Creating Capital Structure and Valuation method of a firm

Various methods may be employed in contacting potential buyers of securities. The most important are: (1) contractual underwriting arrangements with investment bankers; (2)offers to existing share holders on a preemptive (prior-privilege) basis;(3) direct placement with an institutional buyer or trust fund administrator; and (4) competitive bid by all prospective purchasers. The final selection of the method of contacting buyers depends on the relatives cost, conditions prevailing in the capital market, effects of the issue on capital structure, effects on stockholder relations, and the amount of government regulation involved.

In building the capital structure of a company, the following policies may be helpful:

1. Don’t use bonds unless the estimated earnings will give a factor of safety of at least 100% (Ratio of what is left after interest payments to the amount of the interest).
2. Keep the capital structure as simple and conservative as is feasible.
3. Keep the contracts between the security holder and the corporation as flexible as possible.
4. Safeguard the control of the company.
5. Keep that annual cost to a minimum.
6. Keep the best security (most appealing; minimum risk) for emergency financing.

Of critical importance in investment analysis is the determination of the cost of capital. Since capital may be raised by selling shares of equity and by long term debt (leverage) a firm’s cost of capital must involve a weighted average from both sources. It is important for two main reasons: first it provides a basis for evaluation of investment opportunities; second, it emphasizes how the degree of leverage is useful the development of a balanced capital structure. The cost of capital, therefore, is a weighted, after tax average computed on the combined capital structure mix. The future cash payments that must be made on the entire mix of capital sources constitute the cost of capital. Estimating the averages cost of capital involves three steps:

1. Determine the optimum capital structure.
2. Determine the after-tax cost of each type of fund used or sought.
3. Weight the cost of each type of fund by its proportion in the optimal capital structure.

The financial managers from time to time must participate in decisions relative to the purchase of major assets and to consolidation and mergers. During the negotiations for acquiring parts or all of other companies, he has the job of arriving at the dollar value of going concerns. The job is made more difficult inasmuch as value must be based not only on present or past value but on careful of uncertainly. Some of the conventional methods of valuation are:

1. Original asset costless depreciation is based on the theory that an asset is worth what was paid for it, less than value lost through useful wear and tear. Objections are raised to this method because prior cost is no measure of present worth.
2. Asset replacement cost less depreciation avoids the question of changing price levels, but is objected to because of the lack of agreement on what replacement means for example, identical replacement or present worth of replacement.
3. Total book value of claims on assets is another way of saying that the value of the claim is represented by the value of the asset to which the claim applies.
4. Market value of outstanding securities constitutes a composite expression of value incorporating all the factors that influence investment decisions. Wide fluctuations in security prices, however, do not facilitate a sound estimate of established values.
5. Capitalization of earnings is based on the proposition that, in the final analysis, an asset is worth it will produce in the form of a stream of income over a period of years, discounted at a “fair rate or return.
For example, the assets of a given company may be capable of producing “normal” annual earnings of $217,333. A capitalization rate of 12½ % is judged reasonable for a business of this character, considering the degree of risks inherent in the venture. Thus, through the simplest capitalization formula, 12½ x V = $217,333, the value of the business would be $1,738,665. At a capitalization rate of 15 % the estimated value would be $1,448,890 and at 10 % the value would be $2,173,330. Of course, the valuation decision would be no more reliable than the accuracy of the estimated future earnings, and the acceptability of the capitalization rate. Furthermore, better but more complicated formulas are available in more rigorous studies of financial management.