Question

A firm’s capital structure and its overall cost of capital are affected by firm-specific factors as well as market, regulatory, and macro-economic conditions. You are asked to discuss the individual impact of five different scenarios (assuming everything else remains constant) on a firm’s capital structure and its overall cost of capital. Please be specific and provide the theoretical rationale in support of your responses. You can use the space provided in the matrix below or use a separate sheet to answer the questions. Expected changes in the firm, capital markets, and regulation

a)Variance of cash flows is expected to increase.

b)The new U.S. tax policy is expected to reduce the corporate tax rate.

c)Investment in facilities and other tangible assets are expected to increase.

d)New international acquisitions are expected to reduce the firm’s exposure to currency risk.

e)Securities and Exchange Commission (SEC) is expected to question the firm for possible misrepresentation of its annual reports.

Answer 1

(a) If variance of cash flows is going to increase, then it means the company is going through a volatile phase. As volatility increase, both costs of equity & cost of debt will increase, as both investors and debt holders will ask for higher risk premium due to higher volatility. Hence WACC will increase. Since cost of debt will increase as lenders will not be willing to lend aggressively, then the capital structure will have a higher equity component.

(b) If the corporate tax rate decreases, then the cost of debt becomes more expensive as debt is tax-deductible. In such a case WACC will increase because of higher tax rate. Therefore company will go for higher equity component in its capital structure.

(c) If investments in fixed assets is going to increase, then FCFE (free cash flow for equity) of the firm will become volatile while FCFF (free cash flow for firm) will remain constant. In such a case, the cost of equity will increase. Therefore company will include higher component of debt in capital structure to keep WACC in control

(d) If firms exposure to currency risk is reduced, then lenders will be more confident in lending aggressively to the firm as market risk of the firm decreases. Hence cost of debt will come down & company can plan to increase its debt.

(e) If SEC is expected to question the company, then lenders will lose confidence in passing debt to the company. Hence company will have to infuse equity to keep the company afloat. Thus cost of equity & WACC both increase