Capital Structures And Cost Of Capital Report Example

Introduction

Capital structure management is a crucial aspect of effective cost control. That is because the structure determines a company’s cost, hence determining its performance and ability to create wealth for its shareholders. In that view, this analysis seeks to demonstrate how the structures influence companies’ performance as well as decision making. To achieve that, the analysis evaluates three companies in Hospitality industry. In that respect, this report begins with an overview of the companies’ debt structure and how it influences the companies’ cost of capital. That is followed by overview of how the companies’ long term financing polices as well as working capital management influences performance.

Companies Overview

Ruth’s Hospitality
The company is publicly owned, and leading restaurant exclusively focused on the upscale dining segment. The legacy of Chris Steak House, which is owned by Ruth Fertel, began when for $22,000; she mortgaged her home to purchase 60-seat restaurant Chris Steak House which is located in Louisiana New Orleans. Over 40 years later Ruth company continues growing given its core values, which include delivering highest value beverages, food, and services combined with its inviting and a warm atmosphere (Ruth’s Hospitality Overview, n.d.).

DiamondRock Hospitality

DiamondRock Hospitality is a Maryland lodging-focused corporation operating as a REIT. It has 29 premium resort hotels portfolio with approximately 10,900 rooms concentrated in major destination resorts and cities throughout U.S. Virgin Islands and North America. The vision of the company is to become a premier lodging capital allocator and delivering above-average returns to shareholders in all their lodging cycle. The company differentiates itself from others in the industry as a key competitive measure (DiamondRock Overview, n.d.).

Hotel Corporation

Hotel Corporation plc is involved in hotel sector businesses investments in the United Kingdom. The principle assets of the company include the Puma Hotel. The company’s operation is concentrated in PHP and is focusing on adding more than 700 bedrooms, in which 472 of them have already received building consent and planning. Also, there is a scheme of more than 3,000 square meters, where more than 70% of them have received planning consent for more meeting rooms and some leisure clubs upgrades (Hotel Corp Overview, n.d.).

Capital structure impact on the cost of capital

Capital structure refers to the composition of an organization's capital comprising of equity and debt financing. The two capital elements have different costs with equity cost being the amount that the investors forgoes to invest their funds in the market. On the other hand, the cost of debt is the average of an organization’s debt and is usually relatively higher given that it is dependent on the market factors determining a market’s interest rate. On the other hand, the cost of equity is relatively low given that equity’s cost is measured by the market’s risk free return that is usually relatively low as it does not account for the risk factor. In that respect, with a change in the capital structure, a company’s costs of capital is expected to change depending on the proportion of debt and equity (Kester & Hoover, 2005). With that view, the following is an overview of the three hotels debt structure and the cost of capital.

Capital structure

One way of establishing a company’s capital structure is calculating its debt ratio to identify the proportion of capital that is in debt (Damodaran, 2010). In that respect, the following is a summary of the three companies’ debt ratios.
Debt ratio = [Total Debt / Total Assets]
Source: (DiamondRock Balance Sheet, n.d., DiamondRock Income Statements, n.d., DiamondRock 2012 annual Report, 2012, Hotel Corp Balance Sheet, n.d., Hotel Corp 2012 annual Report, 2012, Hotel Corp Income Statements, n.d., Ruth's Balance Sheet, n.d., Ruth's Income Statements, n.d., Ruth's 2012 annual Report, 2012).
The analysis shows the three companies have had relatively low debt ratio comparing their debt to the total assets. In that respect, the companies’ debt is less than their assets. However, DiamondRock has had the highest debt-financed capital structure given the relatively higher ratio followed by Ruth’s Group and finally Hotel Corp that has had the least debt use in its capital structure. In that respect, Diamond Rock is expected to have a relatively higher debt burden compared to the other two given its much relative reliance on debt. On the other hand, the Ruth’s debt structure has been changing with a decrease in debt level while that of DiamondRock has remained relatively stable. On the contrary, Hotel Corp’s debt level has been rising over time in that respect, as Diamond Rocks debt burden is expected to have been relatively constant, that of Ruth’s Group has been decreasing while that of Hotel Corp should be rising.

The cost of Capital Calculation using WACC formula.

The assets of a company get financed either by equity or debt. WACC is an average of costs for these financing sources, each been weighted by the respective use in the given situation. Therefore, by taking the weighted average, one may be able to see the extent to which the company will pay for each dollar of its finances. Further, WACC represents total return required by a company, hence mainly used by directors to determine economic feasibility in expansionary mergers and other opportunities (Kester & Hoover, 2005). In summary, it is the discount rate that is appropriate to make use of the cash flows.
In that view, its calculation entails weighing all capital sources including preferred stock, common stock, bond as well as other any long-run debt, all which are included in the calculation. A firm`s WACC increases when its beta as well as the return rate on equity increases. Thus, WACC identifies a firm's risk and value change as the market conditions change (Damodaran, 2010). In that consideration, the following is a summary of the three hotels’ WACC calculated using t he formula WACC = Kd (D/V) + Ke (D/V) (1-tax rate).
Source: (DiamondRock Balance Sheet, n.d., Hotel Corp Balance Sheet, n.d., Ruth's Balance Sheet, n.d., Treasury, n.d, Bank of England, n.d.).
Given the analysis, it is clear that DiamondRock has the highest WACC followed by Ruth’s Group while Hotel Corp has the least cost. The findings are in line with the expectation that the company with the highest debt level has the highest cost of capital. Thus, as Diamond Rock has the highest debt level followed by Ruth and finally Hotel Corp, the WACC follows a similar trend.

Discussion of why the Companies chose their specific capital structures

There are several reasons why a company chooses a certain capital structure in terms of the debt level. Some of the Factors that managers consider in making decisions on ratio of debt/equity include
The growth rate for the future sales: Such could be the case of Diamond Rocks that chooses to retain high debt level to finance operations with positive market prospects.
The stability of the future sales: In this case, Ruth’s future market prospects could be reason the company seeks to reduce its risk by reducing debt level.
Competitive structure of the industry: For this case, Hotel Corp could be increasing debt level as a means of financing its operations with its challenges with sales.

Asset structure for the industry

The lender attitudes directed toward the company as well as its industry (Kester & Hoover, 2005).
With increased debt, interest expense rises together with the need of cash flows so as to cover the expense interest rise. The issuer of debt becomes nervous in that the firm won`t be in a position to meet its financial obligations in respect of those debts. The stockholders also become nervous. First, when interest increases, the EPS decreases, hence lowering the stock price. Further, if a firm, in the worst situation, goes bankrupt, stockholders are usually the last party to be paid. Thus, with companies having control on their capital structure, they target an optimal structure because, as more of debt is applied, the debt cost increases, and while more equity gets offered, the equity cost increases (Damodaran, 2010).

Use and effect of Leverage

Taking on the debt, as individual or company brings heightened level of the risk because the income must be used in paying back debts even when cash flow and earnings decreases. From the perspective of a firm, the financial leverage use can positively or in some instances negatively affects the equity return as a consequence of increased risk level (Damodaran, 2010).
Source: (DiamondRock Balance Sheet, n.d., Hotel Corp Balance Sheet, n.d., Ruth's Balance Sheet, n.d.)
Given the analysis, it is clear that most leveraged company has been the Diamond Rock that has had a relatively higher proportion of capital in debt compared to the equity component. The company is followed by Ruth’s Groups with Hotel Corp having being least leveraged. On the other hand, the leverage follows the trend of the debt ratio over the five years with Diamond’s leverage being relatively stable while that of Ruth decreases and that of Hotel Corp increasing. .

Dividend policy

The board of the directors of a firm decides the dividend to be paid to those shareholders who already have been registered on the record date. There are various dividends types including:

The Cash Dividends: The Dividends that get paid in the form of cash, usually on quarterly basis.

Regular and the extra dividends: The regular dividends normally remain unchanged even in future, but the special or extraordinary dividends may never be repeated.
The Stock Dividend: The Shareholders tend get new stock within the firm in the form of a dividend. Like stock split, the shares increase, though no cash changes hands (Damodaran, 2010).
Given the three companies’ dividend policies, the following is a summary of their stock price performance showing the effect that the policies have on the companies’ market value.
Source: (DiamondRock Historical Price, n.d., Hotel Corp Historical Price, n.d., Ruth's Historical Price, n.d.).
While the stock prices of DiamondRock and Ruth’s Group have been increasing over the period marked in line with the increasing dividend payments, Hotel Corp’s price has been decreasing with a significant fall from the 2010’s value. That could be associated with markets uncertainty over the future of the company given the issues that lead to its revenues realization deferment effected in 2012 and also the company’s failure to pay dividends to its stockholders over the period (Diamond Rock, 2014).

Long-term financing policy

Long-term funding and investment decisions lead to cash flow in future which, when discounted by appropriate capital cost, determines the company’s market value. However, expected benefits result from such decisions that are long-term if adequate attention is paid to short-terms decisions regarding current liabilities and assets. Current liabilities and assets are liabilities and assets whose maturity period does not exceed one year, and they have to be managed carefully. Working capital refers to the difference between the current liabilities and current assets. In that view, the following is a summary of the companies’ debt ratio over the period indicating their financing decesion over the five years period.
Source: (DiamondRock Balance Sheet, n.d., DiamondRock Income Statements, n.d., DiamondRock 2012 annual Report, 2012, Hotel Corp Balance Sheet, n.d., Hotel Corp 2012 annual Report, 2012, Hotel Corp Income Statements, n.d., Ruth's Balance Sheet, n.d., Ruth's Income Statements, n.d., Ruth's 2012 annual Report, 2012).
The data shows that Ruth’s has been reducing its debt level while Hotel Corp has been increasing is debt. On the other hand, the Diamond Rock has had relatively high and slightly fluctuating debt level. In summary, the long term policy for Diamond is maintaining significant debt level while that of Ruth’s has been decreasing debt as Hotel Corp slightly increases its debt. That could be explained by better future prospects for Diamond while Ruth’s seeks to take caution and reduce risk. However, Hotel Corp could be increasing its debt to finance its assets owing to its past poor performance.

Working Capital Management

Working Capital Management is an accounting strategy, in which management focuses on the efficient level of working capital components including current liabilities and current assets. Management of working capital aims at ensuring that cash flow is sufficient for meeting the operation expenses and debt obligations that are of short-term nature. Implementing effective management is an outstanding way of improving company’s earnings. As management of working capital is important, a clear policy is needed by a company concerning various working capital components. Comparing the working capital with a company’s sales is a great measure of how effective the management is in managing the assets to meet short-term obligations (Damodaran, 2010). In that view, the following is a summary of the three companies’ working capital as a percentage of their sales over the five years.
Source: (DiamondRock Balance Sheet, n.d., DiamondRock Income Statements, n.d., DiamondRock 2012 annual Report, 2012, Hotel Corp Balance Sheet, n.d., Hotel Corp 2012 annual Report, 2012, Hotel Corp Income Statements, n.d., Ruth's Balance Sheet, n.d., Ruth's Income Statements, n.d. & Ruth's 2012 annual Report, 2012).
Given the analysis, it is clear that Diamond Rock’s working capital as a percentage of sales have been fluctuating with a decrease in 2011 and a rise in 2013. On the other hand, Hotel Corp’s working capital about the sales decreased significantly in 2011 and did not reflect for the year 2012, 2013 and 2014 with the deferment of revenues since 2012. Finally, Ruth’s Groups has had negative working capital being an indication that the company’s current assets have been less than its current liabilities hence a higher risk of default on its short-term obligations (Ruth’s, 2014).

Mergers and acquisitions.

Investment strategies adopted by a company has an effect on its stock price. In that respect, it is expected that companies that increase their investments enhance their performance hence an increase in investors’ confidence. On the other hand, companies involved in massive divestiture lowers market confidence hence decrease in market price (Damodaran, 2010). In that view and considering the three companies investments approach, the following is a summary of their stocks performance.
Source: (DiamondRock Historical Price, n.d., Hotel Corp Historical Price, n.d., Ruth's Historical Price, n.d.)
While DiamondRock and Ruth’s group’s stock prices have been rising over the period, the price of Hotel Corp has been decreasing. That could be associated with the massive divestiture the company. The strategy involved the massive sale of its assets hence a decrease in its assets that significantly affected is market valuation since the year 2011. On the other hand, the improvement in the other two companies stock price associated with their increased investments in assets means to enhance their portfolio (Hotel Corp 2014).

Sources and methodology

The analysis has been done using secondary data collection method ha entailed the use of published data on the three companies. In that respect, the data was sourced from the companies’ financial statements over the five years, with the statements being available through the companies’ websites, the SEC’s filings. On the other hand, the data on the market’s performance was sourced from the Treasury websites that were useful in providing information on the risk-free interest rate. Thus, the key sources used include Yahoo Finance, the three companies’ websites and SEC filings, all which are authoritative and reliable sources from which he data can be confirmed.
Regarding the methodology applied for the analysis, the capital structure and cost valuation applied quantitative approach where the debts structures have been analyzed for their trends and effect on the companies’ performance. In that respect, the key approach has been the comparison among the companies as well as a comparison of the performance over the five years period.

Conclusion

Given the analysis, it is clear that a company’s capital structure is a key determiner of its cost of capital, which in turn impacts on its performance. That has been demonstrated by the analysis’ finding that the companies with high debt level relative to their assets and equity have relatively higher WACC, which means they have a higher interest expense burden. In that view, Diamond Rock Company has been identified to have the highest debt level and WACC followed by Ruth’s and finally the Hotel Corporation. Further, the analysis has identified that a company’s long term financing decision and policy is dependent on various factors including the need to respond to market conditions by lowering risks or increasing investments and risks through higher debt. Finally, the analysis has identified the need for effective dividends and working capital management as both have the capacity to influence a company’s market valuation. That is because companies that have consistent and increasing dividends and those that effectively manage their assets enhance investors’ confidence in turn increasing the value of their stocks in the market.

References

Bank of England Treasury Rates. (n.d.). Retrieved July 24, 2015, from http://www.bankofengland.co.uk
Damodaran, A. (2010). Applied Corporate Finance. 3rd Ed. Colorado: Wiley.
DiamondRock. (2012). 2012 Annual Report. Retrieved July 24, 2015, from https://www.last10k.com/sec-filings/DRH/0001445305-13-000424.htm
DiamondRock. (2014). 2014 Annual Report. Retrieved July 24, 2015, from https://www.last10k.com/sec-filings/DRH/0001298946-15-000019.htm
DiamondRock Balance Sheet. (n.d.). Retrieved July 24, 2015, from http://finance.yahoo.com/q/bs?s=DRH+Balance+Sheet&annual
DiamondRock Income Statements. (n.d.). Retrieved July 24, 2015, from http://finance.yahoo.com/q/is?s=DRH+Income+Statement&annual
DiamondRock Historical Prices. (n.d.). Retrieved July 24, 2015, from http://finance.yahoo.com/q/hp?s=RUTH+Historical+Prices
DiamondRock Overview. (n.d.). Retrieved July 24, 2015, from http://www.drhc.com
Hotel Corp. (2012). 2012 Annual Report. Retrieved July 24, 2015, from http://www.thehotelcorporation.co.im/pdfs/faccounts/20121231_HotelCorpFinal.pdf
Hotel Corp (2014). 2014 Annual Report. Retrieved July 24, 2015, from http://www.thehotelcorporation.co.im/
Hotel Corp Historical Prices. (n.d.). Retrieved July 24, 2015, from fromhttp://finance.yahoo.com/q/hp?s=HCP.L+Historical+Prices
Hotel Corp Overview. (n.d.). Retrieved July 24, 2015, from http://markets.ft.com/research/Markets/Tearsheets/Business-profile?s=HCP:LSE
Kester, W. & Hoover, A. (2005). FRICTO Analysis: A Framework for Making Capital Structure Decisions. Journal of Financial Education, 61-68.
Ruth's Group. (2012). 2012 Annual Report. Retrieved July 24, 2015, from https://www.last10k.com/sec-filings/RUTH/0001193125-12-094607.htm
Ruth's Group. (2014). 2014 Annual Report. Retrieved July 24, 2015, from https://www.last10k.com/sec-filings/RUTH/0001437749-14-003872.htm
Ruth's Group Balance Sheet. (n.d.). Retrieved July 24, 2015, from http://finance.yahoo.com/q/bs?s=RUTH+Balance+Sheet&annual
Ruth's Group Income Statements. (n.d.). Retrieved July 24, 2015, from http://finance.yahoo.com/q/is?s=RUTH+Income+Statement&annual
Ruth's Group Historical Prices. (n.d.). Retrieved July 24, 2015, from http://finance.yahoo.com/q/hp?s=DRH+Historical+Prices
Ruth's Group Overview. (n.d.). Retrieved July 24, 2015, from http://www.rhgi.com/
Treasury Bill Rates. (n.d.). Retrieved July 24, 2015, from http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield

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