Please proof the paper attached and complete question 6 and 7.
Moore Plumbing Supply Company
Mort Moore founded Moore Plumbing Supply after returning from duty in the South Pacific during World War II. Before joining the armed forces, he had worked for a locally owned plumbing company and wanted to continue with that type of work once the war effort was over. Shortly after returning to his hometown of Minneapolis, Minnesota, he became aware of an unprecedented construction boom. Returning soldiers needed new housing as they started families and readjusted to civilian life. Mort felt that he could make more money by providing plumbing supplies to contractors rather than performing the labor, and he decided to open a plumbing supply company. Mort’s parents died when he was young and was raised by his older brother, Stan, who ran a successful shoe business during the 1920’s. Stan often shared stories about owning his own business and in particular about a large expansion that was completed just before the market collapsed. Because of the economic times, Stan lost the business but was lucky to find employment with the railroad. He dutifully saved part of each paycheck and was so thankful that his brother returned home safely that he decided to use his sizable savings to help his brother open his business. Mort kept in mind his brother’s failed business and vowed that his company would operate in such a way that it would minimize its vulnerability of general business downturns.
Moore’s extensive inventory and reasonable prices made the company the primary supplier of the major commercial builders in the area. In addition, Mort developed a loyal customer base among the home repair person, as his previous background allowed him to provide excellent advice about specific projects and to solve unique problems. As a result, his business prospered and over the past twenty years, sales have grown faster than the industry. Because of the large orders, the company receives favorable prices from suppliers, allowing Moore Plumbing Supply to remain competitive with the discount houses that have sprung up in the area. Over the years, Mort has kept his pledge and the company has remained a very strong financial position. It had a public sale of stock and additional stock offers to fund expansions including regional supply outlets in Milwaukee, Wisconsin and Sioux City, Iowa.
Recently, Stan decided that the winters were too long and he wanted to spend the coldest months playing golf in Florida. He retired from the day-to-day operations but retained the position of President and brought in his grandson, Tom Moore, to run the company as the new Chief Executive Officer. Tom was an excellent choice for the position. After graduating summa-cum-laud with a degree in communications from the University of Wisconsin, he worked in the Milwaukee operation where he was quickly promoted to manager. In ten years, sales quadrupled under his leadership and employees remained loyal. He was familiar with the supply and demand of various components and was able to spot new trends in the industry before they became widely accepted. Although he had developed a keen sense of financing working capital, he had no background in higher-level corporate finance decision-making.
Tom spent the first few months on the new job trying to get a better handle on the bigger picture and puzzled over the company’s historical balance sheets, income statements and cash flow statements. One area that concerned him was the company’s heavy reliance on equity financing. Moore Plumbing has a large line of credit and uses this and short-term debt to finance its temporary working capital requirements. However, it does not use any permanent debt capital. Other construction related retail and wholesale companies have between 30 and 40 percent of their long-term capitalization in debt. Tom wonders why other companies use more permanent debt and what affect adding long-term debt would have on the company’s earnings and stock price.
Tom met with the company’s vice president of finance, Walt Harriman, and learned that the company projected its earnings before interest and taxes to be $12 million for the next year with projected tax rate to be 40%. Tom next talked to the company’s investment bankers and discovered that the company’s cost of equity was 16%. Since the company did not use debt or preferred stock financing, this also represented the company’s current weighted average cost of capital. The investment bankers indicated that the company could issue at least $30 million of long-term debt at a cost of 9%. The company bonds would be highly rated and would carry a low coupon because the company easily service the debt.
Because of Stan’s depression experience and his early involvement in funding the initial operation, the company not only avoided debt but also followed a policy of paying out most of its earnings as dividends, Stan was frequently quoted saying “a company with a high dividend policy rarely declared bankruptcy”. In lieu of using retained earnings to reinvest in the company, the company used accounts payable and deferred taxes to meet its operating capital needs and issued capital was purchased by members of the Moore family and they currently hold 75 %of the outstanding equity.
Tom is interested in gaining additional insights into capital structure issues and has asked Walt to brief him in the area. He wants a basic review of the terminology but is particularly interested in the impact of different types of risk and in understanding of the better-known financial theorists. Walt knew that Tom could grasp complex issues quickly and felt that a thorough discussion of Modigliani and Miller’s work would be appropriate. He also felt that Miller’s addition of personal taxes to the earlier models would be good to cover, and he determined that a good approximation of personal tax rate on debt income was 28% and for stock income was 20%. He decided to add the more recent considerations of financial distress, agency costs and information asymmetry for a comprehensive overview. To help with this analysis, Walt developed the following estimates for cost of debt and cost of equity that included an increasing premium for financial distress and agency costs as the debt ratio increases.
Debt ratio kd ks
0% —- 16.0%
10% 9.00% 17.0%
20% 9.25% 17.8%
30% 9.75% 19.0%
40% 10.50% 20.5%
50% 12.00% 22.0%
60% 15.00% 26.0%
70% 20.00% 30.0%
80% 30.00% 40.0%
90% 50.00% 60.0%
You have been assigned to help Walt develop the briefing and he has prepared the following questions to help direct your energies. He has also asked you to think about other relevant issues that Moore might bring up. Walt is aware of Tom’s keen intellect but is also aware of his reputation for “asking the right questions” and for having little tolerance for people who are not adequately prepared so he is concerned about covering the issues in an understandable manner.
- What is meant by capitalization? What is meant by a firm’s capital structure? For financial planning purposes, explain why either book or market value should be used to determine the firm’s capital structure. What is capital structure theory?
- Discuss the following issues relating to business risk and financial risk.
- What is the difference between business risk and financial risk? Explain some of the factors that contribute to each. Evaluate Moore Plumbing Supply’s level of business risk.
- How do these risks relate to total risk?
- How does business risk affect capital structure decisions?
- Discuss the following issues relating to Modigliani and Miller’s (MM) 1958 capital structure model.
- What was the importance of the model?
- What are the basic assumptions of the model?
- Discuss MM’s later models (1963) in which they relaxed the no-tax assumption and added corporate taxes. Discuss Proposition I and II. Miller added personal taxes to the model in his 1976 Presidential Address to the American Finance Association. What happens to Miller’s model, in general, if there are no corporate or personal taxes? What happens when only corporate taxes exist?
- Briefly describe the asymmetric information theory of capital structure. What are its implications for financial managers?
- Prepare a summary of the implications of capital structure theory that can be presented to Tom Moore. What insights can capital structure theory provide managers regarding the factors which influence their firm’s optimal capital structures?
- Finally, what recommendations would you make about the capital structure of Moore Plumbing Supply Company? Justify your answer.Capital Decisions
Moore Plumbing Supply Capital Structure
October 29, 2020
1. What is meant by capitalization? What is meant by a firm’s capital structure? For financial planning purposes, explain why either book or market value should be used to determine the firm’s capital structure. What is capital structure theory?
Capitalization is where a cost is included in the value for the useful life instead of being recorded as an expense for the period it was incurred. This expense is not recorded in the current accounting period but depending on the type of property it can be expensed over a period of many years.
A firm’s capital structure is a combination of debt and equity used to finance a company’s operation and growth. This debt to equity ratios can be used to determine the risk level of the companies borrowing practices. Debt includes monies borrowed that needs to be paid back with an interest expense in the form of bonds and loans. The equity consists of items like preferred stock or retained earnings.
The book value is what is found on a firm’s balance sheets representing the value of liquidated assets. Mathematically speaking book value is the difference of a firm’s assets and liabilities, an accounting item. For financial purposes, the market value should be used to determine a firm’s capital structure rather than the book value because it is determined by its market capitalization. Therefore, market value is greater than book value and factors un non-tangibles as well as future growth.
The capital structure theory is an approach uses a combination of equities and liabilities to finance business activities. It is essential to know the capital structure especially in the approach to financing business activities. With this approach it assumes an optimal capital structure which implies that at a certain debt to equity ratio, the minimum cost of capital and the firm value is at a maximum (What Is Capital Structure Theory?, 2019).
2. Discuss the following issues relating to business risk and financial risk.
a. What is the difference between business risk and financial risk? Explain some of the factors that contribute to each. Evaluate Moore Plumbing Supply’s level of business risk.
Financial risk refers more to the amount of debt a firm incurs rather than business operation. The business risk depends on the amount of debts owed unlike financial risk where the debt is added to the firm and then used for debt financing.
There are several factors that contribute to business risk such as market volatility, sales price, cost of goods, debt liability and operating leverage. On the other hand, factors that affect financial risk are interest rates, percentage of debt financing, as well as the debt to equity ratio.
Based on the information provided, Moore’s plumbing does not seem to have a high level of business risk however there are some issues that needs addressing for them to remain viable. The company should perform a risk assessment to determine its exact level of business risk. Conducting the risk assessment could provide Moore’s with a holistic view of the risk it is facing. It not only allows them to identify the risks but to capitalize on their opportunities (Corbett, 2015).
First Moore’s need to identify which risks would affect the company’s ability to survive, maintain relevance in the industry while maintaining financial decisions with a positive public image as well as the quality of its products. They should be considering the effects of things like heavily relying on equity and lack of financing using long-term debt.
Next, they should establish a risk library which will provide the framework for the risk assessment process. This defines the risk the firm is expose to and helps them to facilitate a discussion and promote an awareness culture. The library should be broken up into four categories, insurance, market, operational and strategic risk.
Once the risk is identified assign people to monitor and manage them. They will also persons will also be responsible for the implementation and maintenance of the appropriate controls.
Then determine what controls are in place to mitigate and reduce the risk. Assess the financial impact and risk potential to the company.
Finally, the company should review their risk assessment management process as often as necessary to re-evaluate the financial impact and likelihood (Corbett, 2015).
b. How do these risks relate to total risk?
The combination of business and financial risk combined creates total risk (Langemeier, 2017).
c. How does business risk affect capital structure decisions?
Capital structure is a combination of debt and equity that is related to a firm’s financing decisions. Increased leverage in capital structure increases the rate of interest which increases the risk of bankruptcy. With less risky debt the interest rate slowly increases and when the debt is riskier the interest rate increases at a higher rate (Chong Larry, 2019).
3. Discuss the following issues relating to Modigliani and Miller’s (MM) 1958 capital structure model.
a. What was the importance of the model?
The importance of the model is to prove that when the capital structure changes it does not affect the firm’s market value. The approach developed in the 1950s implies that the valuation of a firm is not relevant to the capital structure. For example, if a firm has a high or low debt component it has no relevance on its market value.
b. What are the basic assumptions of the model?
The assumptions of the M&M approach are:
i. No Taxes
ii. Transaction and bankruptcy cost are non-existent
iii. No symmetry of information
iv. Same cost of borrowing for investors and companies
v. No floatation cost Evaluate Moore Plumbing Supply’s level of business risk.
vi. No corporate dividend taxes
4. Discuss MM’s later models (1963) in which they relaxed the no-tax assumption and added corporate taxes. Discuss Proposition I and II. Miller added personal taxes to the model in his 1976 Presidential Address to the American Finance Association. What happens to Miller’s model, in general, if there are no corporate or personal taxes? What happens when only corporate taxes exist?
M & M’s approach suggests that the valuation of the firm is not relevant to the capital structure. This approach states that the market value of a firm is affected by the operating income regardless of the risk involved (Sanjay Bulaki Borad, 2019). It is one of the modern approaches to the capital structure theory. Corporate taxes were added to their 1963 model, this gave corporations the ability to deduct interest payments as an expense while not allowing dividend payments to stockholders. This treatment invigorated corporations to utilize debt in their capital structure. The results were that Interest payments reduced the tax corporations paid making more cash flows available for investments. A pre-tax income shield was provided by the tax deductibility of the interest payments (Brigham & Ehrhardt, 2019).
Modigliani and Miller Approach
The theory acknowledges the following:
Proposition 1-With Taxes
i. Tax benefits accrued by interest payments
ii. Interest paid is tax deductible
iii. Actual cost of debt is less than nominal cost
iv. Increased debt adds value to the company
Proposition 2-With Taxes
i. Acknowledges tax savings
ii. Debt to equity ratio affects the WACC
iii. The higher the debt the lower the WACC
In general, the implication in Miller’s model with no personal or corporate taxes is that using more debt in the capital structure will not increase the value of the company. In this model cheaper debt will offset the increase in risk equity and its cost. Therefore, the model implies that without taxes the value of the company and its WACC would not be affected by its capital structure (Brigham & Ehrhardt, 2019).
When only corporate taxes exist,
5. Briefly describe the asymmetric information theory of capital structure. What are its implications for financial managers?
The asymmetric theory of capital structure was developed between the 70s and 80s. The assumption under this theory is that one party knows more than the other. that sellers have a greater effect on the skewed price of goods sold than buyers do. The implication is that sellers knows more about the firm’s value which can lead to market failure. Businesses with good expectations prefer to finance with new stock offerings rather than using outside equity Brigham & Ehrhardt, 2019).
The implication for financial managers is that if managers must issue new stock it signals to investors that the firm is doing poorly. This can create two problems, adverse selection where the investor is assuming risk without having all facts. The other problem it creates is moral hazard which is an indication that the company is engaging in risky behavior because it knows that the investor will bear the economic consequences.
6. Prepare a summary of the implications of capital structure theory that can be presented to Tom Moore. What insights can capital structure theory provide managers regarding the factors which influence their firm’s optimal capital structures?
The following is a summary of the implications of capital structure theory.
Tradeoff between tax benefits and bankruptcy costs:
The capital structure theory provides managers with insight into the firm’s optimal capital structure with the respect to expected cash flows, leverage, cost of raising finance, financing tenure and market conditions.
7. Finally, what recommendations would you make about the capital structure of Moore Plumbing Supply Company? Justify your answer.
My recommendations would be to consider tax benefits because this is valuable to a company with positive, pretax income. Another plus is that because they have stable sales, they can comfortably add debt to their finances because they can afford to incur higher fixed charges better than a company with inconsistent sales. Consider refinancing while rates are lower than their current debt rate. Finally, they should consider utilizing the expected cost of financial distress
Brigham, E. F., & Ehrhardt, M. C. (2019). Bundle: Financial Management: Theory and Practice, Loose-Leaf Version, 16th + MindTap, 2 terms Printed Access Card (16th ed.). Cengage Learning.
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