Capital Structure Decisions: Benchmark – Mini Case 6
Capital Structure Decisions: Benchmark – Mini Case 6: The purpose of this assignment is to analyze a firm’s capital structure and its impact on firm performance. Within the assignment, explain core concepts related to business risk and recommend sound financial decisions based on analysis of a firm’s capital structure and capital budgeting techniques…
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Capital Structure Decisions: Benchmark – Mini Case 6
Paper details
The purpose of this assignment is to analyze a firm’s capital structure and its impact on firm performance. Within the assignment, explain core concepts related to business risk and recommend sound financial decisions based on analysis of a firm’s capital structure and capital budgeting techniques.
Read the Chapter 15 Mini Case in Financial Management: Theory and Practice. Using complete sentences and academic vocabulary, please answer questions a and b.
Using the mini case information, write a 250-500 word recommendation of the financial decisions you propose for this company based on an analysis of its capital structure and capital budgeting techniques. Explain why you chose this recommendation.
While APA style is not required for the body of this assignment, solid academic writing is expected, and documentation of sources should be presented using APA formatting guidelines, which can be found in the APA Style Guide, located in the Student Success Center.
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This assignment uses a rubric. Please review the rubric prior to beginning the assignment to become familiar with the expectations for successful completion.
You are required to submit this assignment to LopesWrite. Refer to the LopesWrite Technical Support articles for assistance.
Benchmark Information
This benchmark assignment assesses the following programmatic competencies:
MBA and MSN
9.1 Recommend sound financial decisions based on analysis of a firm’s capital structure and capital budgeting techniques.
MBA
3.1 Recommend sound financial decisions based on analysis of a firm’s capital structure and capital budgeting techniques.
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MBA in Finance
3.1 Recommend sound financial decisions based on analysis of a firm’s capital structure and capital budgeting techniques.
5.1 Analyze a firm’s capital structure and its impact on firm performance.
Solution
Benchmark – Mini Case 6
Using the free cash flow valuation model, show the only avenues by which capital structure can affect value.
The free cash flow valuation approach states that the intrinsic value of a firm is equal to the present value of the free cash flow net the cash flow left over for distribution to the debtholders and stockholders in each period (Brigham & Ehrhardt, 2020). The decisions made on the operating profit and company growth will affect the free cash flow and, eventually, the firm’s value.
The effect on the value of the company is dependent upon the impact of the debt on the free cash flow and the weighted average cost of capital. At the end of the accounting period, the dividends are usually the last to be paid after the interest and principal payments. The debtors usually have the most urgent claims on the outgoings (Brigham & Ehrhardt, 2020). In company operations, the weighted average cost of capital is typically indecisive; nonetheless, it is not advisable to take on more debt as it can lead to bankruptcy.
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(b1) What is business risk? What factors influence a firm’s business risk?
Business risk usually seeks to assess whether a business will be able to make adequate sales to realize sufficient revenues that cover its operational expenses and eventually realize a profit. It is taken into account the costs a firm ought to meet to remain functioning and operational. In summary, it can be said that business risk is uncertainty about future operating income (EBIT). The EBIT (Earnings Before Interest and Tax) aims to ascertain profitability without considering the interest and taxes (Drury & Murphy, 2020).
A firm’s business risk can be influenced by factors such as government regulations, operating leverage, product liability, economic conditions, competition, cost of factors of production, sales volume, and pricing. These factors can be grouped into two categories, systematic and unsystematic (Drury & Murphy, 2020). A company has little control over systematic risk, for example, government policies. On the other hand, it can control unsystematic risks, e.g., pricing.
(b2) What is operating leverage, and how does it affect a firm’s business risk? Show the a operating break-even point if a company has fixed costs of $200, a sales price of $15, and variable costs of $10.
Operating leverage is a cost-accounting concept that aims to analyze the sensitivity of a business operating income with regards to sales. The risk associated with operating leverage usually arises on how the variable and fixed costs are structured (Hayes & James, 2020). Firms that make high volumes of sales at a high fixed cost and low variable costs have high operating leverage.
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These entities are exposed to high risks when compared to those with low operating leverage. High operating leverage means a firm can boost operating income through increasing sales (Hayes & James, 2020). Operating leverage usually magnifies results making losses look worse and gains better. Therefore, any error with high operating leverage during forecasting can eventually lead to considerable financial projection errors.
Fixed Cost (F) = $200
Price per Unit (P) = $15
Variable Cost (V) = $10
Quantity Break-Even (QBE) = Unknown
QBE = F / (P-V)
QBE = $200 / ($15-$10)
QBE = 40 units
Financial Recommendation’s for Pizza Palace
When a company is strategizing on capital structuring and planning, there various options to consider. In Pizza Palace’s case, it is in no danger of failing to meet its financial obligation. Taking on debt financing will enable the company to increase its capital. The move will allow the company to offset some of its financing costs, and that will be of great benefit to the company. The use of debt financing means that there are some privileges that the company stands to enjoy. Such an arrangement can help the company get some tax relief as the interest payment can be deducted as an expense against the income.
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Expansion of financial obligations is the recommended approach when aiming at raising more capital. The use of this technique will also give relief to the collected assessment reserve funds. To execute the process effectively, the company needs to work with investment banks to ensure everything is conducted per the legal requirements. The investment banks can further ensure it gets the best rates in the market.
With additional capital, the entity can enhance its operational activities leading to better machinery or technology, improved marketing, other employees, and even better dividend package for the investors. With an improvement in remuneration, the workforce will be motivated to deliver better performance. The right pay packages will also attract qualified personnel. This team will deliver on the organization goals and objectives making Pizza Place capable of being ahead of its competitors, eventually attracting more consumers and investors.
References
- Brigham, E. F., & Ehrhardt, M. C. (2020). Financial management: Theory and practice [with MindTap] (16th ed.). Mason, OH: South-Western. ISBN-13: 9781337902601
- Hayes, A. & James, M. (2020, May 24). Operating leverage. Investopedia. Retrieved from https://www.investopedia.com/terms/o/operatingleverage.asp
- Murphy, C. B. & Drury, A. (2020, Jun 30). Earnings before interest and taxes – EBIT. Investopedia. Retrieved from https://www.investopedia.com/terms/e/ebit.asp
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