Capital Structure Decision and Cost of Capital
My SLP Company of choice is Wal-Mart Stores. The other two companies I will be relying on for purposes of this discussion are Target Corp. And Costco Wholesale Corporation. Both companies happen to be in the same industry as Wal-Mart Stores. Most specifically, this text will compute the debt ratio and the debt-to-equity ratio of Wal-Mart Stores and discuss whether or not these ratios could be regarded too large or too small. Further, comparisons will be made between the debt-to-equity ratio of Wal-Mart Stores and that of its two competitors – Target and Costco.
The debt ratio in the words of Graham and Smart (2011, p. 44) is “a measure of the proportion of total assets financed by a firm’s creditors.” It is computed by dividing the total debt figure with the summation of equity and total liabilities. All the dollar figures below are in thousands.
Wal-Mart’s debt ratio;
= total liabilities / (total liabilities + equity)
= $126,243,000 / ($126,243,000 + $76,862,000) = 0.62
Debt ratio for short-term liabilities;
= short-term liabilities / (short-term liabilities + equity)
= $71,818,000 / ($71,818,000 + $76,862,000) = 0.48
Debt ratio for long-term liabilities;
= long-term liabilities / (long-term liabilities + equity)
= $54,425,000 / ($54,425,000 + $76,862,000) = 0.41
When it comes to the debt-to-equity ratio, Graham and Smart (2011, p. 44) define the same as “a measure of the firm’s financial leverage….” It is computed by dividing the total debt or liabilities figure with the representative total equity figure. All the dollar figures below are in thousands.
Wal-Mart’s debt-to-equity ratio;
= total liabilities / total equity
= $126,243,000 / $76,343,000 = 1.65
Debt-to-equity ratio for short-term liabilities;
= short-term liabilities / total equity
= $71,818,000 / $76,343,000 = 0.94
Debt-to-equity ratio for long-term liabilities;
= long-term liabilities / total equity
= $54,425,000 / $76,343,000 = 0.71
The debt ratio of Wal-Mart as per the computations above is neither too high not too low. This is particularly the case given the industry Wal-Mart operates in. Retail and utility industries according to Quiry et al. (2011) have highly predictable and relatively stable cash flows. Thus in addition to being stable, cash flows in this case are not volatile. In that regard, Wal-Mart’s debt ratio of 62% is largely manageable. It is also important to note that given that the debt ratio is in this case below 1, the amount of assets Wal-Mart has significantly exceed the debt value.
As per the computations above, Wal-Mart’s debt-to-equity ratio is particularly high. This effectively means that the retailer has been rather aggressive in the utilization of debt to finance growth. However, given that the company operates in a capital intensive industry, the said ratio is within acceptable limits. Therefore, based on these findings, Wal-Mart’s long-term solvency is not in any way threatened.
Table: Debt-To-Equity Ratios of Wal-Mart, Target, Costco
Company
Formula
Computation
Ratio
Wal-Mart
Total Liabilities / Total Equity
$126,243,000 / $76,343,000
1.65
Target
Total Liabilities / Total Equity
$19,450,000 / $10,833,000
1.80
Costco
Total Liabilities / Total Equity
$31,605,000 / $16,558,000
1.91
Note: All dollar figures are in thousands
From the table above, it is clear that Costco has a higher debt-to-equity than Target and Wal-Mart. The company could have decided to have a relatively high ratio so as to generate more earnings. In some cases, a company could generate more earnings through the utilization of a high amount of debt than it would have had it used equity in place of debt (Borowski, 2010). This is particularly the case in those instances where the return the company rakes in by far outweighs the cost of debt. In comparison to Costco and Target, Wal-Mart has the lowest debt-to equity-ratio. Aggressive utilization of debt could according to Borowski (2010, p. 7) “result in volatile earnings as a result of the additional interest expense.” In that regard therefore, the company could have chosen to have a relatively lower ratio so as to avoid earnings volatility.
Conclusion
Module 4 SLP helped enhance my understanding of the concept of optimal capital structure. I learnt that companies generally seek to maximize returns while at the same time minimizing the cost of capital by amongst other things coming up with an ideal mix of debt and equity. I also learnt that as is the case with equity financing, debt financing has its own unique advantages and disadvantages. Unlike is the case with equity financing, the fixed interest rate in debt financing could result in earnings volatility as the same cannot be varied. However, the debt interest (unlike dividends) could be tax deductable (Porter and Norton, 2010).
References
Borowski, A. (2010). Financial Management: The Role and Importance of Capital Markets and EMH. Norderstedt Germany: GRIN Verlag.
Graham, J. & Smart, S.B. (2011). Introduction to Corporate Finance (3rd ed.). Mason, OH: Cengage Learning.
Porter, G.A. & Norton, C.L. (2010). Financial Accounting: The Impact on Decision Makers (7th ed.). Mason, OH: Cengage Learning.
Quiry, P., Fur, Y.L., Salvi, A., Dallochio, M. & Vernimmen, P. (2011). Corporate Finance: Theory and Practice (3rd ed.). Chichester, West Sussex: John Wiley & Sons.
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