FINANCIAL MANAGEMENT

Financial Management



Financial Management

Introduction

Credit ratings and financial performance directly affect the decisions of the capital structure. This paper highlights the appropriate capital structure for the companies included in the analysis. Capital structure is determined on the basis of the nature of operations, market characteristics, product offering, industry structure, and financial performance of the companies.

Capital Structure

In finance, capital structure refers to the way a company finances its assets through a combination of equity, debt or hybrid securities. This forms the composition or 'structure' of its liabilities and equity. Capital structure represents a set of financial assets of the company from various sources of long-term financing; more specifically, the ratio of current liabilities, long-term liabilities and equity of the organization. For example, a company that sells $ 20 billion in capital and $ 80 billion in debt it is said that 20% is financed with stock and 80% is financed with debt. In fact, the capital structure can be very complex and includes dozens of sources (Helfert, 2002). A company must maintain a satisfactory level of working capital.

When a company expands, it needs capital; depending on the kind of business, financing sources distinguish on borrowing or internal funds. Borrowings have two significant advantages. First, the interest paid shall be deducted when calculating the tax, which reduces the actual cost of the loan. Secondly, those who provide the loan, receives a fixed income; in this case, shareholders do not have to share the profits with them, if the company is successful (Shapiro, 2005). However, the debt has its drawbacks. First, the higher the debt ratio, the riskier the company, and consequently, higher cost of capital for firms. Second, if operating profit of a company is not enough to cover interest costs, the shareholders have to compensate for a deficiency. The company is declared bankrupt in case its financial liabilities exceed the total assets capitalization (Ehrhardt, 2010).

Therefore, companies that have unstable earnings and operating cash flows should limit the financing through loans. On the other hand, those companies that have stable cash flows are free to attract debt financing.

Cost of Capital

The cost of capital is the price that the company pays for its capital use, i.e. annual cost of servicing the debt to investors and lenders. Quantitatively, it is measured as a percentage rate that characterizes the ratio of the total amount of capital acquisition expenses to the amount of capital. The cost of any firm is given by the value of its future free cash flows, discounted at the weighted average cost of capital (WACC). Changes in capital structure will influence the risk and cost of each type of capital, as well as the WACC as a whole (Gold, 2006). The capital cost assessment base on the price that the company pays to use the capital. This cost is measured as a rate: there is a fee for the cost of debt and one for the cost of equity.

The concept of cost of capital holds one of the basic theories of financial ...