24-09-2016, 11:20 AM
1456030323-cocacolacapstrucprojexample.doc (Size: 425 KB / Downloads: 23)
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 individuals can borrow at the same interest rate; no taxes; and investment decisions aren't affected by financing decisions. Modigliani and Miller made two findings under these conditions. Their first 'proposition' was that the value of a company is independent of its capital structure. Their second 'proposition' stated that the cost of equity for a leveraged firm is equal to the cost of equity for an unleveraged firm, plus an added premium for financial risk. That is, as leverage increases, while the burden of individual risks is shifted between different investor classes, total risk is conserved and hence no extra value created. Under a classical tax system, the tax deductibility of interest makes debt financing valuable; that is, the cost of capital decreases as the proportion of debt in the capital structure increases. The optimal structure then would be to have virtually no equity at all. However, there is no such perfect market in real world. Under this situation, capital structure is necessary when scrutinize a company’s performance from finance perspective. And our project will examine the capital structure of Coca Cola Company from the aspects of Trade-off theory (bankruptcy cost and debt issue), Pecking order theory (financing priority), and Agency cost (debt-to –equity ratio and cash flow), because all of these theories are related to capital structure.
Trade-off theory concerns about the bankruptcy cost, it states that there is an advantage to financing with debt, the tax benefit of debt and there is a cost of financing with debt, the bankruptcy costs of debt. The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value 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. In addition, the debt-to-equity ratio depends on industrial characteristics and varies among industries.
For pecking order theory, due to the information asymmetric, companies prioritize 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”. Hence internal funds are used first, then debt is issued, and equity is issued as last step.
The agency cost is mainly related to the conflict between bondholders and stockholders. Firstly, as D/E ratio increases, management has an increased incentive to undertake risky projects. This is because if the project is successful, stockholders get all the upside, whereas if it is unsuccessful, bondholders get all the downside. If the projects are undertaken, there is a chance of firm value decreasing and a wealth transfer from bondholders to stockholders. Secondly, when debt is risky, the gain from the project will accrue to bondholders rather than stockholders. Thus, management has an incentive to reject positive NPV projects, even though they have the potential to increase firm value. How is agency cost related to optimal capital structure? What sort of firms will have more debt, according to agency theory? You started off well; but you don’t relate all these things to Coca-Cola.
The following is our analysis of Coca Cola’s capital structure.
Debt-to-equity ratio and Financial Strategies
For coca cola, the following is our calculation of its debt-equity ratio:
We used the amount of long term debt and shareholders' equity to find Coca Cola’s debt- equity ratio by using Excel function. The result is shown below table. For example, debt-equity ratio in 2002 was equal to 0.228898 which are calculated by 2701/11800.
In order to show Coca Cola’s financing methods, the above table presents cash flow from financing activities. Coca Coal is using funds from issuing debt and issuing stocks. Coca Cola believe that their ability to generate cash from operating activities is one of their fundamental financial strengths. They expect cash flows from operating activities to be strong in 2007 and in future years. Accordingly, Coca Cola expects to meet all of their financial commitments and operating needs for the foreseeable future. Also, Coca Cola expect to use cash generated from operating activities primarily for dividends, share repurchases, acquisitions and aggregate contractual obligations.
Coca Cola also has used debt financing for their operations. Coca Cola maintains debt levels they consider prudent based on cash flows, interest coverage ratio and percentage of debt to capital. Coca Cola uses debt financing to lower their overall cost of capital, which increases their return on shareowners’ equity. As of December 31, 2006, Coca Cola’s long-term debt was rated ‘‘A+’’ by Standard & Poor’s and ‘‘Aa3’’ by Moody’s, and their commercial paper program was rated ‘‘A-1’’ and ‘‘P-1’’ by Standard & Poor’s and Moody’s, respectively. Coca Cola debt management policies, in conjunction with their share repurchase programs and investment activity, can result in current liabilities exceeding current assets. Issuances and payments of debt included both short-term and long-term financing activities. For instance, on December 31, 2006, Coca Cola had $1,952 million in lines of credit and other short-term credit facilities available, of which approximately $225 million was outstanding. The outstanding amount of $225 million was primarily related to Coca Cola international operations. The issuances of debt in 2006 primarily included approximately $484 million of issuances of commercial paper and short-term debt with maturities of greater than 90 days. The payments of debt in 2006 primarily included approximately $580 million related to commercial paper and short-term debt with maturities of greater than 90 days and approximately $1,383 million of net repayments of commercial paper and short-term debt with maturities of 90 days or less.
The below table explains aggregate contractual obligations of Coca Cola from 10k, and this table also shows that Coca Cola’s financing method including short-term loans, borrowings and commercial paper.
1 Refer to Note 8 of Notes to Consolidated Financial Statements for information regarding short-term loans and notes payable. Upon payment of outstanding commercial paper, we typically issue new commercial paper. Lines of credit and other short-term borrowings are expected to fluctuate depending upon current liquidity needs, especially at international subsidiaries.
2 Refer to Note 8 of Notes to Consolidated Financial Statements for a discussion of our liability to CCEAG shareowners as of December 31, 2006. We paid the amount due to CCEAG shareowners in January 2007 to discharge our liability.3 Refer to Note 9 of Notes to Consolidated Financial Statements for information regarding long-term debt. We will consider several alternatives to settle this long-term debt, including the use of cash flows from operating activities, issuance of commercial paper or issuance of other long-term debt.4 We calculated estimated interest payments for long-term debt as follows: for fixed-rate debt and term debt, we calculated interest based on the applicable rates and payment dates; for variable-rate debt and/or non-term debt, we estimated interest rates and payment dates based on our determination of the most likely scenarios for each relevant debt instrument. We typically expect to settle such interest payments with cash flows from operating activities and/or short-term borrowings.
5 The purchase obligations include agreements to purchase goods or services 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. We expect to fund these obligations with cash flows from operating activities.
6 We expect to fund these marketing obligations with cash flows from operating activities.
Therefore, Coca Cola has used many sources to finance their operation activities. First of all, the main fund is their cash from operating earnings. Coca Cola is strongly mentioning about this fact. Other 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. For example, in 2006, Coca Cola had 878 million of stock, but they had 3235 million in terms of short term debt and 1314 million in terms of long term debt. In 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 over time, the long-term Debt to Equity ratio has strongly decreased between 2002 and 2004, especially between 2003 and 2004. Since then, the ratio has not changed in a significant way. The variations of the long-term Debt to Equity ratio can be mainly explained by the significant decrease of long-term debts over the period. Between 2003 and 2004, Coca-cola has cut its long-term debts by more than 50 percent. According to Coca-cola, this evolution reflects improved business results and effective capital management strategies. Even though there was a significant change in the long-term Debt to Equity ratio over 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. In other words, the earnings for a single year can wipe Coke’s balance sheet squeaky clean. This is consistent with the belief of Mister Warren Buffet, the largest investor in the company at some point, (“The Buffettology workbook” by Mary Buffet and David Clark) who has discovered that the wealth of a company’s asset, tangible and intangible, is in its ability to produce wealth via earnings. According to him, the best of a company’s financial power is in its ability to service and pay off debt out of its net earnings. The appendix 2 and 3 are the charts of long-term debt-to-equity ratio and long-term debt.
Very descriptive; you are not planning to do any analysis? Explanation of what you see?
Asset
Furthermore, as Corporate Finance taught us, the question of a firm’s capital structure is relevant to bankruptcy cost of the firm, which further requires examining what kinds of assets the firm owns. So next we would like to take a deep look at Coca Cola’s assets.
First, we want to see the composition of Coca Cola’s assets in terms of tangible versus non-tangible. The table below would help us better understand.
Name of Assets 2006 2005 2004 2003
Trademarks with indefinite lives 2,045 1,946 2,037 1,979
Good will 1,403 1,047 1,097 1,029
Other Intangible Assets 1,687 828 702 981
Percentage in Total Assets 17.14% 12.98% 12.25% 14.59%
Ratio of Intangible to Tangible 1:4.84 1:6.70 1:7.17 1:5.85
Note: (units in million except the percentage)
(Source: 10 K of Coca Cola from S.E.C http://www.sec.gov/cgi-bin/browse-edgar?...getcompany)
Clearly from this table, the intangible assets play an important role among all Coca Cola’s assets. This should not be surprising, as we all know; Coca Cola is such a firm which derives a great deal of its value from its brand name. Thus, direct bankruptcy cost of the firm should be rather high because some of its assets are not easily divisible and marketable. That is to say, Coca Cola should use less debt in respect that its assets are less liquid. Why do you say that? What assets are you talking about? Why don’t you use some of the extensive facts that you set out above to buttress your arguments here?
Second, we also need to see whether Coca Cola’s assets are specialized or not. This is one obvious thing that we don’t need to use figures to prove out. The firm’s major business, beverage, which is very popular worldwide, relies on Coca Cola’s production factory settled in many countries around the world. When the firm wants to select a new location to have a new factory, it will consider whatever will be best for a good beverage, for instance, the water conditions will be tested strictly. And most of its equipments are very specialized for producing such beverage products. Therefore, again in terms of liquidation, Coca Cola’s assets will be less likely to fetch its market value in a short time, resulting in higher expected bankruptcy cost. Hence, the company should use less debt based on this point.
Specialized to produce Coca-Cola, as opposed to some other beverages? Really?
Sorts of investors of Coca Cola
Beside expected bankruptcy cost, agency cost of borrowing is also a factor which should be considered by a firm’s management for decision making on capital structure of the company. Thus, we are interested in what sorts of investors does Coca Cola have. As a large publicly traded corporation, Coca Cola issues both stocks and bonds for its financing needs. There are a big number of investors including private stockholders, institutional stockholders, mutual stockholders and bondholders. Consequently, the conflict could easily exist between stockholders and bondholders, resulting in agency cost when Coca Cola wants to raise fund by borrowing. Furthermore, Coca Cola may want to avoid the agency cost by using less debt. This sound like something you could have written for any company – just substitute the name of that company for Coca-Cola’s!