Essaycorporate finance 2 topic capital structure

What is cost of capital?Cost of capital is a company's calculation of the minimum return that would benecessary in order to justify undertaking a capital budgeting project, such as build

THE FINANCIAL UNIVERSITY OF FINANCE — MARKETING

BANKING AND FINANCE DEPARTMENT

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CHAPTER 1: THEORETICAL BASIS

1 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

2 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)

3 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

4, 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

1 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

2 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

Tvxx: Return on VINAMILK’s stock in month t

vu The orlgin coordinates of the regression function

vu Lhe beta coefficient of VINAMILK

Tut Return on VN-Index represents the market portfolio in the period t

t Error

Table 3 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 4 presents monthly returns of VINAMILK and VN-Index over 3 years with a total

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 =x1rpt+ x(1—-tc) x tp

= x 7,22% + x (1 — 20%) x 0,96%

=5,87%

w~, Document continues below

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decimal or percentage It can be interpreted as

are financed by debt

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

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

2 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

6

be reduced when businesses make the purchase and sale of a number of goods and services in exchange In addition, Fern 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

3 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

4 Tax rate