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

The value of a firm depends on its ability to earn the profits. To maximize the profits, a firm tries to minimize its cost of capital. The capital structure of a firm has 2 components : debt and equity. Cost of debt is usually less than then cost of equity as debt provides a leverage effect to the firm in the form of interest tax-shield. However, there is a certain level of debt beyond which the tax-shield becomes less than the interest payments. Therefore, firms try to have an optimal capital structure with optimum levels of debt and equity.

The trade-off theory of capital structure says that a company should increase debt until the value from tax-shield is just off-set by increases in costs of financial distress.The company tries to minimize its cost of capital. The formula to calculate the cost of capital is :

Weighted average cost of capital (WACC) = K_d * (1-T) * (D/V) + K_e * (E/V)

K_d = cost of debt i.e. interest rate, T= tax rate , D= Debt, E=equity , V = D+E , K_e = Cost of equity capital

WACC formula is used to arrive at an optimum capital structure for the firm.

Electric utilities needs to invest heavily in capital assets which provides returns over long periods of time. Therefore, Electric utilities take on heavy debt to invest in capital assets. Software firms on the other hand does not invest in high cost capital assets and hence, their debt levels are very low.

A tech company with high business risk is essentially a growth stock and will provide returns to its investors in future. Hence, it should follow a policy of no dividends for initial few years or until the time it becomes stable in its earnings. Thereafter, it can provide consistent dividends to its stock holders.

An acquisition target is evaluated essentially with its ability generate free cash flows in future.