Stream 6-Team 2-SID:
Finc3600 Individual Report
Capital Structure
Recommendations
● It is recommended that A2 Milk Company Limited (A2M) optimize the capital
structure by issuing more debt to an appropriate level and below the industry average
to avoid bankruptcy risk. An excessive amount of debt increases the risk of
bankruptcy, which lowers the company's market value (Bragg, 2018). As a form of
recapitalization, the acquired capital can be used to invest and repurchase equity.
● The level of equity should remain at the same level or decrease slightly by share
repurchase, which can help consume excess cash and solve the share dilution problem.
Key Implications
● Issuing debt provides a tax shield to the firm, which helps deduct the interest expenses
associated with debt and reduces the cost of capital(Brusov,2011). It makes the cost of
debt lower than the cost of equity since dividend payouts are not tax-deductible.
● The separation between legal ownership and management derives a series of agent
problems where shareholders can make decisions for their own interest rather than try
to maximize the firm value(Aggarwal, 2008). However, re-balancing the capital
structure with more debt constrains managers by restricting the amount of free cash
available to them. Hence, it could alleviate the agency problem and make the
managers behave more consistently with shareholders.
● It’s benefits for A2M to share repurchase, lowering the equity level since it
strengthens shareholders' control right. Based on the annual report, (the net profit
margin of A2M has increased in recent years.) The regulatory and structural factors of
re-seller channel has been impacted by Covid-19. A2M needs to further evolve its
routes to market and brand marketing programs in parallel in order to adjust to the
changing environment in which it operates. A2M’s long-term outlook is positive
supported by a healthy brand and strong balance sheet. However, the low stock price
reflect that the market undervalues the company's stock price, and investors have not
given A2M a reasonable stock valuation. Therefore, managements repurchase stock
could release positive signals to the market, boosting the investors' confidence. Most
importantly, it consumes A2M's excess cash, which can be a simple way to pay off
investors and reduce the overall cost of capital.
Evidence
● A2M has the lowest net debt ratios compared with the peer companies (Table 1). The
main reason contributing to the significant ratio gap is A2M holds too much cash on
hand, leading to a negative net debt of $-799 million. The cash of A2M is $814.47
million, which is the second-highest compared with the peer company. Meanwhile,
A2M’s ROE has decreased significantly from 2020 to 2021 (26.73% to 6.67%).
Based on the formula, issuing more debt can strengthen A2M’s capital gain capability.
● A2M has the lowest net debt-to-EBITDA ratio compared to the peers (-6.4), and it’s
lower than the industry average, indicating sufficient solvency. The fundamental
cause for the negative ratio is that A2M has slightly no debt, they quickly repaid their
debt. Additionally, A2M is willing to acquire for maximising the firm’s value. Issuing
more debt could further support A2M’s investment decision.
Stream 6-Team 2-SID:
Analysis performance
Table 1 (Morningstar, 2021)
References
Aggarwal, R. K. (2008). Executive Compensation and Incentives. Handbook of
Empirical Corporate Finance, 497–538. https://doi.org/10.1016/b978-0-444-53265-
7.50009-3
Bragg, S. (2018, April 8). AccountingTools. Retrieved from AccountingTools website:
https://www.accountingtools.com/articles/optimal-capital-structure.html
Brusov, P., Filatova, T., Orehova, N., & Brusova, N. (2011). Weighted average cost
of capital in the theory of Modigliani–Miller, modified for a finite lifetime company.
Applied Financial Economics, 21(11), 815–824.
https://doi.org/10.1080/09603107.2010.537635