Example of Capital Structure Project – Coca Cola (Fall 2007)

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Example of Capital Structure Project – Coca Cola (Fall 2007)

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  Example of Capital Structure Project – Coca Cola (Fall 2007) Introduction Capital structure refers to the way a corporation finances its assets through some combination of equity and debt. A firm's capital structure is the composition of structure of its liabilities. According to Modigliani-Miller theorem, in a perfect capital market (no transaction or bankruptcy costs perfect information! firms and indi"iduals can borrow at the same interest rate no ta#es and in"estment decisions aren't affected by financing decisions. Modigliani and Miller made two findings under these conditions. $heir first 'proposition' was that the "alue of a company is independent of its capital structure. $heir second 'proposition' stated that the cost of equity for a le"eraged firm is equal to the cost of equity for an unle"eraged firm, plus an added premium for financial risk. $hat is, as le"erage increases, while the burden of indi"idual risks is shifted between different in"estor classes, total risk is conser"ed and hence no e#tra "alue created. %nder a classical ta# system, the ta# deductibility of interest makes debt financing "aluable that is, the cost of capital decreases as the proportion of debt in the capital structure increases. $he optimal structure then would be to ha"e "irtually no equity at all. &owe"er, there is no such perfect market in real world. %nder this situation, capital structure is necessary when scrutinie a companys performance from finance perspecti"e. And our pro)ect will e#amine the capital structure of Coca Cola Company from the aspects of $rade-off theory (bankruptcy cost and debt issue!, *ecking order theory (financing priority!, and Agency cost (debt-to +equity ratio and cash flow!, because all of these theories are related to capital structure.$rade-off theory concerns about the bankruptcy cost, it states that there is an ad"antage to financing with debt, the ta# benefit of debt and there is a cost of financing with debt, the bankruptcy costs of debt. $he marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimiing its o"erall "alue will focus on this trade-off when choosing how much debt and equity to use for financing, thus, affect debt-to-equity ratio as a result. n addition, the debt-to-equity ratio depends on industrial characteristics and "aries among industries. or pecking order theory, due to the information asymmetric, companies prioritie their sources of financing (from internal financing to equity!  according to the law of least effort, or of least resistance, preferring to raise equity as a financing means of last resort/. &ence internal funds are used first, then debt is issued, and equity is issued as last step.$he agency cost is mainly related to the conflict between bondholders and stockholders. irstly, as 012 ratio increases, management has an increased incenti"e to undertake risky pro)ects. $his is because if the pro)ect is successful, stockholders get all the upside, whereas if it is unsuccessful, bondholders get all the downside. f the pro)ects are undertaken, there is a chance of firm "alue decreasing and a wealth transfer from bondholders to stockholders. 3econdly, when debt is risky, the gain from the pro)ect will accrue to bondholders rather than stockholders. $hus, management has an incenti"e to re)ect positi"e 4*5 pro)ects, e"en though they ha"e the potential to increase firm "alue. &ow is agency cost related to optimal capital structure6 7hat sort of firms will ha"e more debt, according to agency theory6 8ou started off well but you dont relate all these things to Coca-Cola.$he following is our analysis of Coca Colas capital structure. Debt-to-equity ratio and Financial Strategies or coca cola, the following is our calculation of its debt-equity ratio97e used the amount of long term debt and shareholders' equity to find Coca Colas debt- equity ratio by using 2#cel function. $he result is shown below table. or e#ample, debt-equity ratio in :;;: was equal to ;.::<<=< which are calculated by :>;?1??<;;.0ebt-2quity @atio   :;;:;;B:;;:;;D:;;:$otal Eong $erm 0ebt?D???B??B>:B?>:>;?5alue of 2quity?=:;?DBB?B=DB?;=;??<;;0ebt-2quity @atio;.;>>;.;>;BB=;.;>:;>;.?><D>;.::<<=< Also, look at the kinds of securities that Coca Cola has used for financing its operations  Source: SEC Annual report of Coca Cola n order to show Coca Colas financing methods, the abo"e table presents cash flow from financing acti"ities. Coca Coal is using funds from issuing debt and issuing stocks. Coca Cola belie"e that their ability to generate cash from operating acti"ities is one of their fundamental financial strengths. $hey e#pect cash flows from operating acti"ities to be strong in :;;> and in future years. Accordingly, Coca Cola e#pects to meet all of their financial commitments and operating needs for the foreseeable future. Also, Coca Cola e#pect to use cash generated from operating acti"ities primarily for di"idends, share repurchases, acquisitions and aggregate contractual obligations. Coca Cola also has used debt financing for their operations. Coca Cola maintains debt le"els they consider prudent based on cash flows, interest co"erage ratio and percentage of debt to capital. Coca Cola uses debt financing to lower their o"erall cost of capital, which increases their return on shareowners equity. As of 0ecember D?, :;;, Coca Colas long-term debt was rated FFAG by 3tandard H *oors and FFAaD by Moodys, and their commercial paper program was rated FFA-? and FF*-? by 3tandard H *oors and Moodys, respecti"ely. Coca Cola debt management policies, in con)unction with their share repurchase programs and in"estment acti"ity, can result in current liabilities e#ceeding current assets. ssuances and payments of debt included both short-term and long-term financing acti"ities. or instance, on 0ecember D?, :;;, Coca Cola had I?,=B: million in lines of credit and other short-term credit facilities a"ailable, of which appro#imately I::B million was outstanding. $he outstanding amount of I::B million was primarily related to Coca Cola international operations. $he issuances of debt in :;; primarily included appro#imately I< million of  issuances of commercial paper and short-term debt with maturities of greater than =; days. $he payments of debt in :;; primarily included appro#imately IB<; million related to commercial paper and short-term debt with maturities of greater than =; days and appro#imately I?,D<D million of net repayments of commercial paper and short-term debt with maturities of =; days or less.$he below table e#plains aggregate contractual obligations of Coca Cola from ?;k, and this table also shows that Coca Colas financing method including short-term loans, borrowings and commercial paper. ? @efer to 4ote < of 4otes to Consolidated inancial 3tatements for information regarding short-term loans and notes payable. %pon payment of outstanding commercial paper, we typically issue new commercial paper. Eines of credit and other short-term borrowings are e#pected to fluctuate depending upon current liquidity needs, especially at international subsidiaries.: @efer to 4ote < of 4otes to Consolidated inancial 3tatements for a discussion of our liability to CC2AJ shareowners as of 0ecember D?, :;;. 7e paid the amount due to CC2AJ shareowners in Kanuary :;;> to discharge our liability.D @efer to 4ote = of 4otes to Consolidated inancial 3tatements for information regarding long-term debt. 7e will consider se"eral alternati"es to settle this long-term debt, including the use of cash flows from operating acti"ities, issuance of commercial paper or issuance of other long-term debt. 7e calculated estimated interest payments for long-term debt as follows9 for fi#ed-rate debt and term debt, we calculated interest based on the applicable rates and payment dates for "ariable-rate debt and1or non-term debt, we estimated interest rates and payment dates based on our determination of the most likely scenarios for each rele"ant debt instrument. 7e typically e#pect to settle such interest payments with cash flows from  operating acti"ities and1or short-term borrowings.B $he purchase obligations include agreements to purchase goods or ser"ices that are enforceable and legally binding and that specify all significant terms, including long-term contractual obligations, open purchase orders, accounts payable and certain accrued liabilities. 7e e#pect to fund these obligations with cash flows from operating acti"ities. 7e e#pect to fund these marketing obligations with cash flows from operating acti"ities.$herefore, Coca Cola has used many sources to finance their operation acti"ities. irst of all, the main fund is their cash from operating earnings. Coca Cola is strongly mentioning about this fact. Lther mainly sources are short term borrowing and long term debts. Coca Cola has maintained less amount of stock compared to short term and long term debt. or e#ample, in :;;, Coca Cola had <>< million of stock, but they had D:DB million in terms of short term debt and ?D? million in terms of long term debt. n this case, short term debts include commercial paper, loans and short term borrowing.  Also, long term debts include notes. At last, look at changes in Coca-colas financing strategy o"er time, the long-term 0ebt to 2quity ratio has strongly decreased between :;;: and :;;, especially between :;;D and :;;. 3ince then, the ratio has not changed in a significant way. $he "ariations of the long-term 0ebt to 2quity ratio can be mainly e#plained by the significant decrease of long-term debts o"er the period. etween :;;D and :;;, Coca-cola has cut its long-term debts by more than B; percent. According to Coca-cola, this e"olution reflects impro"ed business results and effecti"e capital management strategies. 2"en though there was a significant change in the long-term 0ebt to 2quity ratio o"er the period, it is important to notice that this ratio always stays low. Coca-cola carries a long term debt burden of less than one years current net earnings. n other words, the earnings for a single year can wipe Cokes balance sheet squeaky clean. $his is consistent with the belief of Mister 7arren uffet, the largest in"estor in the company at some point, (“The Buffettology workbook” by Mary Buffet and Da!d Clark"  who has disco"ered that the wealth of a companys asset, tangible and intangible, is in its ability to produce wealth "ia earnings. According to him, the best of a companys financial power is in its ability to ser"ice and pay off debt out of its net earnings. $he appendi# : and D are the charts of long-term debt-to-equity
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