## AIOU Code 8402 Capital Structure

Introduction

Capital structure is a set of techniques used to decide when to invest in projects. For example, one would use capital structure to analyze a proposed investment in a new warehouse, production line, or computer system. There are a number of capital structures available, which include the following alternatives.

Discounted Cash Flows

Under the discounted cash flows method, estimate the amount of all cash inflows and outflows associated with a project through its estimated useful life, and then apply a discount rate to these cash flows to determine their present value. If the present value is positive, accept the funding proposal. The weakness of this approach is that future cash flow projections are being used, and so could be quite inaccurate.

Internal Rate of Return

Under the internal rate of return method, determine the discount rate at which the cash flows from a projected net to zero. The project with the highest internal rate of return (IRR) is selected. The weakness of this approach is that the projects selected are not necessarily linked to the strategic direction of the business.

Constraint Analysis

Under the constraint analysis method, examine the impact of a proposed project on the bottleneck operation of the business. If the proposal either increases the capacity of the bottleneck or routes work around the bottleneck, thereby increasing throughput, then accept the funding proposal. This is perhaps the strongest capital structure method, since it focuses attention on just those areas that directly impact overall company profitability.

Breakeven Analysis

Under the breakeven analysis method, determine the required sales level at which a proposal will result in positive cash flow. If the sales level is low enough to be reasonably attainable, then accept the funding proposal. This approach sets a minimum threshold for the projects to be selected.

Discounted Payback

Under the discounted payback method, determine the amount of time it will take for the discounted cash flows from a proposal to earn back the initial investment. If the period is sufficiently short, then accept the proposal. This approach emphasizes a fast payback, and so is more appropriate when long-term returns are uncertain.

Accounting Rate of Return

Under the accounting rate of return method, one would calculate the ratio of an investment’s average annual profits to the amount invested in it. If the outcome exceeds a threshold value, then an investment is approved. This approach should not be used, since it does not account for the time value of money.

Real Options

Under the real options method, one would focus on the range of profits and losses that may be encountered over the course of the investment period. The analysis begins with a review of the risks to which a project will be subjected, and then models for each of these risks or combinations of risks. The result may be greater care in placing large bets on a single likelihood of probability.

Complexity Considerations

When analyzing a possible investment, it is useful to also analyze the system into which the investment will be inserted. If the system is unusually complex, it is likely to take longer for the new asset to function as expected within the system. The reason for the delay is that there may be unintended consequences that ripple through the system, requiring adjustments in multiple areas that must be addressed before any gains from the initial investment can be achieved.

The Capital Structure is the incremental return on investment that a business foregoes when it elects to use funds for an internal project, rather than investing cash in a marketable security. Thus, if the projected return on the internal project is less than the expected rate of return on a marketable security, one would not invest in the internal project, assuming that this is the only basis for the decision. The Capital Structure is the difference between the returns on the two projects.

For example, the senior management of a business expects to earn 8% on a long-term \$10,000,000 investment in a new manufacturing facility, or it can invest the cash in stocks for which the expected long-term return is 12%. Barring any other considerations, the better use of the cash is to invest \$10,000,000 in stocks. The Capital Structure of investing in the manufacturing facility is 2%, which is the difference in return on the two investment opportunities.

This concept is not as simple as it may first appear. The person making the decision must estimate the variability of returns on the alternative investments through the period during which the cash is expected to be used. To return to the example, senior management may be certain that the company can generate an 8% return on the new manufacturing facility, whereas there may be considerable uncertainty regarding the variability of returns from an investment in stocks (which could even be negative during the cash usage period). Thus, the variability of returns should also be considered when arriving at the Capital Structure. This uncertainty can be quantified by assigning a probability of occurrence to different return on investment outcomes, and using the weighted average as the most likely return. No matter how the issue is addressed, the main point is that there is uncertainty surrounding the derivation of the Capital Structure, so that a decision is rarely based on completely reliable investment information.

Capital Structure of a capital is a term unique to economics and finance. It is unique in the sense that you will not find mention of Capital Structure in the accounting books. It is not an explicit cost which is paid out of the pocket. Hence, there is no mention of this cost in the accounting records. Rather, it is an implicit cost which results out of our investment decisions. This article will explain about Capital Structure and how it must be used while making financial decisions:

### Alternate Uses of Money

Capital Structure represents alternate uses of money. Let’s say, if I have a \$1000 to invest and I decide to invest the money in the stock market, I am committing my resources. By investing \$1000 in the stock market, I will now not be able to use the same \$1000 for any other purposes now. I must therefore ensure that I am committing my resources to the best possible project. Let’s say, I have a choice between real estate and stock market investment, when I choose the stock market investment, I make it my best possible choice. Capital Structure tells us what we are foregoing to choose that best possible alternative. Capital Structure is therefore the value of the second best alternative.

### Alternate Projects Must Share Similar Risk Profile

However, we must ensure that we compare Capital Structure of capital across similar projects. This will ensure that we do not see a biased picture and end up choosing the wrong projects. Consider a comparison between a stock market investment and government bonds. Usually, stock markets will offer more return compared to government bonds. So, using government bonds as the Capital Structure will always make them look good. But stock market investments and government bond investments have very different risk profiles. One guarantees a fixed rate of return whereas there are no guarantees in the other. Hence, using one as the Capital Structure for another will provide a skewed picture and the risky alternative will always be chosen. Hence, only projects with similar risk must be used for Capital Structure calculation. This makes these calculations very subjective and open to debate.

### Alternate Uses Represent Implicit Costs

The investment decision is all about prioritizing. It is about choosing the best possible alternative. So, if we have 2 alternatives, one which offers a \$100 return potential whereas another which offers an \$80 return potential, then by choosing one alternative we are alternatively foregoing the other one. So, if we choose to get a \$100 return, we are foregoing the \$80 return. Corporate finance captures this implicit tradeoff in the expected rate of return number.

### How Capital Structure Helps in Decision Making?

Capital Structure helps in choosing the right project when faced with a variety of alternatives. Here is how the decision is affected:

• Higher Capital Structure Lowers NPV: A higher Capital Structure implies a bigger discount rate. A bigger discount rate means that the future values are worth considerably less today. This creates a situation where the NPV is lowered. A high Capital Structure raises the bar for all other projects as well.
• Only the Best Investment Has Positive NPV: Also, we need to understand that in a given set of 2-3 investment proposals, only the best proposal will have a positive NPV. This is because the best proposal will be the Capital Structure for the other projects. Since the Capital Structure will be higher than the cash flows that the project has to offer, the NPV of such a project will be negative. One just needs to be careful about the risk profile of different projects to ensure an “apples to apples” comparison.

Advantage 1: Awareness of Lost Opportunity

A main benefit of Capital Structure is that it causes you to consider the reality that when selecting among options, you give up something in the option not selected. If you go to a grocery store looking for meat and cheese, but only have enough money for one, you have to consider the Capital Structure of the item you decide not to buy. Recognizing this helps you make more informed and economically sensible decisions that maximize your resources.

Another important benefit of considering your Capital Structure is it allows you to compare relative prices and the benefits of each alternative. Compare the total value of each option and decide which one offers the best value for your money. For instance, a business with an equipment budget of \$100,000 may buy 10 pieces of Equipment A at \$10,000 or 20 pieces of Equipment B at \$5,000. You could buy some of A and some of B, but relative pricing would mean comparing the value to you of 10 pieces of A versus 20 pieces of B. Assuming you choose 20 pieces of B, you effectively decide this is more valuable to you than 10 pieces of A.

Capital Structure take time to calculate and consider. You can make a more informed decision by considering Capital Structure, but managers sometimes have limited time to compare options and make a business decision. In the same way, consumers going to the grocery store with a list and analyzing the potential Capital Structure of every item is exhaustive. Sometimes, you have to make an instinctive decision and evaluate its results later.

Though useful in decision making, the biggest drawback of Capital Structure is that it is not accounted for by company accounts. Capital Structure often relate to future events, notes the Encyclopedia of Business, which makes it very hard to quantify. This is especially true when the Capital Structure is of non-monetary benefit. Companies should consider evaluating projected results for forgone opportunities against actual results for selected options. This is not to generate bad feelings, but to learn how to choose a better opportunity the next time.

Literature Review

There are some difficulties linked while using the Capital Structure as a decision making scheme as it is not usually referred in the management decision making strategy. But some of the new management literature has some coverage in the application cost calculation. Capital Structure plays a vital part in the decision making system and coverage. Economists have defined Capital Structure differently as per their context, but the main focus was the same and it is concentrating on the profit that is determined by specific resources and different purposes. Capital Structure is still an important aspect in the decision making of the management.

Decision making system usually overlooked the Capital Structure. Examples of accounting and monetary costs should include books, accommodation fees and tuition fees if assuming a college context. Many Capital Structure examples have been neglected and they are as follows:

Time spent while attending a class could be a working schedule in a company and getting a salary.

Missing of the value of activities in order to get more time for further studies.

The investment in education could be more fruitful rather than purchasing items.

Capital Structure represent the benefits an individual, investor or business misses out on when choosing one alternative over another. While financial reports do not show Capital Structure, business owners can use it to make educated decisions when they have multiple options before them. Bottlenecks are often a cause of Capital Structure.

Assume the expected return on investment in the stock market is 12 percent over the next year, and your company expects the equipment update to generate a 10 percent return over the same period. The Capital Structure of choosing the equipment over the stock market is (12% – 10%), which equals two percentage points. In other words, by investing in the business, you would forgo the opportunity to earn a higher return.

Capital Structure analysis also plays a crucial role in determining a business’s capital structure. While both debt and equity require expense to compensate lenders and shareholders for the risk of investment, each also carries an Capital Structure. Funds used to make payments on loans, for example, are not being invested in stocks or bonds, which offer the potential for investment income. The company must decide if the expansion made by the leveraging power of debt will generate greater profits than it could make through investments.

Because Capital Structure is a forward-looking calculation, the actual rate of return for both options is unknown. Assume the company in the above example foregoes new equipment and invests in the stock market instead. If the selected securities decrease in value, the company could end up losing money rather than enjoying the expected 12 percent return.

For the sake of simplicity, assume the investment yields a return of 0%, meaning the company gets out exactly what it put in. The Capital Structure of choosing this option is 10% – 0%, or 10%. It is equally possible that, had the company chosen new equipment, there would be no effect on production efficiency, and profits would remain stable. The Capital Structure of choosing this option is then 12% rather than the expected 2%.

It is important to compare investment options that have a similar risk. Comparing a Treasury bill, which is virtually risk-free, to investment in a highly volatile stock can cause a misleading calculation. Both options may have expected returns of 5%, but the U.S. Government backs the rate of return of the T-bill, while there is no such guarantee in the stock market. While the Capital Structure of either option is 0 percent, the T-bill is the safer bet when you consider the relative risk of each investment.

The difference between an Capital Structure and a sunk cost is the difference between money already spent and potential returns not earned on an investment because the capital was invested elsewhere, possibly causing financial distress. Buying 1,000 shares of company A at \$10 a share, for instance, represents a sunk cost of \$10,000. This is the amount of money paid out to make an investment, and getting that money back requires liquidating stock at or above the purchase price.

From an accounting perspective, a sunk cost could also refer to the initial outlay to purchase an expensive piece of heavy equipment, which might be amortized over time, but which is sunk in the sense that you won’t be getting it back. An Capital Structure would be to buy a piece of heavy equipment with an expected return on investment (ROI) of 5% or one with an ROI of 4%.

Again, an Capital Structure describes the returns that one could have earned if he or she invested the money in another instrument. Thus, while 1,000 shares in company A might eventually sell for \$12 a share, netting a profit of \$2,000, during the same period, company B increased in value from \$10 a share to \$15. In this scenario, investing \$10,000 in company A netted a yield of \$2,000, while the same amount invested in company B would have netted \$5,000. The \$3,000 difference is the Capital Structure of choosing company A over company B.

As an investor that has already sunk money into investments, you might find another investment that promises greater returns. The Capital Structure of holding the underperforming asset may rise to where the rational investment option is to sell and invest in the more promising investment.

In economics, risk describes the possibility that an investment’s actual and projected returns are different and that the investor loses some or all of the principal. Capital Structure concerns the possibility that the returns of a chosen investment are lower than the returns of a forgone investment. The key difference is that risk compares the actual performance of an investment against the projected performance of the same investment, while Capital Structure compares the actual performance of an investment against the actual performance of a different investment.

Still, one could consider Capital Structure when deciding between two risk profiles. If investment A is risky but has an ROI of 25% while investment B is far less risky but only has an ROI of 5%, even though investment A may succeed, it may not. And if it fails, then the Capital Structure of going with option B will be salient.

Data collection methods

As detailed information about the entire population of buyout investments is unavailable, we can only speculate whether our sample represents typical transaction sizes, transaction structures, leverage ratios, sourcing or exit channels, or preferred industry segments at the time. At least, the ratios and dimensions of our sample transactions are very similar to those from other researchers, as discussed above. However, given the long sample horizon – from 1984 to 2004 – it should be stressed that trends, market conditions, debt interest rates and disclosed returns on buyout transactions changed significantly within that period. The entire capital market segment passed two cycles, as reported by Gompers. Available datasets on PE transactions (such as Thomson Venture Economics or Venture One) usually do not contain any economic information other than the timing and the amount of cash flows. Additionally, it is impossible for us to trace our sample transactions in any one of these (and similar) databases, since they are kept anonymous. In general, our data gathering process is not determined by any economic variable but only by the facts that we first need to have a relationship with a research partner, and second the available PPM must provide sufficient information on the track records. Due to these facts and the impossibility of tracing our sample transactions in any other database, we unfortunately cannot quantify the extent to which our sample is biased through sample attrition. We rely on the data provided by the PPM as a single but primary and reliable source. It should be noted that the information provided is based on audited numbers and audited transactions.

Conclusion

Corporate department management is increasingly recognizing the benefits from optimizing the recruiting process through the corporate Careers site. However, the corporate Careers website is only one component of a broader corporate staffing process. Yet the Careers site is a very public reflection on the corporation, and requires an allocation of corporate resources of labor and budget. While corporate staffing departments are undergoing increased scrutiny and process re-engineering, executive management is simultaneously realizing the impact that external recruiting and internal talent deployment and redeployment practices have on corporate goals. This is especially appreciable with revenue-generating roles such as sales positions. Capital Structure savings may be easily assessed by calculating the cost to the corporation of an unfilled position over time. Careers site best practices can provide savings and create value by contributing to an effective process which efficiently provides quality talent to the corporation.

Capital Structure could be the price that going to pay in the future, in another word, we have to make decision among the alternatives. Although it would be enormous to possess all worthy things, but resources are limited, which allow serving one purpose at one time. Market demand is the key factor to help the management to decide which is the best product or service to implement. In addition, the value of choice should have further benefits and cost relatively. For a simple example, play station games and women magazines are two the most demanding productions; due to the economy crisis, company need to decide cutting back one production (though this is the next best value). As Livingstone wrote that “Effective management decisions require careful comparison of costs and benefits of alternative action”. As a result, play station game shows growth potential and less cost compare to magazines. This could be the better production outcome and reduce unnecessary use of resources.

Based on our research we can conclude that the best way how to calculate the Capital Structure of equity capital is calculation by Build-up model. This method reflected not only external risks but also internal risks of companies which is very important factor. However, the big disadvantage of this model is that quantification is based on the subjective assessment of the analyst as well as the fact that risk additional charges are often estimated only according to the financial statements. Foreign studies confirmed that this model is not applicable for all businesses and for each sector or industry. If the company decided to use the CAPM model, it must consider very carefully what type of bonds should be used for determining the risk-free rate of return. The most ideal way would be to set bonds at the beginning and the end of the examined year or average of these two issues. However, in some countries, as well as in Slovakia, it is very difficult because not all countries have developed capital market. In the concept of CAPM model we recommended to use for calculation the 30-years Pakistan bonds. We realized, that utilization of Pakistan bonds within calculation in Slovak market is not the best way how to expressed the Capital Structure of equity capital as well as how to evaluate the business performance. However, we think that modern indicators are the better way how to calculate cost of equity than traditional indicators which are not as flexible and efficient as modern indicators. We are convinced that the best option how to express the business performance is the combination of financial and non-financial factors. Because of that, we continue with our research and we examine the non-financial factors within the engineering industry on the Slovak market.

Recommendations

Capital Structure is the price one will accept to pay in the future when making decisions between several alternative courses of action. In spite of the fact that it would be ideal to engage all opportunities if one had unlimited resources, this is not realistic. In the business, market demand is the vital factor that helps management decide which is the best profitable plan to the organization. This essay states about the effective management decisions which involve careful comparison of costs and advantage of alternative action. For more outcome the company could find other alternative to go with.

References

1. Jones, Charles M. and Rhodes-Kropf, Matthew (2003): The Price of Diversifiable Risk in Venture Capital and Private Equity, Columbia University Working Paper
2. Kaplan, Steven N. (1989a): The Effects of Management Buyouts on Operating Performance and Value, in: Journal of Financial Economics, Vol. 24, pp. 217 – 254
3. Lee, Cheng F. and Wu, Chunchi (1988): Expectation Formation and Financial Ratio Adjustment Processes, in: Accounting Review, Vol. 63, pp. 292 – 306
4. Lowenstein, Louis (1985): Management Buyouts, in: Columbia Law Review, Vol. 85, pp. 730 – 784
5. Murray, Gordon C. and Marriott, Richard (1998): Why has the Investment Performance of Technology-Specialist, European Venture Capital Funds been so poor?, in: Research Policy, Vol. 27, pp. 947 – 976
6. Phalippou, Ludovic and Gottschalg, Oliver (2008): The Performance of Private Equity Funds, in: Review of Financial Studies, forthcoming
7. Sahlman, William A. (1990): The Structure and Governance of Venture-Capital Organizations, in: Journal of Financial Economics, Vol. 27, pp. 473 – 521
8. Woodward, Susan E. and Hall, Robert E. (2003): Benchmarking the Returns to Venture, NBER Working Paper 10202
9. Zahra, Shaker A. (1995): Corporate Entrepreneurship and Financial Performance: The Case of Management Leveraged Buyouts, in: Journal of Business Venturing, Vol. 10, pp. 225 – 247