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The Capital Structure Decision and the Cost of Capital
Introduction
Firms aim at portraying a positive image through optimization of its capital structure which can be based on equity and debt proportions or total liabilities. The capital structure is crucial in enabling a firm to maximize its market value in totality. It stipulates the dividend policy which means that managers have to aim at maximizing equity and adjusting cost of capital. Theories have been developed to help managers make prudent decisions regarding capital structure and adopt effective measures in cost of capital. This paper will analyze the capital structures of Dynamics Company, Dell and Sprint Corporations, and will suggest recommendations for the capital structure of the companies.
The capital structure decision and cost of capital
Paying out or not paying out dividends is a decision that is based on reasons. This makes the concept of dividend policy controversial. Dividend as a distribution of earnings ranges from regular, special, extra, and stock among others. Developing a dividend policy therefore has to incorporate the dividend variations while associating with rates of adjustment, aim of the payout and income levels. Campbell (1995) argues that dividend policy is not relevant for a firm with fixed vestment policy which holds assumptions of perfect market and expectations that are homogenous. Campbell (1995) asserts that the dividend policy is relevant where there are imperfections in the capital markets which are significantly important and in situations where there is signalization of new information following the announcements of the dividends, (p. 3). The decisions surrounding dividend policy are crucial and thus there are aspects which support high payout ratio and others which oppose it. Those against high payout ratio of dividend include; personal taxes and costs of transactions. On the other hand those that are in favor of high dividend payout ratio include; tax, legal and institutional reasons and the desire for extra income among other factors.
MM and Miller theories try to establish the relationship between the capital structure and its value. This theory assumes that the tax benefits enjoyed by firms increase with the increase in the debt amount used. These assumptions are based on the consistency in the cost of debt and the continued write-off of its tax liability using interest payments at the same rate. The theory also assumes that there is a correlation between corporate leveraging and homemade leveraging by individual investors, negligible costs of transactions, similar interest rates for firms and individuals and consistent tax structure in annual sales and profits. The assertion of 100% debt financing has an effect of causing an increase in the weighted average cost of capital (WACC) and later decreasing in value. Managers have an obligation of optimization of the capital structure to allow for minimization of the WACC and maximization of its value (Welch, 1996).
Trade off models adjusted MM and Miller model to incorporate agency costs and financial distress costs. They take into consideration the risk factor, nature of assets and tax rates. Debt financing increase has an effect of increasing the chances of bankruptcy for a firm. This financial distress can be direct in terms of legal and administrative costs and indirect in terms of loss of trust and sales, increased cost of capital, maintenance of employees and other consequences of drastic actions. Agency costs are presumed to relate to the conflicts in the organization among shareholders, debt holders and management. The lessons that are reviewed by Welch (1996) include; the level of borrowing should decrease with the increase in the risk factor of a firm, firms with intangible assets should borrow less compared to firms with more tangible assets while firms faced with low tax rates should borrow less compared to those with higher tax rates. Other models of dividend policy include the signaling model propounded by Ross (1977) in which a firms issuance of new debt sends a signal of its prospective future improvement to potential investors and the shareholders. The pecking order theory of Myers (1984) stipulates firms preference of internal equity financing over external equity financing due to the lower cost of the latter, (p. 572).
General Dynamics Company
The General Dynamics company is a leader in the market of marine systems and ship building; business aviation; munitions and armaments, land and combat vehicles and systems; and information systems and technologies, (General Dynamics Corporation, 2010, p. 1). The company has four business groups which concentrate on the provision of inventive goods and services which cater to the present as well as future desires of their clients (General Dynamics Corporation, 2010). The capital structure of General dynamics is characterized by tangible assets with the intangible assets being minimal. The risk involved is high because of the nature of the products produced and services offered while the tax rate is considerably significant. The capital structure of General Dynamics should be high. This is because of buildup of tangible assets and the lower risk involved due to the minimal levels of competition and the level of tax rates.
Sprint Corporation
Sprint Nextel is a leader in offering wire line and wireless communication services. It is widely known for its development, engineering and deployment of innovative technologies, leadership in offering mobile data services, and as the initiator of wireless 4G service in the United States from the national carrier, (Sprint Corporation, 2010, p. 1). Sprint boosts wireless and mobile assurance for instant international and national capabilities. Its customers include government users, businesses and individual consumers. The capital structure of Sprint is relatively faced by medium risk, with medium taxes and average stocks of tangible and intangible assets. The debt levels of Sprint Corporation are significant and hence there is need to adopt a medium capital structure.
Dell Corporation
Dell Corporation is a leading company in the manufacture and sale of laptops, printers, personal computers and other computer information systems. Its customers range from businesses, consumers and government. It aims at providing quality services to enhance the efficiency of the customers by adapting to the changing needs (Dell Corporation, 2010). The capital structure should be low. This is because of the high risks of the business, greater competition and the ratios of the tangible assets to the intangible assets.
Conclusion
The capital structure of any firm determines the outcome of the company. Though theories have been developed to help managers in making prudent decisions in capital structure and cost of capital, adequate research is crucial and the application of the same in individual firm due to the differences in the industries. The levels of borrowing for General Dynamics, Sprint and Dell need to be individualized to ensure greater profitability and efficiency in their respective industries.
Reference List
Campbell, R. (1995). Capital structure & payout policies. Web.
Dell Corporation. (2010). About Dell: Investor Information. Web.
General Dynamics Corporation. (2010). About General Dynamics Corporation. Web.
Myers, S. (1984). The Capital structure puzzle. Journal of Finance, 39, 575- 592.
Ross, S. (1977). The determination of financial structure: The incentive-signaling approach. The Bell Journal of Economics, 7, 23- 40.
Sprint Corporation. (2010). About Sprint Corporation. Web.
Welch, O. (1996). A primer on capital structure. California: University of California Graduate School of Management.
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