Important of Capital Structure

Part – 6

In our last tutorial, we understood terminal spot check. In this article, we will discuss the gist of the capital structure of the firm. 

As discussed in the previous section, a DCF requires a discount rate. The discount rate is a function of the risk inherent in any business and industry, the degree of uncertainty regarding the projected cash flows, and the assumed capital structure. In general, discount rates vary across different businesses and industries. The greater the uncertainty about the projected cash stream, the higher the appropriate discount rate and the lower the current value of the cash stream.

Extract the Capital Structure from Annual Report

For calculating the discount rate, we require the proportion of Equity and Debt in the capital structure using our ABC example. For the capital structure calculations, the annual reports of ABC have provided us with the following information on Debt and Equity related items from the footnotes.

The capitalization table of ABC company is as per below.

Understanding the Capital Structure of the Firm

Short-Term Borrowings:

Short-term borrowings are an account shown in the current liabilities portion of a company’s balance sheet. This account comprises any debt incurred by a company due within one year. The debt in this account is usually made up of short-term bank loans taken out by a company. ABC needs to pay $5.2 million within one year and the interest (coupon) of 3.2%.

Revolver

Revolving credit is a type of credit that does not have a fixed number of payments, in contrast to installment credit. Examples of revolving credits used by consumers include credit cards or overdraft facilities. Corporate revolving credit facilities are typically useful to provide liquidity for a company’s day-to-day operations. In the context of company ABC, they have a pre-approved loan facility of up to $30 million. However, ABC has drawn only $14.2 from the bank.

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Typical characteristics of Revolver loan

• The borrower may use or withdraw funds up to a pre-approved credit limit.
• The amount of available credit decreases and increases as funds are borrowed and then repaid.
• The credit may be useful repeatedly.
• The borrower makes payments based only on the amount they’ve actually used or withdrawn, plus interest.
• The borrower may repay over time (subject to any minimum payment requirement) or in full at any time.
• In some cases, the borrower needs to pay a fee to the lender for any money that is undrawn on the revolver; this is especially true of corporate bank loan revolving credit facilities

Bonds

A bond is a debt security in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest (the coupon) and/or to repay the principal at a later date, termed maturity. A bond is a formal contract to repay borrowed money with interest at fixed intervals. Company ABC has taken a loan of $80 million, out of which ABC needs to repay the amortizing portion of the bond i.e. principal repayment of $12 million within a year.

• Long-term = $80 – $12 = $68 (maturity of more than one year)
• Short Term = $ 12 million (amortizing portion, principal repayment)

Convertible Bonds

A convertible bond is a type of bond that the holder can convert into shares of common stock in the issuing company or cash of equal value at an agreed-upon price. It is a hybrid security with debt- and equity-like features. Although it typically has a low coupon rate, the instrument carries additional value through the option to convert the bond to stock, thereby participating in further growth in the company’s equity value. The investor receives the potential upside of conversion into equity while protecting the downside with cash flow from the coupon payments. In ABC, convertible bonds have a face value of $100 and a coupon rate of 4.5% (interest expense). The conversion price is $25, which implies each bond converts into 4 shares.

Straight Preferred Stocks

Preferred stock, also called preferred shares, is a special equity security that resembles properties of both an equity and a debt instrument and is generally a hybrid instrument. Preferred Stocks are senior (i.e. higher ranking) to common stock but are subordinate to bonds.

This stock usually carries no voting rights but may carry priority over common stock in the payment of dividends and upon liquidation. Preferred stock may carry a dividend paid out prior to any dividends being paid to common stockholders.

Cumulative versus Non-cumulative Preferred Stocks

Preferred stock can either be cumulative or noncumulative. A cumulative preferred stock requires that if a company fails to pay any dividend or any amount below the stated rate, it must make up for it at a later time. Dividends accumulate with each passed dividend period, which can be quarterly, semi-annually, or annually. When a dividend is not declared in time, it is said that the dividend has “passed,” and all passed dividends on a cumulative stock are dividends in arrears. A stock that doesn’t have this feature is known as a noncumulative or straight preferred stock, and any dividends passed are lost forever if not declared.

Convertible Preferred Stocks

These are preferred issues that the holders can exchange for a predetermined number of the company’s common stock. This exchange can occur at any time the investor chooses, depending on the conversion price. It is a one-way deal, so one cannot convert the common stock back to preferred stock.

In ABC, the face value (FV) of the preferred stock is $18. Each preferred stock converts to one ordinary share at a conversion price of $20.

The key to getting WACC correct is to get the capital structure right. Hence, we need to classify our capitalization table from the perspective of Debt and Equity.

Summary of Classification as Debt and Equity

 

What Next

In this article, we have understood the capital structure of the firm. In our next article, we will understand convertible features. Till then, Happy Learning!

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Here are some articles that will help you to get more detail about the Detailed Capital Structure, so just go through the link.

1. DCF Excel summary
2. Equity Value
3. Convertible Bonds
4. Terminal Value