Question

Netgear has no debt, a market value of equity of $1.43 billion, $361 million of cash, and an equity Beta of 2.0. Meanwhile, Westar Energy has $4.02 billion of debt, a market value of equity of $7.16 billion, only $3.36 million of cash, and an equity Beta of 0.33.

Thus these two publicly traded firms have very different capital structures. Netgear is profitable and has been for the last decade; however, the firm’s management appears to be quite averse to debt, while the opposite can be stated for Westar Energy. Is the management of Netgear ignorant of the tax benefits of debt or does something else drive their decision to have no debt? How can one explain the sharp difference in capital structure between these two firms?

Answer 1

Net Gear

Debt - 0

MV of Equity - $ 1.43 Billion

Cash - $361 M

Beta Equity - 2

Westar Energy

Debt - $ 4.02 B

Equity - $ 7.16 B

Cash - $ 3.36 M

Beta equity - 0.33

Though Netgear seems to have a good cash position with profits while the same is not true for westar energy, the major factor driving the decision making of the management is the risk that Netgear finds itself in.

The risk of both the firms is given by the Equity beta. While Equity beta of Netgear is 2, the equity beta of Westar energy is 0.33. As Netgear does not have any debt in its capital structure, the Equity beta is same as the firm beta. An equity beta of 2 indicates that if the market return changes by 1 unit, the return of the equity changes by 2 units or double. So any negative impact on the market would be felt as a double impact for the firm. This could possibly explain the management's hesitation to take debt even though there are tax benefits attached to it.