Question

Use appropriate theories of capital structure to offer reasoned explanations of why the following phenomenon are observed in reality: i. Utility and airline companies are likely to have high levels of debt; ii. High-technology companies are likely to rely on equity financing; iii. The most profitable companies, such as Google, Microsoft, have little debt.

Answer 1

the four approaches to capital structure theory are

net income approach states that debt financing decreases overall cost of capital and increases the value of firm

net operating income approach states that WACC is constant when there are no taxes

traditional approach states that there is one optimal capital structure which minimizes capital cost

modigliani millier approach it states that capital structure is irrelevant value of 2 identical firms are always same

1. utility and airline companies are likely to have high levels of debt

utility companies earnings are regular and stable, therefore it is easier for them to rely on debt financing as they have regular sales to payoff interest. because of their sound economic condition it is possible for them to rely on cheaper source of finance that is debt. they completely follow the theory of Net income approach which states that high financial leverage decreases the overall cost of capital and increases enterprise value

airline companies however are highly capital intensive companies and need regular source of finance which is easier to afford. their investments are in millions and to fund that investment they rely on debt financing

2. high technology companies rely on equity financing

high technology companies are not so capital intensive. they rely either on internal source of financing or equity financing as they do not want to bear the risk of debt financing. for them Net operating income approach holds true as they keep their cost of capital constant. they are even sometimes zero leveraged and least financial flexibility.

3. the most profitable companies like Microsoft and Google also have little debt as they have good reputation in equity stock market and they pay high dividends and reduce agency cost of free cash flow. they generate more cash flow to fulfill their financial needs. they somewhat follow the traditional approach of capital structure theory