Question

6. Please describe how changes in capital structure affect the value of the firm in a world with taxes and including the possible costs of financial distress. Is there an optimal capital structure for a firm? Please discuss. Electric utilities have an average 60% debt/total capitalization ratio whereas software firms have debt ratios close to zero. Why? Please explain the dividend policy that you would advise for a tech company to adopt that has very high business risk. How do you financially evaluate an acquisition?

Answer 1

a) Capital Structure refers to the combination of debt and equity funds applied in the firm. There are various theories on capital structure which are classified into two schools of thought: Traditional and Modern. While the traditional school of thought believes that there is no impact of the cost of debt on financial leverage, the modern school of thought substantiates the impact of cost of debt on the financial leverage of a company.

The proposition of changes in capital structure impacting the value of the firm in a world with taxes (and cost of financial distress) can be explained through the Modigliani and Miller Approach (with taxes). The model assumes that interest expense is tax deductible. Therefore, the value of a levered firm (with debt), is higher than the value of an unlevered firm. This theory is also called the Trade-off theory of Leverage.

WACC = ke ×	E	+ kd × (1 - t) ×	D
	V		V

The actual cost of debt is less than the nominal cost of debt due to the tax benefit accrued. Therefore,

if,

Net Income = $100

Tax Rate = 10%

Interest Payment (on debt) = $20

Debt to Equity Ratio = 2

Cost of Equity = 5%

In case the firm receives tax benefit,

the cost of debt = $20* (1- 10%)

   = $18

Therefore, weighted average cost of capital (WACC) = (1/3)*5% + (2/3)*18

= 13.67 %

If tax benefit is not incorporated for WACC = (1/3)*5% + (2/3)*20

= 15 %

Therefore, cost of capital is lower in a firm receiving tax benefit.

b) There exists an optimal capital structure in a business environment with taxes (benefit). The optimal capital structure employs debt till the time;

Tax Benefit from debt <= Financial Distress costs

Herein, the tax benefit the financial distress costs refer to the cost of bankruptcy, that is the risk associated with a firm unable to meet its financial obligations.

c) The electric utility companies require high amount of capital since they have high dynamic infrastructure requirements, which requires continuous investment. Since, these companies are mostly public undertakings, their profit levels are low (may even be sick units), and the public is hesitant to invest in low-profitability firms. Moreover, software companies are heavily invested in due to high growth potential, and require lesser amount of debt funding. Therefore, the debt to total capitalisation ratio is higher in Electric Utility companies than in Software Companies.

d) The dividend policy of a company is affected by many factors such as profitability, trade cycles, industry practices, government regulations, nature of business, liquidity of funds and distribution of shareholdings, etc.. For a tech company with a high associated business risk, the dividend policy would depend mainly on the profitability of the company, future fund requirement and industry practices.