Question

1. How do the finance managers find the optimal capital structure for their companies? Don’t write more than 6 lines.
2. Should we also calculate cost of retained earnings with them being internally generated, and not a form of direct investment by the outsiders? Explain in less than 8 lines.
3. Describe the inventory system mostly used in the industries where the number of input item used in the manufacturing process are numerous. Don’t write more than 8 lines.
4. Explain the rationale behind Economic Order Quantity Model of managing inventories? Don’t write more than 8 lines.
5. List six activities which would result in the change of capital structure for a company.
6. Describe the relation between optimal capital structure and firm valuation. Don’t write more than five lines.

Answer 1

Question (a)

The optimal capital structure of the company is estimated by calculating debt and equity mix that minimizes the weighted average cost of capital (WACC) of a company and maximizing the market value of the company. When the cost of capital to discount the cash flows, is less, the present value of the firm's future cash flows will be greater amount. Companies find the optimal point at which the marginal cost of debt equals the marginal benefit.

The capital structures of the companies are measured by the debt-to-equity ratio. If the debt equity ratio is favourable, there will be enough equity to mitigate the risk of debt obligations. That means there will be a limit to the amount of debt to be used by the company.

In a business with variable cash flows, the optimal capital structure contains less amount of debt and a large amount of equity. And in a business with consistent cash flows, the optimal capital structure contains a much higher percentage of debt.