Suppose the company president asks you to determine the target capital structure for the firm and...

Suppose the company president asks you to determine the target capital structure for the firm and tells you that your compensation for next year will be related to the performance of the stock price over the next six months. Discuss what methods you will use to determine the target debt-equity ratio.

Expert Solution

Our financing decision will be to determine what combination of equity and debt will result in the lowest WACC. For determining the capital structure with the lowest WACC, we will take into account the following factors:

i) Debt is cheaper than equity after considering tax benefits

ii) Issuance of more debt to replace expensive equity with debt

iii) However, more debt also implies more interest payment so profits also reduce to that extent after which shareholders can get paid their dividends. Also, there is increase in the volatility of dividend payment to shareholders with higher debt levels resulting in higher financial risk to shareholders increases increasing the cost of equity leading to higher WACC

iv) So, we will have to determine optimal capital structure with the best mix of debt, preferred stock, and common stock to maximizes the market value and simultaneously minimize the cost of capital to company. The right blend of debt and equity will depend upon our line of business, what is the stage of development (nascent/mature) and external factors like changes in interest rates.

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