Financial Management & Corporate Finance Case Study

Dilemma of Garner Fertilisers: Applying Relevance and Irrelevance Capital Structure Theories

OR

Abstract:
The objective of this case study is to understand the concept and theories of capital structure. Financing decisions form one of the core aspects in the corporate business activities. They have a long-term implication on company’s profitability as it determines the overall cost of capital. A prudent finance manager should always try to keep the cost of capital at minimum which is the fundamental principle underlying financial decisions. Thus, a judicious mix of various sources of finance becomes indispensable to achieve the objective of minimum cost of capital. An appropriate mix of capital structure (mix of debt and equity) is an indication of company’s sound finances. However, there is a difference of opinion in viewing the impact of capital structure on the valuation of a firm. One school of thought comments that the financing-mix has no impact on the value of the firm or cost of capital and both are independent of each other. Another school of thought supports the capital structure decisions and states that financial leverage influences the company’s market value and has an effect on cost of capital. One such company, Garner Fertilisers, established in 2004 is in a dilemma regarding its capital mix as it is in need of finances for further expansion. It has been trying to find out at what level of capital mix, will the firm maximise its value, keeping its cost of capital at the minimum.

Further, this case study provides a rich discussion on the technical relationship between capital structure, cost of capital and the valuation of a company.

Pedagogical Objectives:

• To have an overview of ‘capital structure’ and to debate and discuss the importance of designing an optimal capital structure for a firm
• To have an in-depth understanding of capital structure theories (Relevance and Irrelevance) and to debate on the suitability and efficacy of those theories for firms
• To evaluate the financial performance of Garner Fertilisers, and to assess its value.

Keywords : Leverage Equity, Debt, Capital Structure, Theories of Capital Structure, Optimal Capital Structure, Cost of equity, Cost of Debt, EBIT, EPS, Weighted Average Cost of Capital(WACC), Net Income Apprach, Net Operating Income Approach, Modigilani-Miller Approach, Opportunity Cost, Arbitrage, Trade-off theory, Cost of Financial Distress