Quinlan Electrical has quite a few positive NPV projects from which to choose. T
ID: 2778399 • Letter: Q
Question
Quinlan Electrical has quite a few positive NPV projects from which to choose. The problem is that it has more of these projects than it can finance without issuing new stock and the board of directors refuses to issue any new shares in the foreseeable future. Norton's projected net income is $150.0 million, its target capital structure is 25% debt and 75% equity, and its target payout ratio is 65%. The CFO now wants to determine how the maximum capital budget would be affected by changes in capital structure policy and/or the target dividend payout policy. Versus the current policy, how much larger could the capital budget be if (1) the target debt ratio were raised to 75%, other things held constant, (2) the target payout ratio were lowered to 20%, other things held constant, and (3) the debt ratio and payout were both changed by the indicated amounts.
Explanation / Answer
Capital Budgeting
First of all,we should understand what is capital budgeting .
Capital budgeting evaluates the costs and benefits of long-term assets. The process examines and compares the returns, cash flows and risks associated with acquiring new capital assets or enhancing the existing ones. Financing decisions, meanwhile, concern the availability of funds to meet the budget obligations of your small business. Your financing decisions should be influenced by the cost of different sources of finance, such as debt and equity capital.
Capital structure and capital budgets
Seek a balanced ratio of debt to equity so as to minimize your cost of capital and maximize returns for your small business. There should be equilibrium between your equity capital and debt financing. Unrestricted borrowing reduces your profits because you will spend significant portion of your income on debt repayment. Similarly, excessive equity capital dilutes profits because you will have to distribute the bigger chunk of earnings to shareholders. Choose long-term financing that attracts minimum interest rates to reduce your borrowing costs.
1.If the target debt ratio is increased to 75% versus current 25%,it will definitely involve an increased cost of capital in the form of fixed interest obligations which will drain the returns coming from the project.
It will also increase the cost of capital .Hence,it will affect the NPV of the projects because inflows will remain the same however outflows will increase drastically on the loan obligations.
If the debt is increased by 75%
It might happen that cost of capital >return from project where capital is invested,hence it will affect the profitability of the projects.
2.If the payout ratio is lowered to 20% ,it will mean greater earnings reinvested in business.
This will have a positive impact on the profitability of the business.
Because it does not involve extra cost in the form fixed obligations.
However,it might cause a adverse impact on the shareholder’s confidence in the business as they expect regular dividend payments as a share in the profits and earnings.
3.If debt ratio and payout are changed by mentioned amounts.
Increase in debt component means increased cost in the form if fixed obligations
Decrease in dividend payout means greater earnings reinvested in business.
This will be an ideal decision as this will balance out the additional cost of capital and profits reinvested into business.
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