Capital Structure Decision and the Cost of Capital

Capital Structure Decision and Cost of Capital

In basic terms, capital structure has got to do with how companies finance their overall operations using various sources of funds. In this text, I recommend what is in my opinion the optimal capital structure for the three companies selected for purposes of this discussion. The companies that will be used for purposes of this discussion are: Alaska Air Group, the Clorox Group, and eBay.

Optimal Capital Structure: Analysis and Recommendations

In seeking to determine the optimal capital structure for each of the three firms, it would be prudent to rely on a number of factors including but not limited to each firm's profitability and liquidity, nature of industry, company characteristics, etc.

EBay

EBay is essentially one of the largest online retailers in the world. According to Yahoo Finance (2014), the company "provides online platforms, tools, and services to help individuals and merchants in online and mobile commerce and payments in the United States and internationally." On its website, the company points out that as of today, it has approximately 124 million customers and users scattered across the globe (eBay, 2014). Its key competitors include but they are not limited to Overstock.com Inc. And Amazon.com Inc. The company retails a wide range of items through its numerous segments.

Table 1: Key Financial Statement Items

Item

Value (in $)

Current assets

21,398,000

Long-term assets

15,676,000

Current liabilities

10,924,000

Long-term liabilities

5,285,000

Revenue

14,072,000

Note: All dollar figures are in thousands

Table 2: Financial Ratios

Ratio

Value

Debt-to-equity ratio

0.78

Profit margin

0.19

Return on assets

0.07

Return on equity

0.13

EBay has a debt to equity ratio of 0.78. This ratio, according to Graham and Smart (2011), attempts to measure the financial leverage of a firm. This, as the authors further point out, it does by focusing solely on the long-term debt of an entity. In that regard therefore, eBay deems it fit to finance a significant proportion of its operations and assets using equity as opposed to debt. Like is the case in the Retail Industry, the Catalog & Mail Order Industry does not face significant fluctuations with regard to sales. Indeed, within the last three financial years, eBay's sales have not experienced significant fluctuations. In that regard therefore, the company can be permitted to have a high degree of financial leverage. Based on the company's profitability -- as indicated by its return on equity, the company would not have trouble meeting interest payments. In that regard therefore, the company should consider increasing debt proportion in its capital structure so as to have an optimal capital structure.

The Clorox Group

The Clorox Group according to Yahoo Finance (2014) manufactures and offers for sale a wide range of professional and consumer products. Some of the company's key segments include the Cleaning Segment, Household Segment, and Lifestyle Segment (Yahoo Finance, 2014). Each of these segments offer a unique and specialized product. Some of the company's main competitors in the House wares and Accessories Industry include but they are not limited to Procter and Gamble and Colgate Palmolive Co.

Table 3: Key Financial Statement Items

Item

Value (in $)

Current assets

1,420,000

Long-term assets

2,891,000

Current liabilities

1,134,000

Long-term liabilities

3,031,000

Revenue

5,468,000

Note: All dollar figures are in thousands

Table 4: Financial Ratios

Ratio

Value

Debt-to-equity ratio

28.53

Profit margin

0.10

Return on assets

0.13

Return on equity

3.71

Given its relatively high debt to equity ratio, it is clear that this particular company has been extremely aggressive in financing its growth and operations using debt. In this case, the debt holders have many times more claim of the various assets of the company than equity holders. It is important to note that except for the year under consideration, the company has in the past had negative equity. Currently though, the company's interest payments are sufficiently covered given its impressive revenues. It should, however, be noted that the current debt load significantly limits just how much money can be spent on not only share repurchases but also on dividends. In my opinion, the company may need to shed off some of the leverage it carries on its balance sheet, as its debt ratio is -- in its current state, unacceptable.

Alaska Air Group

With its headquarters in SeaTac, Washington, this company, "through its subsidiaries, provides scheduled air transportation for passengers and cargo" (Yahoo Finance, 2014). Currently, the company has an impressive fleet that enables it to adequately serve its clientele in all the areas it serves. Some of its key competitors in the marketplace are Southwest Airlines Co. And Delta Air Lines Inc.

Table 5: Key Financial Statement Items

Item

Value (in $)

Current assets

1,737,000

Long-term assets

3,768,000

Current liabilities

1,501,000

Long-term liabilities

2,583,000

Revenue

4,657,000

Note: All dollar figures are in thousands

Table 6: Financial Ratios

Ratio

Value

Debt-to-equity ratio

2.87

Profit margin

0.07

Return on assets

0.06

Return on equity

0.22

Typically, companies in the airline industry usually have a significantly high debt-to-equity ratio. The reason is simple. Unlike many other industries, the airline industry is particularly capital intensive. For instance, for a company like Alaska Air Group, its largest capital assets are airplanes. Given that the cost of a single Boeing aircraft could go up to $300 million, it is not difficult to see why this particular industry is capital intensive. The significantly high debt-to-equity ratio in this particular case is therefore justifiable. It is clear form the company's debt to equity ratio that most of its assets have been financed by debt as opposed to equity. In my view, the mix of debt and equity in this case is ideal.

Betas of all the Three Companies

Beta essentially helps in the determination of how risky a given entity's stock is. In that regard therefore, the relevance of beta cannot be overstated when it comes to the determination of selection of stock portfolio. The betas of the three companies are:

EBay = 0.91

The Clorox Group = 0.47

Alaska Air Group = 1.13

(Source: Yahoo Finance, 2014)

From the data above, Alaska Air Group's beta is clearly the highest. In that regard therefore, the said company's stock can be termed the riskiest. The least risky stock (based on its low beta) is the Clorox Group, followed by eBay. In other words, if we were to list the stocks in the order of their volatility -- starting with the one with the highest volatility to the one with the lowest volatility -- we would have Alaska Air Group, eBay, and the Clorox Group Respectively.

Debt vs. Equity Financing: Advantages and Disadvantages

From the onset, it is important to note that unlike equity financing, debt is in most cases treated as a tax-deductible expense. Further, where a company does not want to further dilute control, debt financing may come in handy. According to Pride (2013, p. 573), "common stock is voting stock; holders of common stock elect the corporation's directors and often must approve changes to the corporate charter." Although it has some unique advantages, debt financing also has a number of disadvantages. One of these is that unlike equity, it has to be repaid. Payments in this case entail both the principal and interest. It should also be noted that given the effect it has on the financial leverage of a firm, debt financing does have a negative impact on a firm's cost of equity.