BUS FPX 4070 Assessment 8 Capital Structure and Financial Health

BUS FPX 4070 Assessment 8 Capital Structure and Financial Health

Student Name

Capella University

BUS-FPX4070 Foundations in Finance

Prof. Name:

Date

Problem 1: Optimal Capital Structure

XYZ Inc. is currently determining its optimal capital structure, with the Chief Financial Officer (CFO) estimating that the ideal debt-to-capital ratio ranges between 25% and 60%. After analyzing various projections, the company has obtained the following data:

To determine the optimal capital structure and the debt-to-capital ratio at which the Weighted Average Cost of Capital (WACC) is minimized, XYZ Inc. must analyze these figures. According to the Corporate Finance Institute (CFI), capital structure refers to the balance of debt and equity a firm uses to fund its operations, and the optimal structure is the one that results in the lowest WACC.

From the data, XYZ Inc.’s optimal capital structure appears to be at a 45% debt-to-capital ratio. At this ratio, the projected stock price is relatively high, and the projected earnings per share (EPS) are also stronger. This suggests a favorable balance between equity and debt that helps minimize the WACC.

Problem 2: Break-Even Analysis

XYZ Inc. sells photo frames at $20 each, with fixed costs totaling $60,000 and variable costs of $7 per frame. The following analysis reveals the gain or loss at different sales levels:

The break-even point indicates the minimum number of units needed to cover production costs. If the selling price per photo frame increases to $25, the break-even point changes to 4,615 units.

When both the selling price and variable costs increase (with variable costs rising to $13 per frame), the break-even point increases further, now requiring 5,000 units to break even. This demonstrates how both selling price and variable cost changes impact the break-even point, emphasizing the importance of pricing strategies and cost management.

Problem 3: WACC and Optimal Capital Structure

XYZ Inc.’s finance department has analyzed its debt cost data at various debt-to-capital ratios and used the Capital Asset Pricing Model (CAPM) to estimate the cost of common equity. Based on an equity/asset ratio of 60% and a debt weight of 40%, XYZ’s WACC is calculated at 13.8%.

An anticipated increase in business risk would likely lead XYZ to adjust its capital structure, potentially reducing debt to mitigate the effects of higher risk. Furthermore, an increase in the corporate tax rate would likely prompt a reduction in the company’s debt, given the tax-deductibility of interest expenses. This would, in turn, lower the WACC.

Problem 4: Cost of Trade Credit and Bank Loan

XYZ Inc. purchases $10 million worth of materials with credit terms of 3/5, net 60, and has analyzed the costs of forgoing these discounts and obtaining additional credit. The nominal cost of not taking the discount is 20.57%, and the effective cost is 22.22%.

Furthermore, the effective cost of a bank loan at 8% interest, paid monthly, is calculated at 7.8%. Given these figures, it appears that utilizing the bank loan is a more cost-effective financing option compared to the trade credit, due to the lower effective cost.

References

Brigham, E. F. (n.d.). Fundamentals of financial management. Retrieved from https://capella.vitalsource.com/reader/books/9780357088562/epubcfi/6/62[%3Bvnd.vst.id ref%3DM31]!/4/528/1:621[199%2C4.]

Corporate Finance Institute. (n.d.). Capital structure. What is capital structure? Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/finance/capital-structureoverview/

BUS FPX 4070 Assessment 8 Capital Structure and Financial Health

Edspira. (2018, September 9). How to calculate cost of equity using CAPM [Video]. Retrieved from https://www.youtube.com/watch?v=JyUBm9M7Wyw