Summary Of Target Corporation Capital Structure

Capital Structure Analysis for Target Corporation

Unit 5 Assignment

GB 550: Financial Management

Kaysha Covington

Professor Mitchell Miller

May 22, 2018

Abstract

The capital structure decisions for Target Inc. are significant since the profitability of the firm is specifically influenced by this decision. Profit maximization is part of the wealth creation process and wealth maximization can be a lengthy process for financial managers. Profits affect the value of the firm and it is expressed in the value of stock. Cost of capital is how investors evaluate weighted average cost of capital (WACC). Capital structure ratios help investors gauge the level of risk that a company is taking on through financing. While Target

Corporation (NYSE: TGT) struggled in 2015, its capital structure has still not been in line with its peers as it stands today. Both the debt-to-market equity ratio and the enterprise value show that while Target's short-term debt has gone up and market capitalization has gone down. This study is aimed at investigating the impact of capital structure on the profitability and shareholder wealth for Target Inc.

Table of Contents

Abstract PG. 2
Introduction PG. 3
Capital Structure Issues PG. 3
Business and Financial Risks PG. 5

Introduction
Target Corporation runs as a general merchandise retailer in the United States.

Target Corporation was founded in 1902 and is headquartered in Minneapolis, Minnesota. It sells its products through its stores and digital channels, including Target.com, and presently operates 1,826 stores. This report will focus on the capital structure of Target Corporation, discuss Target's most recent short-term and long-term financing decisions, give an analysis of the economic, business, and competitive background in which they operate, discuss Target's international investment and financing opportunities, review Modigliani and Miller’s capital structure theory as it relates to Target Corporation, and finally offer possible outcomes that would optimize Target's financial policy and capital

structure.
Capital Structure Issues
As of April 2016, Target had 603.8 million shares outstanding, down considerably from a peak of 665 million in August 2015. As a result, market capitalization was down from $44.4 billion to $39.4 billion, after reaching a peak of $54.3 billion in August 2015. Short-term debt increased significantly as well, from $91 million in January 2015 to $1.627 billion in April 2016. However, cash has nearly doubled from $2.2 billion to $4.0 billion. A debt-to-equity ratio below 40% for large-cap stocks is considered financially healthy.
A high debt-to-equity ratio differs depending on the industry, because some industries tend to utilize more debt financing than others. For Target, the debt-to-equity ratio stands at around 98-100%, which indicates that the company is holding a high level of debt relative to its net worth. While debt-to-equity ratio has several factors at play, another way to check whether Target’s leverage is at a sustainable level is to check its ability to repay the debt. A company generating earnings at least three times its interest payments is considered financially sound. In Target’s case, its interest is excessively covered by its earnings as the ratio sits at 8.58x. This doesn’t ensure that lenders will be motivated to lend more money to the company though.
Target’s debt levels have fallen from $12.75 billion to $11.59 billion over the last 12 months, which is made up of current and long-term debt. Additionally, Target has produced cash from operations of $6.92 billion in the last twelve months, leading to an operating cash to total debt ratio of 59.75%, signalling that Target’s debt is appropriately covered by operating cash. Although Target’s debt level is towards the higher end of the spectrum in comparison to its US Multiline Retailer industry competitors, its cash flow coverage looks adequate to meet debt obligations which means the debt they are incurring is being efficiently utilized. Gill, Biger and Mathur (2011) stated that the relationship between capital structure and profitability cannot be ignored because the improvement in the profitability is necessary for the long-term survivability of the firm examined the effect of capital structure on profitability of the 272 American firms. Their findings show a positive relationship between short-term debt to total assets and profitability; long-term debt to total assets and profitability; and total debt to total assets and profitability in the manufacturing industry.
Business and Financial Risks
Kumar and Bodla (2014) advise that managers should keep into account both financial and non-financial factors in designing capital structure of their firms. They are required to analyze pros and cons of use of debt and equity. For instance, use of debt, unlike equity, does not dilute the controlling power of existing owners. But it increases financial risk. Earnings for Target Corporation are highly susceptible to the state of macroeconomic conditions and consumer confidence in the United States. Virtually all of the company’s sales are in the United States, making results highly dependent on U.S. consumer confidence and the health of the U.S. economy. Additionally, a significant portion of total sales is concentrated in stores located in five states: California, Texas, Florida, Minnesota and Illinois, resulting in further dependence on local economic conditions in these states specifically. Weakening in macroeconomic conditions or consumer confidence could negatively affect Target Corp. in many ways, including slowing sales growth, reduction in overall sales, and reducing gross margins. The company, like many other brick-and-mortar retailers, is being hurt by on-line sales. Management has responded and has taken several steps to become more competitive online, as well as to boost in store traffic. While Target’s on-line sales have grown, they are less profitable than in-store sales, causing them to re-evaluate the outlook for the company’s profitability and growth potential.
High and low rated companies have a low level of leverage, whereas mid-rated companies have a high level of leverage. It is evident that costs and benefits of each rating scale have a substantial effect on the behavior of a company's choices for optimal capital structure. A study completed by Sajjad and Muhammed (2018) suggests that policymakers, investors, and financial officers should consider the company’s rating as an important variable prior making financing decisions to achieve its optimal capital structure.
In the event of financial turmoil, the company may have difficulty meeting interest and other debt obligations. Target’s high cash coverage means that, although its debt levels are high, investors shouldn’t panic since the company is able to utilize its borrowings efficiently to generate cash flow. At the current liabilities level of $13.20 billion, it appears that the company has not maintained a sufficient level of current assets to meet its obligations, with the current ratio last standing at 0.95x, which is below the industry ratio of 3x.

Modigliani and Miller’s (MM) Theory
The Modigliani-Miller theorem argues that it does not matter how the firm is financed, the profitability and viability of the firm is unaffected by its financing decisions. However, the theory holds only if a number of underlying assumptions are valid. Modigliani and Miller themselves argue the effects of taxes in two ways that are as follows:
M-M Model (Corporate Taxes):
The interest payment to bondholders are not taxed, whereas the dividends paid to shareholders are taxed. From the company’s point of view, there is a tax savings associated with bonds. The company should favor debt for their capital structure, which Target does.
M-M Model (Personal Taxes):
The investors bear higher personal income tax on their interest payments on bonds as compared to the personal income tax on dividend payments. From the investor’s perspective, he should prefer to invest in shares (equity) than in bonds (debt). The effects of the taxes are different on optimal capital structure from both perspectives. Therefore, the net effect is difficult to measure, but the effect of corporate tax is strong. Companies with high collateral should favor higher debt in their capital structure. Equity can often be more expensive to issue than debt, plus interest payments are tax deductible.
One of the theorem's underlying assumptions is that when a corporation gets hold of extra money, it will not squander the cash. No matter how much free cash it has sitting in the bank, the firm will invest if there are worthy investment opportunities; but if there aren't, it will return the money to shareholders in the form of dividends. This assumption doesn't always pan out in the real world of corporate finance. Experience shows that firms do tend to squander excess cash, often taking on extremely risky projects with the free cash at hand which is what Target did in 2015 when divulging into the e-commerce expansion with Target.com.
Capital Structure Evidence and Implications
As of today, Target Corp's weighted average cost of capital is 5.23%. Target Corp's ROIC % is 16.45%. Target Corp. generates higher returns on investment than it costs the company to raise the capital needed for that investment. Target is earning excess returns over the long run, making it an attractive option for investors despite their less than industry average growth. A firm that expects to continue generating positive excess returns on new investments in the future will see its value increase as growth increases. Target has paid a dividend each quarter since the retailer went public in 1967. It has also raised that payout in every one of those years, which translates into a streak of 51 years of increases. Target had posted weaker profits recently in 2015 as the company scaled up investments in its e-commerce strategy while cutting prices to keep customer traffic rising. Yet the spending hasn't come close to jeopardizing its dividend. Target's payout was less than half of earnings over the past year and should amount to roughly the same proportion of the $5.30 per share that management is expecting to generate in 2018.
Deciding the optimal capital structure is one of the essential obligations of finance manager.

Managers are encouraged to act more in the interest of shareholders and the amount of leverage in the capital structure affects firm profitability (Ebaid, 2009).

References

Ebaid, I. E.-S. (2009). The impact of capital-structure choice on firm performance: empirical evidence from Egypt. The Journal of Risk Finance, 10(5), 477–487. http://doi.org/10.1108/15265940911001385

Gill, A., Biger, N., & Mathur, N. (2011). The effect of capital structure on profitability: Evidence from the United States. International Journal of Management, 28(4), 3.

Kumar, R., & Bodla, B. S. (2014). A Study of the Determinants of Capital Structure Choice. BVIMR Management Edge, 7(2), 79-93.

Sajjad, F., & Zakaria, M. (2018). Credit Rating as a Mechanism for Capital Structure Optimization: Empirical Evidence from Panel Data Analysis. International Journal of Financial Studies, 6(1), 1. doi:10.3390/ijfs6010013

Appendix

Key Ratios

Data