, finances its assets, and finances its operations It can also show how company acquisitions and capital expenditures can affect the profitability of the business What is cost of capital? Cost of capital is a company's calculation of the minimum return that would be necessary in order to justify undertaking a capital budgeting project, such as building a new factory The term cost of capital is used by analysts and investors, but it is always an evaluation of whether a projected decision can be justified by its cost Investors may also use the term to refer to an evaluation of an investment's potential return in relation to its cost and its risks Many companies use a combination of debt and equity to finance business expansion For such companies, the overall cost of capital is derived from the weighted average cost of all capital sources This is known as the Weighted Average Cost of Capital (WACC) What is the debt ratio? A debt ratio helps determine how financially stable a company is with respect to the number of asset-backed debt it has It acts as one of the solvency ratios for investors as they can assess the probability of a firm turning bankrupt in the long run based on the debt-to-asset value The ratio also helps the top management check their company’s performance and make relevant decisions What is optimal capital structure? The optimal capital structure of a firm is the best mix of debt and equity financing that maximizes a company’s market value while minimizing its cost of capital In theory, debt financing offers the lowest cost of capital due to its tax deductibility However, too much debt increases the financial risk to shareholders and the return on equity that they require Thus, companies have to find the optimal point at which the marginal benefit of debt equals the marginal cost CHAPTER 2: COST OF CAPITAL & DEBT RATIO Introduce VINAMILK: Vietnam Dairy Products Joint Stock Company another name: VINAMILK; stock code HOSE: VNM, is a company manufacturing and trading milk and dairy products as well as related machinery and equipment in Vietnam VINAMILK is the largest dairy company in Vietnam Based on UNDP's Top 200 Vietnam's Largest Enterprises report 2007, it is also the 15th largest company in Vietnam and formerly the most valuable public company listed in Vietnam VINAMILK was listed on the Ho Chi Minh City Stock Exchange on January 19, 2006, then the capital of the State Capital Investment Corporation had a holding rate of 50.01% of the Company's charter capital Determining VINAMILK's cost of capital 2.1 Cost of debt VINAMILK’s interest expense in 2021 is about 88,8 million billion dongs (Table 2) While the opening balance is about 7483,92 million billion dongs and the end balance is about 9457,98 million billion dongs Thus, if calculated according to the open balance, the interest rate is up to 1,2%/year, and according to the end balance, it is only 1%/year So, the cost of debt will be 0,96%/year 2.2 Cost of equity VINAMILK's cost of equity estimate is based on the Capital Asset Pricing Model (CAPM), which shows the relationship between the expected return of an asset and the systematic risk of that asset Estimated beta coefficient of VINAMILK This is a measure of the correlation between the variability of corporate stock returns and the return of the market portfolio For consistency, the VN-Index is still used to represent the market portfolio The most common method of estimating the beta coefficient in practice is based on historical data Beta is estimated according to the regression equation rVNM,t = VNM + VNM x rM,t + t rVNM,t Return on VINAMILK’s stock in month t VNM The origin coordinates of the regression function VNM The beta coefficient of VINAMILK rM,t Return on VN-Index represents the market portfolio in the period t t Error Table presents the VN-Index and VINAMILK's share price from listing until January 2011 The return on VN-Index and VINAMILK stock is calculated based on VN-Index and stock price adjusted shares for dividend payment, additional issues, or bonus shares Table presents monthly returns of VINAMILK and VN-Index over years with a total of 36 observations The results of the regression are summarized below: rVNM,t = -2,02% + 0,57x rVN -INDEX According to the CAPM model, VINAMILK's cost of equity depends on VINAMILK's risk-free rate of return, market risk premium, and beta  Risk-free rate of return = 2,399%  Beta = 0,57  Required market return = 10,86% Cost of equity = 2,399% + 0,57 x (10,86% - 2,399%) = 7,22% 2.3 Weighted Average Cost of Capital (WACC) After determining the target capital structure and the cost of capital of all kinds, the weighted average cost of capital after tax is calculated: WACC = x rE + x (1 – tC) x rD = x 7,22% + x (1 – 20%) x 0,96% = 5,87% Document continues below Discover more tài doanh from: nghiệp A9835 Trường Đại học Tài… 447 documents Go to course 163-CÂU-TRẮC33 NGHIỆM-MÔN-TÀI-… 100% (37) Phan tich bao cao tai 34 chinh sabeco 100% (12) QB Chap6 Working 92 13 capital management tài doanh… 100% (1) Gencon 94 - JUST FOR DOWNLOAD tài doanh… 100% (4) Cost of capital 74 exrctvbynumi, tài doanh… Thus, VINAMILK's weighted average cost of capital is determined to be 5,87% 9749 Nguyen Debt ratio 100% (1) Thanh Phat 7931 The term debt ratio refers to a financial ratio that measures the tài extent of a company’s None leverage The debt ratio is defined as the ratio of total debt to total assets,nghiệp expressed as a doanh decimal or percentage It can be interpreted as the proportion of a company’s assets that are financed by debt Debt ratio (2021) = = 0,18 = 18% Debt ratio (2020) = = 0,15 = 15% Debt ratio (2019) = = 0,12 = 12% Total assets of the enterprise are greater than total liabilities, the company is still maintaining solvency by using its available assets CHAPTER 3: OPTIMAL CAPITAL STRUCTURE The optimal capital structure of a firm is the best mix of debt and equity financing that maximizes a company’s market value while minimizing its cost of capital In theory, debt financing offers the lowest cost of capital due to its tax deductibility During their operations, especially with large-scale business plans that require large amounts of investment capital, businesses must consider the rational use of accessible capital sources to achieve maximum efficiency the best Enterprises will have to calculate whether to use loans from banks, capital from issuing bonds, stocks or use the company's own retained earnings Optimal capital structure refers to the ratio between equity and debt capital that minimizes the cost of capital, minimizes business risk, and maximizes business value In addition, the optimal capital structure changes over time and depends on the nature of the business as well as factors outside the operating environment In fact, managers often set a debt-to-assets ratio of the business, such as 30% to 40%, instead of setting a specific number Statistically, capital structure is characterized by a firm's financial leverage, or debt-to-total assets ratio The optimal capital structure will vary between firms and across industries In industries that require a large concentration of capital, such as mining, metallurgy, or chemicals, the capital of enterprises is often from loan sources However, real estate companies, airlines, financial institutions, and their operating capital depend heavily on external loans For that reason, these businesses often maintain a high debt ratio In contrast, in brainstorming industries such as pharmaceuticals, advertising, and technology, companies tend to maintain low debt ratios These companies often have little or low financial leverage Optimal capital structure can help maximize the value of the business Theoretically, because managers tend to minimize the weighted average cost of capital (WACC), they will try to adjust capital structure (Brealey et al 2011) In the following sections, the relationship between the weighted average cost of capital (WACC) and firm value will be presented in more detail Regardless of where the business's capital is financed, the business will always be obligated to pay the cost of capital, which is the interest paid on bonds, financial institutions, or dividends to shareholders Therefore, in the long-run valuation process, the cost of capital The weighted average (WACC) will be used to estimate the overall cost of capital WACC is an important investment analysis tool for both investors and managers From the investor's perspective, WACC indicates the minimum return that a business must achieve to satisfy investors (Pushner 1995) More specifically, if the profit ratio of the enterprise is less than the WACC, it indicates that the operating performance of the enterprise is not good and is not attractive to investors In addition, management uses the WACC as a useful indicator to see whether a company's future investment projects and financing strategies are truly worth doing (Pushner 1995) Finally, WACC plays an important role in business valuation In the future cash flow valuation models of the business, financiers often use WACC as the discounting factor For the same reason, businesses tend to minimize the weighted average cost of capital to reduce the cost of capital and enhance the attractiveness of the business in the eyes of investors, but more importantly, to increase the cost of capital business value Because businesses always want to minimize the cost of capital, the amount of borrowed capital and the cost of borrowed capital play an important role in determining the efficiency of the business Therefore, adjusting the above two factors can help the firm achieve its optimal capital structure (Nickell and Neil, 1997) CHAPTER 4: THE DETERMINANTS OF THE COMPANY’S CAPITAL STRUCTURE Profitability There is a strong relationship between profitability and financial leverage The first reason is that the higher the profitability ratio, the lower the probability that the company is at risk of bankruptcy This will make the business a higher priority than borrowed capital, leading to an increase in financial leverage Besides, according to the trade-off theory, due to the benefit of the tax shield, the firm will borrow more and be incentivized to borrow more In addition, according to Jensen (1986), there are benefits to an entrepreneur efficient business increases its loan capital For example, instead of wasting money on infrastructure investments or negative NPV projects, businesses can invest in safer and more affordable loans However, according to pecking order theory, firms increase the use of internal capital while debt and equity issues are preferred last When compared with inefficient companies, profitable businesses will have more money, so they will make full use of this internal capital Sharing the same view, Titman and Wessel (1988) argue that when other factors are held constant, firms with high profitability will have lower financial leverage Firm size First, according to the equilibrium theory, financial leverage and firm size are positively correlated because firms with large size and diversified portfolio of activities will have lower bankruptcy risk when compared with smaller firms (Titman and Welssels, 1988) In other words, large companies will have an advantage when collaborating with financial institutions when compared to smaller companies Specifically, the transaction costs will be reduced when businesses make the purchase and sale of a number of goods and services in exchange In addition, Ferri and John (1979) argue that loan interest rates will tend to be higher for small businesses due to small loan size and low transaction frequency In addition, according to Ozkan (2000), small businesses are more vulnerable to economic fluctuations such as economic crisis or the downturn of the entire economy, leading to increased bankruptcy risk Therefore, from the customer's point of view, small companies seem riskier to invest in This also indicates that the possible solution here is that small businesses should put a high ratio of short-term debt instead of long-term debt In addition, as pointed out by Diamond (1991), small firms often have limited access to loans The rationale for this is that large firms typically have low intermediaries, low cash flow volatility, and greater access to credit markets (De Angelo et al., 1980) ) Therefore, the creditworthiness of large enterprises will be higher than that of small-sized enterprises Growth rate According to Myers (1984), high growth rates mean higher bankruptcy costs Therefore, according to trade-off Theory, due to bankruptcy costs, in businesses with high growth rates, financial leverage tends to decrease Besides, Titman and Wessels (1988) also confirmed that intermediate costs are higher in fast-growing industries due to the diversity of investment options in the future Therefore, according to the intermediate theory, the debt ratio will be said to tend to decrease However, some researchers have shown that high growth rates lead to increased financial leverage As evidenced by the fact that companies with high growth rates are said to have good health in the loan market and easy access to loans In addition, given the prospects for future growth, these companies are likely to increase their borrowings to maintain high growth opportunities in the future (Chen, 2003) On the contrary, according to Bevan and Danbolt (2002) high growth means high long-term leverage ratio but low short-term leverage ratio Tax rate According to Modigliani and Miller (1958), the tax rate is an important tool in determining the source of a firm's structure Proven binding from theories, when faced with high tax rates, businesses will tend to borrow more to take advantage of tax shields That is explained because the debt to equity ratio is the cumulative result of many years of operating with exceptional valuation while there is a possibility of loss from the tax revenue generated year after year Accordingly, the author's research mainly shows the impact of corporate tax rates including the existence of shields and investment taxes From that point of view, the author concludes that corporate tax rates have an impact on financial leverage This is Coinciding with presentations by Modigliani and Miller Business cycle In industries with large seasonal fluctuations in business, short-term loan terms will account for a high proportion This business must choose a contract capital structure is very important in each business period of the business The products were all born, developed, and ultimately concurrent with him At the beginning of the period, the rate of error is high, mainly the source account in this period is the capital owner At this stage, it is very difficult for businesses to get loans When an enterprise is in the development stage, it needs a lot of capital to expand its production and business scale As the business cycle enters a thriving growth phase, businesses must be prepared to face the financial implications of digital business major seasonal and cyclical operations If the business is preparing to enter the philosophy phase, it is important to build a structured resource that allows you to easily compact the resources used Inflation Another factor to consider in the financing decision is inflation By using debt financing during periods of high inflation, we will repay the debt with dollars that are worth less As expectations of inflation increase, the rate of borrowing will increase since creditors must be compensated for a loss in value Since inflation is a major driving force behind interest rates, the financing decision should be cognizant of inflationary trends Control Whenever additional funds are required by a firm, the management of the firm wants to raise the funds without any loss of control over the firm In case the funds are raised though the issue of equity shares, the control of the existing shareholder is diluted Hence they might raise the additional funds by way of fixed interest bearing debt and preference share capital Preference shareholders and debenture holders not have the voting right Hence, from the point of view of control, debt financing is recommended But, depending largely upon debt financing may create other problems, such as, too much restrictions imposed upon imposed upon by the lenders or suppliers of finance and a complete loss of control by way of liquidation of the company Risk There are two types of risk that are to be considered while planning the capital structure of a firm viz (i) business risk and (ii) financial risk Business risk refers to the variability to earnings before interest and taxes Business risk can be internal as well as external Internal risk is caused due to improper products mix non availability of raw materials, incompetence to face competition, absence of strategic management etc internal risk is associated with efficiency with which a firm conducts it operations within the broader environment thrust upon it External business risk arises due to change in operating conditions caused by conditions thrust upon the firm which are beyond its control e.g business cycle Financial leverage The use of long-term fixed interest-bearing debt and preference share capital along with equity share capital is called financial leverage or trading on equity Effects of leverage on the shareholders return or earnings per share have already been discussed in this blog If the assets financed by debt yield a return greater than the cost of the debt, the earnings per share will increase without an increase in the owners’ investment Similarly, the earnings per share will also increase if preference share capital is used to acquire assets But the leverage impact is felt more in case of debt because (i) the cost of debt is usually lower than the cost of preference share capital, and (ii) the interest paid on debt is a deductible charge from profits for calculating the taxable income while dividend on preference shares is not Because of its effect on the earnings per share, financial leverage is one of the important considerations in planning the capital structure of a company Companies with high level of the Earnings Before Interest and Taxes (EBIT) can make profitable use of the high degree of leverage to increase return on the shareholders’ equity 10 Cost of capital Cost of capital refers to the minimum return expected by its suppliers The expected return depends on the degree of risk assumed by investors A high degree of risk is assumed by shareholders than debt-holders The capital structure should provide for the minimum cost of capital Measuring the costs of various sources of funds is a complex subject and needs a separate treatment Needless to say that it is desirable to minimize the cost of capital Hence, cheaper sources should be preferred, other things remaining the same The main sources of finance for a firm are equity share capital, preference share capital and debt capital The return expected by the supplier of capital depends upon the risk they have to undertake For shareholders the rate of dividend is not fixed and the Board of Directors has no legal obligation to pay dividends even if the profits have been made by the company The loan of debt-holders is returned within a prescribed period, while shareholders can get back their capital only when the company is wound up This leads one to conclude that debt is a cheaper source of funds than equity The tax deductibility of interest charges further reduces the cost of debt The preference share capital is cheaper than equity capital, but is not as cheap as debt is Thus, in order to minimize the overall cost of capital, a company should employ a large amount of debt 11 Number of years of operation From the studies of Abor (2008), the number of years of operation of the company is directly proportional to the large company itself This is easily understood because, with the more years a company has been in business, the more credit it will have, the easier it will be to access loans To further support this argument, Diamond (1991) showed that a firm's years of operation are related to the transparency of the firm's information in the credit market In other words, long-standing companies will minimize the risk of any 10 information for banks and credit institutions Therefore, debit account will be easier, leading to intermediaries to reduce costs In that case, it will be more difficult for startups to access loans 12 Prospects of the capital market If interest rates will increase and borrowing becomes difficult, then right now, the tilt of financial leverage must be increased And vice versa, if interest rates are expected to decrease, then there must be a plan to reduce or postpone the current borrowing CHAPTER 5: CONCLUSION The objective of this study is to clarify the determinants of the capital structure of VINAMILK listed on the Vietnam Stock Exchange Based on the collection and analysis of financial statements of VINAMILK in the period of 2019 - 2021, the cost of capital and the debt ratio have been calculated Most 11 businesses strive to grow and expand There may be many options: expand a factory, buy out a rival, build a new, bigger factory Before the company decides on any of these options, it determines the cost of capital for each proposed project This indicates how long it will take for the project to repay what it cost, and how much it will return in the future Such projections are always estimates, of course But the company must follow a reasonable methodology to choose between its options A debt ratio of less than 100% indicates that a company has more assets than debt Used in conjunction with other measures of financial health, the debt ratio can help investors determine a company's risk level CHAPTER 6: DATA Table 1: VINAMILK's summary balance sheet Unit: Million billion VND 12 2019 2020 2021 2665,19 2111,24 2348,55 12435,74 17313,68 21025,74 4503,15 5187,25 5822,03 Inventory 4983,04 4905,07 6773,07 Current assets 134,43 148,48 140,52 Total assets 44699,87 48432,48 53332,4 Accounts payable 14968,62 14785,36 17482,29 Short-term debt 5351,46 7316,5 9382,35 Long-term debt 122,99 167,42 75,63 Total debts 5474,45 7483,92 9457,98 Equity 29731,26 33647,12 35850,11 Cash Short-term financial assets Accounts Receivable Table 2: VINAMILK's summary income statement Unit: Million billion VND 2019 2020 2021 Revenue 56318,12 59636,29 60919,16 Interest expenses 108,82 143,82 88,8 13 EBIT 12904.53 13662,36 13011,06 EBT 12795,71 13518,54 12922,26 Net Income 10554.33 11235.73 10632,54 Table 3: VN-Index and VINAMILK stock price at the end of the month VINAMIL Months VN - Index 30/1/2019 915.84 135.5 29/11/2019 970.8 121.5 31/1/2019 910.60 135.00 31/12/2019 961 116.5 28/2/2019 965.5 141.1 31/1/2020 936.6 108.5 29/3/2019 980.8 134.8 28/2/2020 882.2 104.5 26/4/2019 979.6 129.8 31/3/2020 662.5 91 31/5/2019 959.9 129.5 29/4/2020 769.1 99 28/6/2019 949.9 123 29/5/2020 864.5 115 31/7/2019 991.7 123.2 30/6/2020 825.1 112.7 30/8/2019 984.1 123 31/7/2020 798.4 107 30/9/2019 996.6 129.7 31/8/2020 881.6 121 31/10/2019 998.8 130 30/9/2020 905.2 108.9 30/10/2020 925.5 108 30/6/2021 1408.6 90.4 30/11/2020 1003.1 108.2 30/7/2021 1310 86.1 31/12/2020 1103.9 108.8 31/8/2021 1331.47 87.4 29/1/2021 1056.6 102.8 30/9/2021 1342.1 89.6 26/2/2021 1168.5 104.8 29/10/2021 1444.3 90.7 31/3/2021 1191.4 98.4 31/11/2021 1478.4 87.6 29/4/2021 1239.4 93.5 31/12/2021 1498.3 86.4 31/5/2021 1328 90.5 4/1/2022 1525.58 86.7 K 14 Source: Ho Chi Minh City Stock Exchange Table 4: Monthly return of VN-Index and VINAMILK stock Months VN - Index VINAMILK 31/1/2019 -0.57% -0.37% 31/10/2019 0.22% 0.23% 28/2/2019 6.03% 4.52% 29/11/2019 -2.80% -6.54% 29/3/2019 1.58% -4.46% 31/12/2019 -1.01% -4.12% 26/4/2019 -0.12% -3.71% 31/1/2020 -2.54% -6.87% 31/5/2019 -2.01% -0.23% 28/2/2020 -5.81% -3.69% 28/6/2019 -1.04% -5.02% 31/3/2020 -24.90% -12.92% 31/7/2019 4.40% 0.16% 29/4/2020 16.09% 8.79% 30/8/2019 -0.77% -0.16% 29/5/2020 12.40% 16.16% 30/9/2019 1.27% 5.45% 30/6/2020 -4.56% -2.00% 31/7/2020 -3.24% -5.06% 29/4/2021 4.03% -4.98% 31/8/2020 10.42% 13.08% 31/5/2021 7.15% -3.21% 30/9/2020 2.68% -10.00% 30/6/2021 6.07% -0.11% 30/10/2020 2.24% -0.83% 30/7/2021 -7.00% -4.76% 30/11/2020 8.38% 0.19% 31/8/2021 1.64% 1.51% 31/12/2020 10.05% 0.55% 30/9/2021 0.80% 2.52% 29/1/2021 -4.28% -5.51% 29/10/2021 7.61% 1.23% 26/2/2021 10.59% 1.95% 31/11/2021 2.36% -3.42% 31/3/2021 1.96% -6.11% 31/12/2021 1.35% -1.37% Source: Calculated from table 15 CHAPTER 7: REFERENCE [1] HAYES, A (2022) Cost of Capital Definition [2] LOTH, R (2022) Analyzing a Company's Capital Structure [3] Nguyễn Xuân Thành, Đ T (2013) Định giá Công ty Cổ phần Sữa Việt Nam VINAMILK [4] Trâm, L N (2010) Phân Tích Các Nhân Tố Tác Động Đến Cấu Trúc Vốn Của Doanh Nghiệp Việt Nam [5] Vaidya, D (n.d.) Debt Ratio Meaning [6] Titman, S., & Wessels, R (1988) The determinants of capital structure choice The Journal of finance, 43(1), 1-19 16