Evaluation Of Capital Structure Of Alumina Limited And Amp Limited

This study is the reflection of a detailed analysis carried out with the help of two ASX200 listed companies naming Alumina Limited and AMP Limited whose last five year financial status starting from the Financial year ending as on 31^st December 2013 and ending as on 31^st December, 2017 have been taken into consideration to evaluate the relevance of their Capital structure, corresponding cost of capital and significant risk ad returns associated with them and how these considerations have significant influence on the decisions to be made by the proposed investor in these companies (Boccia & Leonardi, 2016). In order to carry out this evaluation an attempt has been made to bring into light the relevant theories of capital structure, the procedure to compute the Weighted Average cost of Capital, the effect of taxes on the computation of cost of capital, the payout policy of the companies in terms of dividend, computation of cost of equity, the measurement of the risk and corresponding return and other corresponding relevant factors while making the decision relating to investment have been discussed along with the standard deviation as a method of measurement of risk and other methods for the computation of measurement of risk (Werner, 2017).

There are various sources of fund available with any corporate entity with a view to financing its operations with the objective of future growth, which can basically be categorized under the head debt fund and equity fund including the preferred stock though both have some merits and demerits associated with it (Alexander, 2016). The appropriate proportion of these funds in the capital structure of company helps it to achieve the optimum cost of capital for increasing productivity of the entity as a whole. The following table provides a brief description of the capital structure of Alumina Limited and AMP Limited for last five years that shall assist us to make a comprehensive study of the same.

From the figures reflected through the above table it is quite evident that the major similarities noticed in the capital structure of both o the companies is explained hereunder:

1. That both have kept the percentage of equity fund higher in comparison to the debt fund (Choy, 2018).
2. That both have shown a fluctuation in the proportion of debt fund incorporated in the financial statement of last five years, as at times they were increased and subsequently decreased too.

The difference in the capital structure is that the component of debt is much higher in case of Amp limited. Both the companies are maintaining their component of debt and equity similar to that of the material and financial industry.

 Two of the major capital structure theories are discussed hereunder.

1. Static Theory of capital structure : This theory is based on the fact that while choosing the debt as a mode of financing has the benefit in terms of tax shield earned on the interest paid/payable on such debt, but at the same time the firm may have to bear the cost of bankruptcy too, in case it is overburdened with such debt, hence the firm while choosing the appropriate proportion of debt in its capital structure should always keep in mind the trade off between the equity and the debt so that to ensure the maximization of the value of the firm (Jefferson, 2017).
2. Pecking order theory of capital structure: This theory clearly enumerates the fact that while choosing for the mode of finance a firm always maintains a hierarchy or order of preference in accordance with which first preference is given to the internal fund, next is the debt and the last source being resorted to is the equity. In other words, a firm shall always give priority to internal financing over debt and debt over equity, only when external financing requirement is being felt(Heminway, 2017).

Weighted average cost of Capital is being calculated using the following formula:

AMP Limited

WACC = [(E / V) * RE] + [(D / V) * RD * (1 – TC)]

Where,

E =Market Value of Equity

V= Total value of equity Plus debt

RE= Return on equity

D= Market value of debt

RD= Return on debt

TC= Tax Rate

In Our calculation we have computed the WACC for both the companies for the financial year ending 31st December 2017.

WACC for the Alumina Limited

Let the return on equity in both the cases be 10%, Tax rate = 40% and after tax cost of debt be 8%

WACC (Alumina Limited)

= 7000/7107.2*10%+107.2/7107.2*8%

=9.84%+.12%

=9.86%

WACC (AMP Limited) = [(E / V) * RE] + [(D / V) * RD * (1 – TC)]

                                       =15144.42/21813.42*10%+6669/21813.42*8%

                                       =6.94%+2.44%

                                       =9.38%

The tax effect on cost of capital varies depending upon the sources of fund being utilized for financing. This is because use of debt fund provided tax shield (i.e. Tax savings ) as the interest that is paid or payable on such debt is being considered as a tax deductible expenditure, hence the tax component on such amount of interest being saved by the firm, on the other hand neither equity nor preferred stock provide any such savings to the firm as whatever payment in form of dividend is made to the shareholders in form of dividend is not considered as a tax deductible expenditure, hence tax does not effect in determining the cost of equity or preferred stock (Belton, 2017).

In order to make the decision relating to investment a number of capital budgeting techniques have been provided though in this case decision to be taken is based on the two major criteria or evaluation techniques to be used are mentioned hereunder:

1. Discounted Cash Flow Technique
2. Relative Valuation Approach
3. Discounted Cash Flow Technique

It is one of the method of evaluation of the opportunity to make the future investment for which the decision is to be taken in present based on the reasonable estimate of free cash flows expected to be generated in future. Under this approach the future cash flows to be generated are discounted at a rate which is generally nothing but the weighted average cost of capital of the entity (Visinescu, Jones, & Sidorova, 2017). There are basically three factors which determines the discounted rate that are cost of equity, cost of debt and the risk free rate of return. The moment the sum of discounted cash flows to be generated exceeds the present cost of investment then the investment opportunity is considered acceptable.

1. Relative Valuation Approach

Alumina Limited

As per this Capital budgeting technique an attempt is made to evaluate the value of a business or an entity in relation to the value of business or entity’s owned by its competitor’s or its industry peers, so that a comparative position can come to the picture (Linden & Freeman, 2017). The various tools used to obtain the relative valuation rather than absolute valuation by this technique are ratios, benchmark, average or multiples etc. In our calculation the multiple used is the price earning ratio, that is calculated dividing the per unit price of the stock by the earning per share, so that to know the stock’s price multiples of its earnings. The entity having the higher P/E ratio is being traded at a higher price in comparison to the price of the stock of its competitors or peers is considered as overvalued stock and vice-versa.

The following are the major factors other than the capital budgeting techniques discussed above while making investment decision in an entity:

1. Stability Factor
2. Management or Leadership
3. Relative Strength of the Industry
4. Stability factor is one of the most important factor to be considered while making investment decision especially when if there is large amount of uncertainty shall increase the amount of risk, whereas every prospective investor has different risk bearing capacity(Meroño-Cerdán, Lopez-Nicolas, & Molina-Castillo, 2017).
5. It is the management whose strategic decision is going to decide how profitably the funds acquired through various means of financing are going to be utilized considering the optimum balance of required rate of return and risk. An effective management can enhance the value of the firm ensuring the optimum utilization of funds. Their decision making capacity is one of the key factor to determine the future of the organization.
6. The industry in which we are gong to make the investment its relative position in the economy along with contributions are also the major factors to be considered while making investment decision(Solicitors, 2016).

 Standard deviation only measures the risk associated with the individual stocks, as it is basically the measurement of volatility (Goldmann, 2016). It is actually the beta that measures the risk of the market as a whole or in other words it can be told that the beta measures the market risk premium. Use of standard deviation as a measurement of risk can be found suitable for determination of the stand-alone risk or for those assets which are held in isolation. In other words such risks are either unsystematic or diversifiable or unique in nature. Standard deviation is the measurement of volatility.

The other options for measurement of risks are as follows:

i). Beta

ii). VaR (Value at Risk)

iii). Conditional VaR

• VaR – It is one of the statistical measurement of risk to determine the amount of risk associated with the company or the portfolio(Gerlach, Mora, & Uysal, 2018).

1. Conditional VaR measure the amount of risk to ascertain what shall happen in a case when the value of an investment reaches beyond its maximum threshold limit of loss.

Conclusion

From the above analysis it is quite evident that the concept of capital structure is a key factor while making investment decision of the company (Farmer, 2018). We can see that there are many variables which needs to be taken care off while calculating the weighted average cost of capital and for the given 2 companies, it is almost the same with very less difference. The proportion of the debt and equity in the company plays a very important role in the outcome of the return of the company.

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