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The capital structure of a company is comprised of the different sources of funding used to finance the company’s operations and growth, specifically debt, equity and retained earnings. The reason for analysing the capital structure of a business is to determine whether or not the proportion of debt to equity will allow a business to create wealth, without endangering the entity. There are many different ratios and techniques that can be used to analyse the capital structure of a business, and whether or not there are signs of financial distress, such as considering the debt-to-equity ratio, the current/quick ratio and gearing ratios.
Further within this report (see Appendix X), we have performed multiple ratios on the financial data for both Vodafone Group Plc. and Samsung, such as: * Current Ratio – We chose to use this ratio as it is a strong ratio for measuring the liquidity of a company, determining their ability to pay off their current liabilities if they were to fall due
* Net Working Capital Ratio – Again, we chose this ratio as it is also strong for liquidity measurement * Debt Ratio – The debt ratio measures how much of the businesses assets are currently financed by debt, with a lower percentage indicating less financial leverage, and also less risk * Debt-to-Equity Ratio – The debt-to-equity ratio is used to determine how much debt a business has for every £1 of shareholder’s equity * Interest Coverage Ratio – The interest coverage ratio is used to determine the extent to which a business can pay the interest required from any outstanding debt Vodafone & Samsung Results
Liquidity analysis
As shown in Appendix X, Vodafone has had a current ratio below 1 for the past 5 years, indicating that Vodafone does not have enough current assets to cover its current liabilities if they came due at this point in time.
As expected, the quick ratio is even lower for each year than the current ratio. Although the current ratio is a concern and points to financial distress, it should be noted that Vodafone appears to be actively increasing their current ratio, with indications that it will soon rise above 1. INCLUDE SAMSUNG INFO AND COMPARE WITH MARKET AVERAGES For the past 5 years, the net working capital ratio has been negative, due to the fact that Vodafone has had a negative working capital.
This portrays that Vodafone does not have sufficient liquidity to satisfy short term liabilities. Again, it should be noted that this figure has been improving steadily over the past few years, with no indicators showing that will not continue into the future. INCLUDE SAMSUNG INFO AND COMPARE WITH MARKET AVERAGES Overall, it would appear that Vodafone currently (and for the past 5 years at least) has liquidity issues, indicating potential financial distress. However, Vodafone has been consciously improving their liquidity scores, and may soon be in a good position relating to liquidity.
INCLUDE SAMSUNG INFO AND COMPARE WITH MARKET AVERAGES
Financial Leverage Ratios
When looking at the results of the debt ratios, Vodafone’s most recent score of 25% appears to be at a good level offering stability, as there is not a heavy reliance on debt finance to ensure operations can continue. There is also no difference between the 2011 and the 2012 result, suggesting that Vodafone were not interested in taking a larger proportion of debt INCLUDE SAMSUNG INFO AND COMPARE WITH MARKET AVERAGES The debt-to-equity ratio for Vodafone for the past 5 has constantly resulted in a ratio below 0.5. This is a strong ratio for Vodafone, and permits a strong degree of protection for lenders. Again, the ratios for 2011 and 2012 are almost identical, suggesting that Vodafone are currently happy with their capital structure.
INCLUDE SAMSUNG INFO AND COMPARE WITH MARKET AVERAGES Finally, Vodafone has a remarkably good ratio interest coverage ratio at 5.94, although this ratio has been sporadic over the past 5 years with a high of 23.14 and a low of 2.73. It could be argued that the current ratio, as well as the ratio from the previous year, are actually too high, indicating that Vodafone is being too careful with the use of debt, which may mean lower risk, but also means lower returns. INCLUDE SAMSUNG INFO AND COMPARE WITH MARKET AVERAGES Overall, Vodafone has extremely good financial leverage ratios, which have all also been strong for the past 5 years, indicating that Vodafone’s level of debt finance is well under control and easily manageable, ensuring that on this front, there are no early indications of financial distress. INCLUDE SAMSUNG INFO AND COMPARE WITH MARKET AVERAGES Possible changes in Capital Structure – Vodafone
In regards to debt, there does not appear to be much change over the past 4 years, with both the long term debt and the current debt not increasing/decreasing by large amounts. However, when it comes to share issue, Vodafone have in fact been buying back shares from the public Link to newspaper article and Vodafone website, and possible reasoning for this. Possible changes in Capital Structure – Samsung
Capital Structure Finance Theories
This section of the report will briefly discuss multiple finance theories associated with the capital structure of an organisation. Modigliani and Miller Irrelevancy Theory The Modigliani-Miller theorem is crucial to the way in which we currently consider capital structure. The financial theory states that the methods a business uses to finance its operations is irrelevant when considering the value of the business, and only the earning power, as well as the risk of its underlying assets determine the market value. This would occur in a “perfect market”, which specific assumptions being made. Therefore, it is commonly viewed as being an entirely theoretical result, due to the fact that it excludes multiple vital factors in the decision making of capital structure.
Pecking Order Theory
There are numerous different theories relating to the capital structure, one of which is the pecking order theory. Myers (1984, p2) defined the pecking order theory was then “the firm prefers internal to external financing, and debt to equity”. As pointed out by Myers and Shyam-Sunder (1999, p220), “there is no well-defined optimal debt ratio”. In effect, when a business’ retained earnings are inadequate for investment opportunities or dividend
commitments, debt will be issued rather than equity.
Trade-off Theory
The trade-off theory “weighs the benefits of debt that result from shielding cash flows from taxes against the costs of financial distress associated with leverage” (Berk and DeMarzo, 2011, p520)”. Basically, a business will decide on how much finance will come from debt, and how much from equity, by attempting to balance the benefits (for example, tax benefits) and the costs (including both bankruptcy and non-bankruptcy costs, such as worse payment terms, loss of staff/suppliers etc.).
Clientele Effect
The clientele effect is the theory that investors are attracted to businesses because of their specific policies, such as having high dividend pay-outs, low amounts of debt etc. If the business was then to change these policies, by lowering their dividend pay-out or taking on greater debt, these investors are likely to sell their shares, thus causing movement in the stock prices.
Traditional View & Shareholders Wealth
The traditional view on capital structure is that an optimal capital structure exists (combination of debt and equity) when the WACC is minimised and the market value of assets is maximised. In order to maximise the shareholders wealth, the business must attempt to get the balance right. By opting to use debt to increase growth, this may lead to increased earnings being split between the debt obligations and the shareholders, which is considered undesirable by them. This is intricately tied with the trade-off theory, as already discussed.
Vodafone
There are two theories which equally affect Vodafone’s capital structure, being the Trade-off theory and the Pecking Order theory. Vodafone prefer to borrow debt, as stated on their investor’s website, and have moved to buy back shares from the public (Vodafone, 2012).
Samsung
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Bankruptcy Prediction Models
Univariate – Beaver’s Failure Ratios
Beaver’s failure ratios combine the use of multiple Univariate indicators to assess whether or not the business is likely to face bankruptcy issues. There are six main groups of ratios, all of which contain multiple different ratios. However, we shall only focus on six individual ratios in this report, as they possess the greatest discriminating power (Andrikopoulos, 2012).
Strengths & Weaknesses
Ratios are a convenient method of summarising data into a form that is easily understandable, and also promotes comparability from both previous years and other businesses in the same industry. Ratios are also able to highlight possible trends, allowing the possibility of making predictions. In terms of the weaknesses of using failure ratios, it can sometimes be a subjective view as to whether a ratio is strong or not, as well as providing misleading comparisons if different companies use different accounting methods.
Rationale
The main reasons for selecting to use failure ratios to discuss bankruptcy include the easy summary they provide, as well as the clear level of comparability. Multivariate – Altman’s Z-Score Altman’s Z-Score is a model created by Edward Altman in 1968, and is used explicitly to attempt to determine the likelihood of a business going bankrupt. It combines 5 key ratios, with the formula being demonstrated in Appendix X Strengths & Weaknesses
The Strengths of using Altman’s Z-Score includes the fact that it is considered to be largely accurate, boasting 90% accuracy when projecting bankruptcy a year into the future, and 80% accuracy when projecting 2 years into the future (Altman, 2000). Accuracies were lower when it came to predicting bankruptcy for a firm more than 2 years into the future (Chuvakhin & Gertmenian, 2006). The Z-Score also incorporates a variety of financial ratios, including taking into account the current market. One of the weaknesses with the Z-score, which is apparent with all financial ratios, is that the score relies on the quality of the financial statement. If the figures are not entirely correct, the Z-score will not be a true representation. Rationale
The main rationale behind selecting to use the Z-Score was the strengths, as stated previously. With such high accuracy, it was decided that the Z-score would be an extremely valuable tool to use when predicting bankruptcy.
Multivariate – Ohlson’s Logit Score
In 1980, James Ohlson created a bankruptcy prediction model that is still often relied upon, despite alternative models (MDA, Probit, Hazard Models etc.).The Ohlson model works by using logistic regression in order to predict failure using nine independent variables. Both the formula and the ratios can be found in Appendix 3.
Strengths & Weaknesses
The Ohlson model also boasts high accuracy percentages, with a reported 88% success rate when identifying firms one year before bankruptcy (He, Kamath and Meier, 2005). The model is also rather versatile. The main weaknesses with this model include the fact that it was created using a perfect capital market, as well as not being as accurate for non-industrialised companies.
Rationale
Like Altman’s Z-Score, the main reason for selecting Ohlson’s model was the high accuracy of the model when predicting possible bankruptcy. Vodafone & Samsung Bankruptcy Prediction Analysis
Univariate – Beaver’s Failure Ratios
Multivariate – Altman’s Z-Score
As demonstrated in Appendix 2, the Z-scores for Vodafone for the past 5 years has been significantly below 1.8, meaning that Vodafone is supposedly within the Distress zone, suggesting that, technically, Vodafone should have defaulted already (Altman, 1968). In this scenario, the Z-score is evidently flawed, as the past 5 years have clearly shown a type II error (Altman, 1968). In 2009, Vodafone saw a severe drop in their Z-Score, due to a huge decrease in EBIT, caused mainly by an increase in costs, specifically administration costs. INCLUDE SAMSUNG INFO AND COMPARE WITH MARKET AVERAGES Multivariate – Olhson’s Logit Score
Conclusion
References
http://www.sciencedirect.com/science/article/pii/S0304405X02002520# http://www.sciencedirect.com/science/article/pii/S0304405X00000787 http://www.blurtit.com/q226794.html
http://www.tamut.edu/jolb/Scholar/2010Summer/2010Wang-Campbell.pdf http://www.westga.edu/~bquest/2000/bankrupt.html
http://www.stockopedia.co.uk/content/improving-on-the-altman-z-score-part-2-the-ohlson-o-score-70800/ http://www.investorwords.com/2186/GNP.html
http://www.vodafone.com/content/index/investors/debt_investors/financing_strategy.html http://www.vodafone.com/content/index/investors/shareholders/share_buyback_programme.html http://dealbook.nytimes.com/2008/07/23/vodafone-announces-2-billion-stock-buyback/ http://www.telegraph.co.uk/finance/newsbysector/mediatechnologyandtelecoms/7987965/Vodafone-to-spend-4bn-China-cash-on-buy-back.html http://gbr.pepperdine.edu/2010/08/predicting-bankruptcy-in-the-worldcom-age/ http://www.freepatentsonline.com/article/Academy-Accounting-Financial-Studies-Journal/182468597.html
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