STRATEGIC CORPORATE FINANCE

Capital Structure Decision and the Cost of Capital

Capital Structure Decision and the Cost of Capital

Introduction

The objective of this assignment is to discuss the concept of debt equity ratio and the impact of nature of a company on its capital structure. Three companies including Mattel, Clorox, and MGM Resorts International have been selected for the purpose of assignment. The paper commences with an introduction on debt equity ratio and overview of the three companies. Recommendations are presented for the three companies pertaining to the in the capital structure, on the basis of the nature of business and the riskiness of the companies.

The main objective of any organization is to maximize the shareholder's health. The determination of capital structure, that is the percentage of debt and equity, is one of the most critical decisions in this regard. Theoretically, the optimal capital structure is at the point where the share price of the company is maximum and weighted average cost of capital is minimum (Peterson, 1999). However, the determination of capital structure highly depends upon the nature of the company and cost of capital. Companies with the high cost of debt and leverage are recommended to move towards equity issuance. Debt equity ratio is the tool to measure the percentage of debt over equity. It is calculated by dividing the total liabilities over total equity (Baker, 2002).

Discussion

Mattel Inc. is one of the largest toy companies in the world. It is the manufacturer of some of the most popular and evergreen brands including Barbie, Fisher Price and Hot Wheels. Mattel Inc. is the third largest company in the global toys and games sector. The company operates exclusively in the traditional toys and games sector. Moreover, it also generates substantial revenue through the licensing of its brands to film, television and computer game franchises.

Industry analysts have forecasted mid single digit sales growth of Mattel Inc. for the next five years. In terms of product life cycle, Mattel has reached the corporate turning point from maturity to decline. Mattel Inc. has also sold the Learning Company and is in the process of cost cutting for the purpose of rejuvenating the overall business. Management insists that it is on the right track to achieving more efficient operations. Moreover, the company has also borne enormous losses in recent quarters, primarily because of the acquisition of the Learning Company. Debt has increased substantially in recent quarters, impacting the balance sheet in a negative manner (Bannon, 1999). The free cash flows have also declined immensely. Mattel Inc. is highly leveraged. The long-term debt is approximately equal to the shareholder equity. Under these circumstances, it is recommended for the company to focus on debt servicing and lower its debt equity ratio. The optimists are of the opinion that the company Mattel has the advantage of a reaching the experience curve in the industry. The brands are all time-tested brands which could help the company in times of economic downturn. The reason being that, in hard times, people tend to buy ...