Capital structure – case study in thang long mechanical four and construction joint stock company

Final thesis

Academy of finance

ENGAGEMENT

I would like to engage that I made this thesis by myself. The figures and
information in the thesis are all honest.
The author
Tran Thi Minh Nguyet

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TABLE OF CONTEND
ENGAGEMENT................................................................................................i
LIST OF ABBREVIATED WORDS...............................................................v
PREFACE..........................................................................................................1
CHAPTER 1: OVERVIEW OF CAPITAL STRUCTURE AND TARGET
CAPITAL STRUCTURE..................................................................................3
1.1. Capital structure.........................................................................................3
1.1.1. Definition................................................................................................3
1.1.2 The theories of capital structure...............................................................4

1.1.2.1. Modigliani and Miller approach...........................................................4
1.1.2.2. Capital Structure theory – Traditional approach..................................5
CHAPTER 2: SITUATION OF CAPITAL STRUCTURE OF COMPANY
THANG LONG MECHANICAL FOUR AND CONSTRUCTION JOINT
STOCK COMPANY.......................................................................................19
2.1 Overview of company Thang Long mechanical four and construction joint
stock company.................................................................................................19
2.1.1 The basic information about company Thang Long mechanical four and
construction joint stock company....................................................................19
2.1.1.1. The basic information.........................................................................19
2.1.1.2. The organization chart of

Thang Long mechanical four and

construction joint stock company....................................................................20
2.1.1.3. The system of accounting of the company.........................................21
PICTURE 2.2: SYSTEM OF ACCOUNTING OF THE COMPANY............21
2.1.2 The business characteristics of company Thang Long mechanical four
and construction joint stock company.............................................................22
2.1.2.1. Material and technical facilities.........................................................22
2.1.2.2. Situation of material supply...............................................................23

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2.1.2.3. The capability of skilled workmanship of Thang Long mechanical
four and construction joint stock company......................................................24
2.1.2.4. Output market and the ability to compete of the company.................24
2.1.3 Overview of financial situation and performance of company Thang
Long mechanical four and construction joint stock company ........................25
2.2 Situation of capital structure of

Thang Long mechanical four and

construction joint stock company ...................................................................27
2.2.1. Situations of capital structure................................................................27
2.2.1.2. The situation of financial leverage.................................................34
2.2.2. Evaluating the effect of capital structure to the firm.............................35
2.2.2.1. The effect of financial leverage to ROE............................................35
2.3 Assessment of the company’s capital structure decisions.........................41
2.3.1 The achievements...................................................................................41
2.3.2 The shortcomings and reasons...............................................................42
2.3.2.1. The shortcomings...............................................................................42
2.3.2.2. The reasons.........................................................................................43
CHAPTER 3: SOLUTIONS FOR
MECHANICAL

FOUR

AND

ESTABLISHING THANG LONG

CONSTRUCTION

JOINT

STOCK

COMPANY ’ TARGET CAPITAL STRUCTURE.........................................45
3.1. The development strategies of Thang Long mechanical four and
construction joint stock company....................................................................45
3.1.1 Social and economic background...........................................................45
3.1.2.1. Objectives of business operation........................................................46
3.1.2.2. The orientation of business.................................................................46
3.2. Solutions for establishing Thang Long mechanical four and construction
joint stock company ’ target capital structure..................................................47
3.2.1.Improving capital structure by decreasing gearing................................47

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3.2.2.Strengthening the management of recievable account to recover capital
in short term....................................................................................................50
3.2.3. The solutions to improve the situation of net working capital of the

company...........................................................................................................52
3.2.4. The company should have solutions to improve the performance in next
fiscal year to increase the benefit for shareholders........................................53
3.3. The petitions for the government.............................................................54
CONSCLUTION.............................................................................................55
BIBLIOGRAPHY...........................................................................................56

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LIST OF ABBREVIATED WORDS
DFL
EBIT
EPS
NWC
ROA
ROE
ROS
WACC

Tran Thi Minh Nguyet

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:
:
:
:
:
:
:

Degree financial leverage
Earning before interest and tax
Earning per share
Networking capital
Return on assets
Return on equity
Return on sale
Weight average cost of capital

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LIST OF TABLE AND PICTURE
PICTURE 2.1: THE ORGANIZATION CHART OF THE COMPANY
TABLE 2.1: THE CAPABILITY OF SKILLED WORKMANSHIP

THANG LONG MECHANICAL FOUR AND CONSTRUCTION JOINT
STOCK COMPANY
TABLE 2.2: SOME FINANCIAL RATIOS OF THE COMPANY IN
RECENT YEARS.
TABLE 2.3: SIZE, STRUCTURE AND FLUCTUATION OF CAPITAL
STRUCTURE FROM FISCAL 2013 TO 2015.
TABLE 2.4: GEARING AND DEBT/EQUITY OF THE COMPANY FROM
FISCAL 2013 TO FISCAL 2015
TABLE 2.5: DEGREE OF FINANCIAL LEVERAGE FROM FISCAL 2013
TO FISCAL 2015
TABLE 2.6: THE EFFECT OF FINANCIAL LEVERAGE TO ROE
TABLE 2.7: THE RATIOS OF THE ABILITY TO PAY FOR CREDITORS
OF THE COMPANY
TABLE 2.8: THE SITUATION OF NET WORKING CAPITAL OF THE
COMPANY

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PREFACE
In the market economy, to start a business, people need to the certain
amount of capital. Capital is the important condition with business process of

the company. Morever, when the competition between companies in the
market is more and more violent, the decisions which relate to capital
management will influence on the success of the companies, so they are not
easy for managers. And one of those decisions is to establish capital structure
to maximize the value of the company and owners. It also decides the
company’s product ability in the market.
Because of Understanding the importance of establishing capital
structure, I decided chose the topic “ Capital structure – case study in Thang
Long mechanical four and construction joint stock company”.
1.

Research problem.

Research problem is about overview and the solutions of capital
structure in Thang Long mechanical four and construction joint stock
company: capital structure and target capital structure with its affects.
2.

Purpose and thesis questions

-

Systematizing the issues about capital structure in the company

and the factors affecting target capital structure.
-

Researching situation of capital structure :

+ Studying and evaluating about situation of capital structure in Thang

Long mechanical four and construction joint stock company
+ Proposing solutions for establishing capital structure in mechanical
four and construction joint stock company
3.

Scope of research

-

About space: Studying about capital structure and solutions for

establishing capital structure for Thang Long mechanical four and

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construction joint stock company.
-

About time: the figures provided by financial statements of the

company in 2014 and 2015.
4.

Methodology

The thesis uses the methodologies: analytical method, statistical
method, experimental method…to clear the topic of the thesis.
5.

Thesis structure

Apart from preface, conclusion and bibliography,the thesis structure
includes three major parts:
Chapter 1: Overview of capital structure and target capital structure
Chapter 2: Situation of capital structure of company in Thang Long
mechanical four and construction joint stock company
Chapter 3: Solutions for establishing the Thang Long mechanical four
and construction joint stock company ‘s target capital structure.
Because of limited time and knowledge, my thesis also has some
mistakes in research process. I would like to express my thanks to PhD. Pham
Thi Thanh Hoa and the managers of Thang Long mechanical four and
construction joint stock company because they helped me finish this thesis.

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CHAPTER 1

OVERVIEW OF CAPITAL STRUCTURE AND TARGET CAPITAL
STRUCTURE
1.1. Capital structure
1.1.1. Definition
In market economy, a company is able to use many different sources of
capital to satisfy its demand in the business. However, it is very important to
combine sources of capital to establish the best capital structure for the value
objective.
Capital structure is a term that refers to the propotion of capital sources
in total of capital which the company finances for its business operations. In
other word, it can show how a company decides to finance its assets by
various sources of capital like: borrowing from banks, issuing shares or
bonds, retained earning from the business…
The dicision about capital structure is very important with the company
because:
- Capital structure of the company affects the cost of capital.
- Capital structure affects the company’s return on equity or earning per
share and financial risk.
Capital structure of the company is usually expressed by the relationship
between debts and equity ( owner’s capital). Capital structure is discribed
through some main ratios:
This ratio shows the percentages of debt in capital structure of the
company.
Debt/ Equity

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The company can have various capital structure, but all of them are to
maximize the value of the company.
1.1.2 The theories of capital structure
1.1.2.1. Modigliani and Miller approach
This theory was devised by Modigliani and Miller during 1950s.
Modigliani and Miller advocates capital structure irrelevancy theory. The
valuation of a firm does not depend on the capital structure of a company.
Whether a firm is highly leveraged or not in the financing mix, the value of
the company is not affected.
Modigliani and Miller Approach proposes that the market value of a firm
is affected by its future growth prospect apart from the risk involved in the
investment. If a company has high growth prospect, its market value is higher
and its stock prices would be high.
Assumptions of Modigliani and Miller Approach
o

There are no taxes.

o

Transaction cost for buying or selling securities and bankruptcy

cost are zero.
o

There is symmetry of information. This means that an investor

can have access to same information that a company can access.
o

The cost of borrowing is the same for investors as well as

companies.
o

Debt financing does not affect to companies EBIT

Modigliani and Miller Approach: Two Propositions without Taxes
Proposition 1: With the assumptions of no taxes, the capital structure
does not influence the valuation of a firm. In other way, if the company
finances debt, it does not increase the market value of the company.

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Proposition 2: It says that financial leverage is in direct proportion to the

cost of equity. With increase in debt component, the investors realize a higher
risk for the company. So the cost of equity is higher to make up the risk, the
weight average cost capital of the company does not change, because the
increase in the cost of equity is same to the decrease in the cost of debt.
Modigliani and Miller Approach: Propositions with Taxes (The
Trade-Off Theory of Leverage)
Proposition 1: The value of the company which combines debt in capital
structure is higher than the value of the company which does not use debt. In
other word, the value of the company which has a mix of debt and equity
equals the value of the company which does not use plus present value tax
shield.
Proposition 2: If there is income tax, the cost of equity of a company
which has a mix of debt and equity is higher than the company which
doesnot. The more debt financing the company uses, the higher required rate
of return of the owners is, because of the higher risk. However, the increase in
the cost of equity is lower than the defference between the rate of return of
asset and the cost of debt, the weight average cost capital decreases.
1.1.2.2. Capital Structure theory – Traditional approach.
This theory states that there is a optimal capital structure where the value
of the company can be magnified by suitable financial leverage level.
According to this theory, the cost of capital can be decreased by using debt
financing. However, when the company increases debt financing, risk of the
company will increase too. The creditors require the higher rate of return.
When the gearing increases to a certain level, risk is higher, the increase in the
required rate of return of debt and equity makes the cost of capital increase
too. It makes the the benefit of using debt disappear.

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Assumptions under Traditional Approach:
1. The rate of interest on debt is constant for a certain period and
thereafter with increase in leverage, it increases.
2. The expected rate by equity shareholders remains constant or increase
gradually. After that the equity shareholders starts perceiving a financial risk
and then from the optimal point and the expected rate increases speedily.
3. As a result of activity of rate of interest and expected rate of return,
the WACC first decreases and then increases. The lowest point on the curve is
optimal capital structure.

Diagrammatic Representation of Traditional Approach to Capital Structure
PICTURE 1.1. COST OF CAPITAL AND TRADITIONAL APPROACH

1.1.2.3. Capital Structure theory – Net operating income approach
This theory believes that WACC and the value of the company do not
change when financial leverage level changes. In other word, the theory
claims there is no optimal capital structure, the value and the price of shares
of the company do not depend on capital structure.
This means that when the company finances more debt, the general rate
of return of the company is fixed, so the price of share and the value of the

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company do not change.
Assumptions under Traditional Approach:
1. The overall capitalization rate remains constant irrespective of the
degree of leverage. At a given level of EBIT, value of the firm would be
“EBIT/Overall capitalization rate
2. Value of equity is the difference between total firm value less value of
debt i.e. Value of Equity = Total Value of the Firm – Value of Debt
3. WACC (Weightage Average Cost of Capital) remains constant; and
with the increase in debt, the cost of equity increases. Increase in debt in the
capital structure results in increased risk for shareholders. As a compensation
of investing in highly leveraged company, the shareholders expect higher
return resulting in higher cost of equity capital.
1.1.2.4. Capital Structure theory - Pecking order theory.
In fact, there is not symmetry of information. That means the directors
understand about their company clearlier than thr investors from outside. So
the projects first financed by internal sources of capital, usually retained
earning, then issuing new debt and final is issuing shares. Issuing shares is the
final choice when the company had used debt which can be financed. This
theory explains why the companies which have the low profitability usually
use more debt financing because they don’t have internal capital and debt

financing is at top of external sources of capital.
The companies having the high profitibility and limited investment
chances will try to establish the low rate of debt, the companies having
investment choices more than internal source of capital must borrow more.
This theory is not right with all of companies, there are many firms still
issue common shares althought they can borrow easilly. But this theory can
explain why most of them prefer debt financing in raising fund.

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1.2 Effect of capital structure to the firm value
1.2.1 The financial leverage
In

maitaining the business operation, the company uses debts or

liabilities to make up a deficit of capital and increase return on equity (ROE)
or earning per share (EPS). This decision also increases the company’s
financial risk.
Financial risk refers to the uncertainty of return on equity or earning per
share and it can affect the company ‘s payable at maturity when the company
uses debt or the other type sources of capital which have fixed financial cost.
Althougt financing by debt or liabilities can increase ROE or EPS, it can
make ROE waver more drasticlly. When basic earning power ratio (BEP) of
the company is higher than the cost of debt, financial leverage can make an
increase in ROE. But if BEP is lower than the cost of debt, financial leverage
can make a decrease in ROE quicklier. On the other hand, if the firm finances
debt, it must pay the fixed cost for the creditors and this cost does not depend
on its profit. The more a firm finances debt, the riskier it can face to.
Financial leverage is the degree of debt financing use in a firm’s capital
structure to increase ROE or EPS of the company. The more debt financing
the company uses, the higher its financial leverage.
- Effect of financial leverage to ROE or EPS:
When the company uses financial leverage, its managers hope to make
an increase in ROE. However, if it does not use the debt effectivelly, that
means earning before income tax is lower than the interest, ROE or EPS will
decrease more rapidlly.
Formular of ROE:
EBIT: earning before income tax

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BEP: basic earning power ratio
D: debt
E: equity
V: total of asset
I: interest
r : interest rate
t: corporate income tax rate.
So we have formular to caculate ROE:

Because (1-t) is constant, ROE is depends on BEP, r and D/E.
Proposition 1: BEP >r, the more debt financing the company use, the
higher ROE is. That means financial leverage magnifies an increase in ROE.
Proposition 2: BEP lower ROE is and the higher financial risk. That means financial leverage
magnifies a decrease in ROE.
Proposition 3: BEP = r, ROE is the same in the different situation of
capital structure.
To evaluate effect of financial leverage to ROE, we use degree of
financial leverage (DFL)

DFL is the measure of sensitivity of EPS or ROE to change in EBIT as a
result of change in debt.
Or

Q: Quantity of consumption

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P: Price per good or service
V: Variable cost per good or service
F: Fixed cost
Example: With Newco's current production:
V= 100 million VND with D= 50 million VND, r= 10% a year, Q=
10.000 products, P= 20.000VND, V= 14.000 VND, F= 40 million VND
Given the company's 1% increase in EBIT, the DFL indicates EPS will
increase 1,33%.
1.2.2 The relationship between EBIT and EPS
The relationship between EBIT and EPS shows the effect of different
financing plan to EPS. Although manager choses different financing plan, we
can find a EBIT level which results in the same EPS. It is break -even EBIT
level.

Break - even EBIT level is the different point where EPS under
alternative financing plan is the same.
Mathematically, the break-even EBIT level is:
EBIT = indifference point between the two alternative financing plans
I1, I2 = interest expenses
t

= income-tax rate

SH1, SH2 = number of equity shares outstanding after adopting financing
plans 1and 2
Consider a company A., which is considering the following two
financing options:
 Financing a new project by issuing 100.000 common shares with the
value is 2.000.000 VND.

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 Financing, a new project is invested by 50.000 common shares with the
value is 1.000.000VND and 50% remain is borrowed at rate of 12%.
Applying the above equation for company A. (considering the tax rate is

25%), we get
(EBIT* - 0) (1-25%)
-----------------------

(EBIT* - 120.000.000) (1- 25%)
=

------------------------------------

100.000

50.000

EBIT= 240.000.000 VND
Therefore, the break-even EBIT level, is .240.000.000 VND for A
company. If the present EBIT level of A is more than the break-even EBIT,
then it would be better off to finance the new project by issuing bond. The
equity finance option will be favourable if the present level of EBIT is below
the break-even EBIT level.
1.3 The target capital structure
1.3.1 Definition
1.3.1.1. Weight average cost of capital.


The cost of debt

To meet demand of capital for business, the company has to borrow
money from banks or financial organzations or issuing bonds..The investors
lend the company money with a required rate of return. It is the cost of this
source capital.

-

The cost of debt before tax.

Vt: The money from borrowing which the company can use for
investment.
Ti: The principle and interest expense which the company pays for
creditors in ist year.

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rdt: The cost of debt before tax
n: the periods of borrowing.
- The cost of debt after tax:

rd=rdt(1-t%)
rd: The cost after tax
t%: Rate of income tax.
 The cost of preferred shares
The cost of preferred shares is the required rate of return of preferred
shareholders when the company raises fund bu issuing preferred shares.

rp:The cost of preferred shares.

: Devidend of a preferred shares.
: The price of issuing
: Rate of the cost of issuing


The cost of retained profit

Cost of retained earnings () is the return stockholders require on the
company's common stock.
There are three methods one can use to derive the cost of retained
earnings.
a) Capital-asset-pricing-model(CAPM) approach
b) Bond-yield-plus-premium approach
c) Discounted cash flow approach
a) CAPM Approach
To calculate the cost of capital using the CAPM approach, you must first
estimate the risk-free rate (rf), which is typically the U.S. Treasury bond rate
or the 30-day Treasury-bill rate as well as the expected rate of return on the

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market (rm).
The next step is to estimate the company's beta, which is an estimate of
the stock's risk. Inputting these assumptions into the CAPM equation, you can
then calculate the cost of retained earnings.
= + ( - )
: Risk free rate
: Required rate of return
Beta of security
: Expected market return
b) Bond-Yield-Plus-Premium Approach
This is a simple, ad hoc approach to estimating the cost of retained
earnings. Simply take the interest rate of the firm's long-term debt and add a
risk premium (typically three to five percentage points):

c) Discounted Cash Flow Approach:
Also known as the "dividend yield plus growth approach". Using the
dividend-growth model, we can rearrange the terms as follows to determine

: The current market value per share
:Devidend at tst year.
: Required rate of return


The cost of new common stock

When evaluating a new project, a company is presented with the
decision of financing the project using internal or external sources. If a
mixture of these sources is used, the company must then decide the proportion

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of internal versus external sources that will be utilized, and subsequently the
marginal cost of capital.
If a company plans to issue new common equity, or external equity, in
order to finance a new project, the cost of that equity must be calculated and
factored into the weighted average cost of capital to be used during the
evaluation process. The cost of external equity is higher than the cost of
existing equity, or retained earnings. We can determine how much higher the
cost of external equity will be by factoring in flotation cost.
=+g
: The cost of new common stock
: The devidend for a current year
: The price issuing of a new common share
: The percentage flotation cost
g:The constant rate of growth
 The weight average cost of capital
The weighted average cost of capital (WACC) is the rate that a
company is expected to pay on average to all its security holders to finance its
assets. The WACC is commonly referred to as the firm’s cost of capital.

Importantly, it is dictated by the external market and not by management. The
WACC represents the minimum return that a company must earn on an
existing asset base to satisfy its creditors, owners, and other providers of
capital, or they will invest elsewhere
WACC =
: The percentage of finance of each source of capital
: The cost of a source of capital

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1.3.1.2. The definition of target capital structure
Capital structure is an important issue in financial management of the
company. To establish an capital structure, managers need to consider two
main issue:
- Cost of capital depends on the company ‘s capital structure .
- There is an optimal capital structure.
The key point in capital structure is gearing and the manager has to
decide the optimal percentage of debt in capital structure. Establishing capital
structure bases on principle of exchange of risk and return. The more debt
financing makes increase in risk of the company but brings the higher
expected rate of return. The increase in risk makes the price of shares

decrease while the high rate of return makes the price of shares increase, so an
optimal capital structure is the capital structure that balances risk and the
owner’s rate of return; maximizes the value of the company. Therefore, the
optimal capital structure can minimize the company’s weight average cost
capital.
In fact, it is difficult for the manager to establish an optimal capital structure
exactly. They need to base on the principle of optimal capital structure;
consider risk and rate of return in the company’s condition, situation to
establish capital structure.
1.3.2 The factors affecting target capital structure.
1.3.2.1. The factors inside of the company.
- Stability of sales and profit of the company: sale and profit affects
directly to the size of capital. As usually, if sale and profit are stable, the
company can pay for loans within required time. In this case, the percentage
of debt in capital structure is high and in opposite situation, it is lower.
- The features of business operation of the company: The firms which

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produce finished goods and use a lot of material, equipment and machinery
usually have the low percentage of debt in capital structure. The firms which

are in commercial services industry have the higher gearing in capital
structure.
- The relationship between BEP and interest rate: If BEP is higher than
interest rate, the company usually wants to establish capital structure with
more debt than equity to increase ROE, that means it uses higher financial
leverage level.
- Business leverage: If a firm has great fixed business cost, it usually
uses less debt in capital structure because it needs long term source of capital
like owner’s equity to invest in fixed assets.
- The right of control: If the owners of the company don’t want to share
the right of management, they will use more debt to finance projects inspite of
issuing shares. That means it has higher gearing than the others.
- Growth rate of the company: If a company has lots of chances to
develop and a high gearing, its owners usually don’t want to invest in
projects. Because earing from projects is helpful for creditors than the owners.
So the company will use more equity for business than debt.
- The payable ability of the company: A company has higher payable
ability than the others, it can finance more debt for its projects because it is
able to pay back money within required time.
- Management style: If the qualification of managers is not good,
establishing capital structure will be not sensible. If the manager is prefer risk
than stability, he or she usually choses capital structure with more debt than
equity to finance the company’s projects.
- Asset structure of the company: According to theories, the higher the
rate of fixed assets on total assets is, the more debt the company uses.

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Because if the company goes bankrupt, the fixed assets for ensuring debt are
worth more than the others.
1.3.2.2. The factors ouside of the company.
- Market condition: Market conditions can have a significant impact on a
company's capital-structure condition. The development of capital market
makes the company be able to raise fund more favourably and decrease cost
of capital. The company can raise money by issuing shares, bonds or the other
securities. This makes an increase in long term capital in capital structure of
the company.
If the company predicts that interest rate will increase in the future, it
should borrow more money by long term loan inspite of short term loan in
order to reduce expense. In opposite case, the company should stop to borrow
because it can raise money with lower cost in the future when interest rate
decreases.
- The economic policy of the government:
+ Investment policy: The government can orient the companies to
invest in some main industries through investment policy. This can limit or
encourage the business of the company and change the company’s capital
structure .
+

Monetary policy: The policies that involves credit, interest rate,

exchange rate,…affects typically money surpply in the market and the
borrowing activity of the company. If the policy is sensible, the company can
borrow money favourably and its gearing is higher.
+ Tax policy: Debt payments are tax deductible. As such, if a company's
tax rate is high, using debt as a means of financing a project is attractive
because the tax deductibility of the debt payments protects some income from
taxes.

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- The attitude of lenders: The creditors usually prefer to lend the
company which use more equity than debt because their money can be
ensured better.

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