Question

In: Finance

First on the president’s list is an evaluation of where the firm is at the present....

First on the president’s list is an evaluation of where the firm is at the present. He has provided you with all the information you need to find the answers he wants. For starters, the capital structure for the past year of operations is:

Mortgage bonds (Debt) $2,000

Debentures (Debt) 1,500

Retained earnings (Equity) 500

What is the current financial mix (this was in the Cost of Capital video lecture)?

Answer:

The president informed you that DWOTT has chosen to raise capital by issuing stocks and bonds in the ratio of 6.5:3.5.

What does that mean for your company (in other words, their target is no more than 35% debt…how does that relate to where they currently are? Can they afford to take on more debt)?

Expert Solution

Q. 1). Solution :- Current financial mix (of debt and equity):-

Value of debt = Amount of bonds + Amount of debentures.

= 2000 + 1500

= $ 3500.

Value of equity = $ 500. (Retained earnings)

Weight of debt = Value of debt / (Value of debt + Value of equity)

= 3500 / (3500 + 500)

= 3500 / 4000

= 0.875

Weight of equity = Value of equity / (Value of debt + Value of equity)

= 500 / (3500 + 500)

= 500 / 4000

= 0.125

Current financial mix = Debt : Equity

= 0.875 : 0.125 (i.e., 87.5 % capital raised by issuing bonds / debentures and remaining 12.5 % capital raised by issuing stocks).

Conclusion :- Current financial mix of debt and equity = 0.875 : 0.125 (87.50 % in debt and 12.50 % in equity).

Q. 2). Answer:- If company choosing to raise capital up to maximum 35 % only by issuing bonds / debentures (i.e., debt) then it may be due to cost of debt is higher than the cost of equity and accordingly, company is choosing an ideal combination of debt and equity that may attain the marginal goal i.e., maximizing of market value will be maximized or the cost of capital (weighted average cost of capital) will be minimized when the real cost of each source of funds is the same. It is formidable task of the finance manager to determine the combination of various sources of finance (debt / equity).

The company can afford to have more debt amount in its capital structure provided that the cost of debt does not exceed than the cost of equity, in other words, Capital structure should combine various sources of finance into an optimum capital mix, involving the least average cost of capital and in this way helping in maximizing of returns for company in long-run.

jeff jeffy answered 2 years ago

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