Question

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

Answer:-

The changes in capital structure that affect the value of the firm with taxes can be explained by Modigliani and Merton Miller (MM) proposition.

This MM proposition with taxes can be arrived under the consideration that in most countries interest expense are a pretax expense and are therefore tax deductible whereas the dividends are paid on an after tax basis.The difference in tax treatment encourages the firms to use debt financing as the debt provides the tax shield that increases the value of the company.

The tax shield can be calculated by multiplying the marginal tax rate and the amount of debt in the capital structure.

The addition of debt in the capital structure makes a firm levered

The value of the levered firm is equal to the value of unlevered firm plus the tax shield.

V(L) = V(U) + (T x D)

V(L) = value of levered firm
V(U) = value of unlevered firm
T = marginal tax rate
D = value of debt in the capital structure

The optimal capital structure for the firm can be achieved by by increasing the debt to 100%, however the higher the leverage the higher the probability of financial distress.

The Weighted average cost of capital (WACC) is minimized with use of 100% debt. The tax shield provided by the debt causes the WACC to decline with the increase in the leverage of the firm, as the cost of debt is lower than the cost of equity. Therefore as the proportion of debt increases in the capital structure the WACC starts declining, and with 100% as the debt the WACC is minimized.

In general the IT companies does not have enough assets for collateral and is service based. In software firms there is less probability of incurring debt due the uncertainty over the future of a technology or an innovation. The electric utility companies have an debt / capital ratio of 60% because they need high investments to built their infrastructure to generate electricity and also are high regulated by governments in terms of charging the consumers which is most cases are subsidized.

The tech company which has very high business risk should adopt the residual dividend policy as the firms will have highly variable earnings and the earnings can be used for capital expenditures and the remaining earnings can be distributed as dividends. The stable dividend and constant dividend policy cannot be adopted for these companies because of fluctuating earnings.

The parameters used to financially evaluate an acquisition are the

1) Price paid for the target whether it is correctly priced or not.
2) The balance sheet of the target as it should be clean with low levels of debt and no legal issues involved such as patent and trademark issues.
3) The cash flows generated by the target company and the synergies involved in the acquisition.
4) The type of acquisition whether a stock purchase or by cash or a mix of both.