Question

In: Finance

3. A. Explain what is meant by the capital structure of an industrial firm (such as...

3.

A. Explain what is meant by the capital structure of an industrial firm (such as a manufacturing company). Be precise.

B. List components of the capital structure that you have defined above.

C. Are the items you have listed in part B above long term in nature (more than one year?)

D. Explain (in as much detail that you wish, including numerical analysis and graphs) the net income view or the traditional approach in regards to the relationship between the WACC and the value of the firm.

E. Explain (in 5 lines) why you would agree with the net income approach as listed in part D above.

F. Explain (in as much detail that you wish including numerical analysis and graphs) the operating income view or the neo-classical approach in regards to the relationship between the WACC and the value of the firm.

G. Explain (in 5 lines) why you would agree with the operating income or the neo-classical approach as listed in part D above.

Solutions

Expert Solution

A) Capital Structure refers to the amount of debt and/or equity employed by a firm to fund its operations and finance its assets. The structure is typically expressed as a debt-to-equity or debt-to-capital ratio.

Debt and equity capital are used to fund a business’ operations, capital expenditures, acquisitions, and other investments. There are tradeoffs firms have to make when they decide whether to raise debt or equity and managers will balance the two try and find the optimal capital structure.

B)Capital is the aggregation of the items appearing on the left hand side of the balance sheet minus current liabilities( Debt & Equity, Assets)

C) Yes The items considered in Capital structure are Long term

D)The relationship between the WACC and the value of the firm is, if the WACC is minimized then the firm value will be maximized. The weighted average cost of capital is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm.

E)Net Operating Income Approach:

The essence of this approach is that the capital structure decision of the firm is irrelevant. Any change in leverage will not lead to any change in the total value of the firm and the market price of shares, as the overall cost of capital is independent of the degree of the leverage.

The Net Operating Income Approach is based on the following propositions: 1. Overall cost of capital is constant: The overall cost of capital remains constant for all degrees of leverage. The value of the firm, given the level of EBIT is determined by V = EBIT/ko. 2. Residual value of equity: The value of equity is residual which is determined by deducting the total value of debt from the total value of the firm. 3. Changes in cost of equity capital: The cost of equity increases with the degree of leverage. With the increase in the proportion of debt the financial risk of the shareholders will increase. To compensate for the increased risk, the shareholders would expect a higher rate or return. 4. Cost of debt: The cost of debt has two parts: explicit and implicit cost. The explicit cost is represented by the rate of interest. Irrespective of the degree of leverage the firm is assumed to be able to borrow at a given rate of interest. This implies that the increasing proportion of debt in the financial structure does not affect the financial risk of the lenders and they do not penalize the firm by charging higher interest. Increase in the degree of leverage causes an increase in the cost of equity. This increase in cost of equity being attributable to the increase in debt is implicit part of cost of debt. Thus the advantage associated with the use of debt supposed to be a cheaper source of funds in terms of the explicit cost is exactly neutralized by the implicit cost represented by the increase in cost of equity. As a result the real cost of debt and the real cost of equity according to Net Operating Income are the same and equal to overall cost.

Traditional Approach:

The Traditional Approach or the Intermediate Approach is a mid-way approach between the Net Income and Net Operating Income approach. It partly contains features of both the approaches

The traditional approach accepts that the capital structure of the firm affects the cost of capital and its valuation. However, it does not subscribe to the Net Income approach that the value of the firm will necessarily increase with all degrees of leverages. It subscribes to the Net Operating Income approach that beyond a certain degree of leverage, the overall cost of capital increases resulting in decrease in the total value of the firm. However, it differs from Net Operating Income approach in the sense that the overall cost of capital will not remain constant for all the degree of leverages. The essence of the traditional approach lies in the fact that a firm through judicious use of debt-equity mix can increase its total value and thereby reduce its overall cost of capital. According to this approach, up to a point, the content of debt in the capital structure will favourably affect the value of the firm. However, beyond that point, the use of debt will adversely affect the value of the firm. At this level of debt-equity mix the capital structure will be optimum


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