Table of Contents

Introduction...............................................................................................................................................2
Question 01................................................................................................................................................3
Question 02................................................................................................................................................3
2.1 Defining the Optimal capital structure..........................................................................................3
2.2 Relationship between the WACC and optimal capital structure.................................................3
2.3 Determining the optimal capital structure for Snack food limited..............................................4
Question 03................................................................................................................................................6
Question 04................................................................................................................................................7
4.1 Mechanisms of debt financing........................................................................................................7
4.2 Special Considerations....................................................................................................................7
4.3 Sources of Debt Financing..............................................................................................................7
4.4 Advantages of debt financing..........................................................................................................8
4.5 Disadvantages of debt financing.....................................................................................................9
4.6 How to choose the right debt financing for Snack Foods..............................................................9
Conclusion................................................................................................................................................11
References................................................................................................................................................12

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Introduction
The report is started by calculating the present value of an investment by using the future value
formula. Then underlying theories concerning the optimal capital structure is discussed followed
by determining the optimal capital structure of Snack food limited. Next, cost of capital is
determined at various debt to capital levels in a share repurchasing situation. Finally,
recommendations are provided for determine the sources of debt financing with reference to the
available literature and qualitative/quantitative data provided.

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Question 01

Present Value = Future Value ÷ (1 + Discounted Rate) ^ No. of Years

=180,000 ÷ (1 + 0.3) ^ 4

= 63,023.00

Question 02
2.1 Defining the Optimal capital structure
The optimal capital structure of a company can be described as the perfect composition of equity
and debt that maximizes the market value and minimizes the cost of capital of a company (Scott
Jr, 1976). Generally, debt financing comprehends the lowest cost of capital given the tax
deductibility (Miao, 2005). However, too much of a debt composition can increase the risk to
shareholders enabling them to demand a higher return on equity. Therefore, companies are to
discover the optimal point where the marginal benefits of debts will be equal to the marginal cost
(DeAngelo, 1980).

The optimal capital structure is determined through the calculation of the mix of equity and debt
that gives the minimum weighted average cost of capital (Leland, 1994). Therefore, one of the
fundamental goals of any finance department of a company should be to discover the optimal
capital structure that results into creating the lowest WACC while maximizing the value of the
company (De Wet, 2006).

2.2 Relationship between the WACC and optimal capital structure

As stated above, the cost of debt is regarded as less expensive when compared to the equity as it
is less risky (Van Binsbergen, 2010). The required rate of debt for compensating the debt
investors are lesser than the required rate of equity for compensating the equity holders as the
interest payments are given the priority over dividends and similarly debt holders are receiving
the priority in case of liquidation (Lorca, 2011). On the other hand, when compared with the
equity, debt is cheaper as the companies are getting tax reliefs due to the interest. However,
companies should be mindful that an excessive amount of debt can incorporate an increase in
interest payments, earning volatility and risk of bankruptcy (Mansi, 2011).

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2.3 Determining the optimal capital structure for Snack food limited
When determining the optimal capital structure of Snack food limited, it is required to determine
the debt to capital combination that results in generating the minimum cost of capital. Therefore,
as per the provided scenario, cost of debt, cost of equity and WACC at the given debt to capital
ratios should be calculated to find the optimal capital structure.

 Cost of Debt

0% Debt-to- 20% Debt-to- 40% Debt-to 60% Debt-to-

Capital Capital Capital Capital
Interest Cost 0 4.1 12.8 33.5
Debt 0 145 290 435
Cost of Debt 0 0.028 0.044 0.077
Income Tax 53.7 52.3 49.2 41.8
IBT 151.3 147.2 138.5 117.8
Tax Rate 0.355 0.355 0.355 0.355
Tax Adjusted Cost 0 0.018 0.028 0.050
of Debt

 Cost of Equity

The CAPM model is used to calculate to cost of equity

ERi =Rf+βi (ERm−Rf)

where: ERi = expected return of investment

Rf = Risk-free rate

βi = Beta of the investment

(Erm-Rf) = Market Risk Premium

0% Debt-to- 20% Debt-to- 40% Debt-to 60% Debt-to-

Capital Capital Capital Capital
Risk Free rate 1.8% 1.8% 1.8% 1.8%

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 Beta 1.2 1.3 1.5 1.8
Expected Market 8% 8% 8% 8%
return
Cost of Equity 9.24% 9.86% 11.10% 12.96%

 Weighted Average Cost of Capital

0% Debt-to- 20% Debt-to- 40% Debt-to 60% Debt-to-

Capital Capital Capital Capital
Debt 0 20% 40% 60%
Equity 100% 80% 60% 40%
Tax Adjusted Cost of 0.000 0.018 0.028 0.050
Debt
Cost of Equity 0.092 0.099 0.111 0.130
WACC 0.092 0.083 0.078 0.082

We can identify that at 40% debt to Capital Structure WACC is 0.078 which is the lowest when
compared to other structures.

Therefore, we can state that the optimum capital structure of the company is at 40% debt
and 60% capital.

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Question 03
When determining the cost of capital with regards to share repurchases, we have to identify the
new cost of equity by adjusting to the increase in market premium as follows.

 Cost of equity after share repurchase

0% Debt-to- 20% Debt-to- 40% Debt-to 60% Debt-to-

Capital Capital Capital Capital
Risk Free rate 0.018 0.018 0.018 0.018
Beta 1.2 1.3 1.5 1.8
Expected Market return 0.08 0.08 0.08 0.08
Market premium 0.062 0.062 0.062 0.062
Increase of premium n/a 15% 25% 30%
Market premium after 0.062 0.071 0.078 0.081
repurchasing
Cost of Equity 9.24% 11.07% 13.43% 16.31%

 New WACC (Cost of financing) after share repurchase

0% Debt-to- 20% Debt-to- 40% Debt-to 60% Debt-to-

Capital Capital Capital Capital
Debt 0% 20% 40% 60%
Equity 100% 80% 60% 40%
Tax Adjusted Cost of 0.000 0.018 0.028 0.050
Debt
Cost of Equity 0.092 0.111 0.134 0.163
WACC 9.24% 9.22% 9.19% 9.50%

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Question 04
Debt financing is occurred when a company is raising money for working capital and capital
expenditure by sale of debt instruments to individuals or institutions (Valipour, 2011). As a
consequences of lending money, those individuals and institutions become creditors with a
promise for principal and interest repayment. Debt financing is in contrast to the equity financing
which is earned through issuing shares at public offerings (Ghosh, 2010).

4.1 Mechanisms of debt financing

Selling of equity, borrowing debt, or using a hybrid version of both debt and equity are the
primary ways of acquiring capital for a company (Cooper, 2001). Equity is a representation of
the ownership of the company which require a claim for the shareholders and not necessary to
pay back. In case of bankruptcy, shareholders are the last in line to receive their money (Benson,
1991). When a company is adopting a debt financing strategy, it entails selling of fixed income
assets such as bonds, bills and notes to certain individuals and institutions. The amount of the
loan or the principal should be paid back on an agreed future date along with an interest. If the
company is bankrupted, the leaders are given the priority on any liquidated assets than the
shareholders.

4.2 Special Considerations

Cost of Debt

The dividend can be regarded as the cost of equity that is paid to shareholders while the interest
or the coupon payments are the cost of debt that is paid to lenders. The sum of the cost of equity
and cost of debt is the cost of the capital of the company. The cost of capital is a representation
of the minimum return that the company should be earning on its capital for satisfying the
shareholders and debt holders. Hence, when Snack food is initiating future investment decisions,
they should always consider on options that will generate returns that are larger than the cost of
capital. If the returns on capital expenditures of the company are lesser than the cost of capital,
the company will not be generating positive returns for the investors and will require to
restructure prevailing capital structure.

4.3 Sources of Debt Financing

Loans

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Loans can be regarded as the most popular mode of debt financing source for a company.
Companies often borrow money from commercial lenders such as banks by keeping collateral
securities against the loans. Loans obtained from banks and other leaders will be for a designated
period of time and the business will be required to pay regular interests. The loans can either be
short terms or long-term depending upon the business requirements.

The loan lenders will often consider the capital structure of the company, solvency, credit risk,
earnings, and collaterals in their lending decisions. In terms of Snack food, we can observe that
the company is currently having a 0 debt to capital ratio whereas the company does not have a
higher leverage and can easily pay off the interest expenses. Similarly, the Moody’s analytics
has rated the current credit rates as “AAA’’ which is the highest credit quality. On the other
hand, the company is flourishing in terms of their business and possesses a great operational
excellence. Hence, the company is capable at raising their debt capital through loans easily.

Trade Credits

Trade credits are a short of arrangement where the business can purchase goods at now and pay
for them later. Trade credits can be regards as the good mode of financing for the small-scale
companies who are not able to place higher collaterals for obtaining loans at a higher amount. As
Snack food is not a startup it is not necessary to raise their capital for investments by terms of
trade credits.

Asset Based Lenders

Asset Based Lenders are the institutions that are lending money for the business for purchasing
assets. The businesses are supposed to pledge their assets such as inventory, accounts receivables
or cash in return. This type is debt financing can be helpful if the company is possessing a higher
inventory, receivable, and cash balance.

Bonds

Bonds are also a source of debt capital for well established businesses that requires funds for the
long-term growth. Snack food can raise funds through selling bonds to various buyers and
sharing profits for the projects that the bonds are issued.

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4.4 Advantages of debt financing
Ability to maintain the control of the business – When compared to the equity financing, the
debt financing is providing the advantage of maintaining the control of the business. The lenders
who are providing funds will not be having a say in daily business operations unless with the
equity financing.

Ability to receive tax deductions – The interest payments that are paid are tax deductible
whereas they will help to lower the interest rate.

Easier to obtain – Typically, debt financing is easier to acquire when compared with the equity
financing that involves a greater deal of complications in issuing shares.

Availability of various options – As explained above there are various types of debt financing
sources available based upon the requirement of the organization.

Building of the business credit – One of the biggest advantages of debt financing is that if the
company is maintaining a good payment history, it well helps to build the business credit can
increase the business credit score. This will be helpful when the business is growing the business
financial profiles and will increase the chances of qualifying for other debt financing options in
the future.

4.5 Disadvantages of debt financing

Business Risk – If the company is not capable at paying off the debt, the company’s assets will
be at risk. In addition to that, in the absence of sufficient collaterals, the lenders will demand to
sign personal guarantees whereas the borrower will be held obliged to pay off the loan.

Impact over cash flows – The debts will involve as monthly payment of an installment whereas
if the business did not receive the expected cash flows, will not be able to pay off the monthly
interests which would have an impact over the cash flow.

Difficulties for qualifying – Although easier to obtain when compared to equity financing, it
can also be difficult obtain debt financing if the company is newer to the business and possesses
a bad credit reputation.

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4.6 How to choose the right debt financing for Snack Foods
Amount of needed Finance – The size of the loan will be a reflection of what can be afforded. If
the company is not having a realistic plan for finance repayments, it is advised not to go for debt
financing.

Need for funds – There are various debt financing options available, and those options are
suitable for various funding requirements. For example, if the purpose of funding is purchasing
an equipment, the company should be considering an asset-based loan.

Nature of the business – The type of financing can vary depend on the nature of the business on
various aspects such as industry, competitive landscape, income levels, customer, suppliers and
etc. In terms of Snack foods, the company is involved in food industry whereas there are industry
centric funding requirements involved that are needed to be carefully addressed.

Affordability – This can be considered as a critical consideration. As per the calculations

conducted in the above, it was discovered that the optimum capital structure of the company
should be maintained at 40% debt capital and 60% equity capital. Therefore, the company should
not be considered in increasing the debt capital over 40% as it will increase the leverage of the
company and increase the cost of capital. On the other hand, at 40% debt to equity the WACC
will be 7.80% and company should be focusing over investments that will generate over 7.80%
return on equity employed (ROCE).

Ability for Qualifying – As explained, the ability for qualifying will be harder. However, given
the 0 leverage, AAA credit rating, business successes and industry growth, the Snack food
company will be capable at qualifying for loans.

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Conclusion
The present value of the investment was discovered as £63,023. Then the concept of optimal
capital structure was discussed with reference to the available literature and 40% debt to capital
structure was determined as the optimal capital structure for snack food limited. Then the cost of
capital was calculated in a share repurchase scenario. Finally, recommendations were provided to
on sources of financing for increasing the debt.

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References
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on Legis. pp. 28, p.401.
Cooper, I. a. D. S., 2001. The cost of debt.
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Meditari:. Research Journal of the School of Accounting Sciences, pp. 14(2), pp.1-16.
DeAngelo, H. a. M. R., 1980. Optimal capital structure under corporate and personal taxation.. Journal of
financial economics, pp. 8(1), pp.3-29.
Ghosh, A. a. M. D., 2010. Corporate debt financing and earnings quality. Journal of Business Finance &
Accounting, pp. 37(5‐6), pp.538-559.
Leland, H. .., 1994. Corporate debt value, bond covenants, and optimal capital structure.. The journal of
finance, pp. 49(4), pp.1213-1252.
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Accounting Studies, pp. 16(1), pp.116-142.
Miao, J., 2005. Optimal capital structure and industry dynamics.. The Journal of finance, pp. 60(6),
pp.2621-2659.
Scott Jr, J., 1976. A theory of optimal capital structure.,. The Bell Journal of Economics, pp. pp.33-54.
Valipour, H. a. M. M., 2011. Corporate debt financing and earnings quality.. Journal of applied finance
and banking, pp. 1(3), p.139.
Van Binsbergen, J. G. J. a. Y. J., 2010. The cost of debt.. The Journal of Finance, pp. 65(6), pp.2089-
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