1. Changes to capital structure The capital structure indicates the amount ofdebt and equity, which is used by a firm to finance its assets.
This is usuallyshowed in the form of a debt – to – equity ratio, which calculates the amountof debt and liabilities, both short term and long term against theshareholder’s equity. “The capital structure is how a firm finances its overalloperations and growth by using different sources of funds” (Investopedia.2018). Equity financing is when company sells its shares within the businesswhereas debt financing is borrowing money and having pay interest on top of theborrowed amount. To understand the capital structure of thetwo firms we will have to work out the gearing ratio.
“The gearing ratio isalso concerned with liquidity. However, it focuses on the long-term financialstability of a business” (Tutor2u.2018). Thegreater the ratio % the greater the amount of the company’s capital that isborrowed. From the data the gearing ratio was calculated for Land SecuritiesGroup showing that in 2013 it was 31.62% which decreased every year and in 2017it had dropped down to 18.51% (shown in appendix 1). In 2013, it can besaid that Land Securities Group had normal gearing and was happy to finance itsactivities using debt.
But in 2017 it’s become even more well-establishedbusiness as the gearing have reduced which suggests it’s more financiallystable and the firm is performing well in their capital structure on the basisof gearing. Thegearing ratio for Grainger Plc in 2013 was 69.014% (shown in appendix 2)”The more acompany relies on debt the less control it has over its finances and more it isat risk” (Vause, 2014). This is highly geared meaning the firm has to pay backinterest and loans before being able to re-invest in earnings which decreasesthe performance of the firm as it decreases net profit.
But in 2017 it hasdropped down to 6.94% is very good as it shows it has become more financiallystable and its ratio is lower than Land Securities Group. Weighted Average Cost of Capital (WACC) “is afinancial metric used to measure the cost of capital to a firm” (WallStreet Oasis. 2018). WACC shows the return to stakeholders, equity owners andlenders which they can expect to receive for their investments. Gearing isrelated with WACC calculations as gearing increases the WACC decreasestherefore it will increase the shareholder wealth.
Modiglianiand Miller(M&M) with tax shows that interest expenditures of thecompany’s debt is deductible, allowing tax savings. Mtheory (no tax) Debt is cheaper but cost of equity increases so WACC isconstant. From the data the WACC was calculated forLand Securities Group showing that in 2013 it was 7.14% (appendix 3) withouttax and increases to 7.
49% in 2014, then it decrease to 6.92% in 2015 andafterward it went up slightly for 2 years to 7.91%.On the other hand the WACCwith tax showed a same pattern as WACC without tax, as it can be seen appendix3.
The WACC without tax for Grainger PLC, was10.75%(appendix 4) in 2013, then itdecreased for two year to 10.35% in 2015, then it increases to 12.11% in 2016and it decreases back down to 10.50% in 2017. Same againthe WACC with tax showed a same pattern as WACC without tax, as it can be seenappendix 4. It’s good to have low WACC because this will mean the debt ischeaper therefore it will increase the market value of the firm which willenable to increase the capital structure of the company.
Aswe can see both WACC figures without and with tax is clear that they both firm performwell with the use of tax. We can see by having higher WACC, it’s morerisky as more shareholders to invest in because increase in WACC means increasein debt. It allows the investors an insight of the risk involved within thefirm but they should also consider higher the risk the higher the return willbe. Land Securities Group and Grainger PLC must change and increase theirfluctuation to improve the WACC. 2. Bankruptcy risk Bankruptcy is a risk of legal process to getout of debt when you can no longer make all your required payment. “Bankruptcyinvolves a transfer of most of the debtor’s assets to a licensed trustee whosells them and distributes the money amongst the debtor’s creditors” (Bennett,2001). Altman’s (1968) Z score and Beaver model (1966)will identify the risk of bankruptcy and explain the risks involved.
Beaver is univariatediscriminating modelling, whereas Altman is multi-variate dominant modelling. Altman’s Z-Score shows numerical method topredict the probability of bankruptcy. Zones of Discrimination:v Z> 2.99 -“Safe” Zonesv 1.
81< Z < 2.99 -"Grey" Zonesv Z< 1.81 -"Distress" Zones Land Securities Group Z-score was 1.903 in2013, 2.476 in 2014, 2.858 in 2015, 2.959 in 2016 and 2.629 in 2017(appendix 5)results show that the firm is slowly improved in the Z-score which suggests thefirm is less likely to become bankrupt.
For Grainger Group Plc Z-score was 1.571in 2013, 1.716 in 2014, 1.653 in 2015, 2.
120 in 2016 and 1.638 in 2017(appendix6) results show that the firm is most likely to become bankrupt due to thefindings of Altman’s Z-score prediction. 3. Critical discussion Bankruptcydoes have an affect on firm’s cost of capital, considering the theory of Modiglianiand Miller capital structure. As the firm takes more debt, its WACC increases whichrelates to the M theory therefore more debt will mean more interest coststo pay which will then reduce the earnings and cash flow. It will also mean thathigh debt in the capital structure will increase the cost to finance.
This willincrease the bankruptcy risk because of the increase in debt of the firm’scapital structure which is also affected by the increase in WACC. TheZ- score is not only used to forecast when a company will go bankrupt, as it allowsthe likelihood of bankruptcy actually occurring. Some of the external factorswhich are not considered when calculating the Z-score such as the pre-bankruptcynon-financial events, economiccircumstances, firm size and geographical location therefore it can affect the bankruptcyprediction. Altman Z-score is difficult when predicting the company futurevalue as it uses the past financial data which is considered as historical data.Beaver model has drawbacks as it give unclearand unpredictable organization results for the different ratios because lookingat different ratios at one time it becomes challenging to decide if the firm islikely to become bankrupt as each ratio will give different results. Wecan say overall the results show that the gearing has decreased and Z-scorehave increased for the companies. Grainger PLC is at higher risk of goingbankrupt because debt ratio is significantly high in 2017 would mean they willfind it hard to pay back their debts when compared to Land Securities. This doessuggest that Land Securities is in safe zone when looking at the Z-scorehowever it can be said that they are better positon than Grainger PLC.