Question

Assumptions: An analysis of how the assumptions made in designing the approach to the calculations impacted your results.  Some possible things to consider that may or may not have had an impact on your results (identify which ones you think are more and less important and explain your reasoning)

1. The process for the cost of debt assumes the times interest earned is a good proxy for measuring credit risk, what other financial variable if any should be considered? Does this assumption limit the results? (each time the level of debt changes. Will this actually occur and does this limit the applicability of your results.

2. The base level of interest rates, the risk free rate, changes over time. Is this important in calculating the optimal level. Since the estimate is based on the current environment does it matter if this changes.

3. The beta may change over time, does keeping it constant limit your results or is that an acceptable assumption.

4. The credit spreads can change as the broad economy changes. The spread used represent estimates of the current spreads, is this the best approach or would an average spread for each credit risk level be more appropriate.

Answer 1

· Times interest earned is a measure of firm’s ability to repay the debt and there are many other factors that can affect the credit risk and cost of debt. Some factors are debt to equity ratio, profit margin, market share, general creditworthiness of the company in the market. If the debt to equity ratio is high, that means the debt is already high and more debt means more credit risk. Higher profit margin means the company has good market hold and if price increase then it can pass the cost to the customer and still earn good profit on its investment and the risk of debt default would be low. Again, if the company has large market share in the industry then its ability to consistently generate revenue is high and risk is low. General creditworthiness is how the company is perceived from the debtor’s perspective. Again, these variables are not constant and they can change can differ from industry to industry or even from company to company. And we have to consider all these factors each time the level of debt changes.

· Yes, the risk-free rates are important while calculation of optimal level of capital structure as the risk-free rate is used as a rate over which other risk premiums are added to calculate the cost of different sources of funds. If these rates change then you cost will also increase. If we keep the beta of the company constant then the output will not be reliable as the level of debt in the company increases the beta will increase and so will the cost of equity will increase. So, if we are keeping the beta constant then it will either underestimate the cost or overestimate the cost.

· It is true that as economy goes from one phase to another phase of the economy the credit spread changes and it widens when the economy is experiencing difficulty and narrows down when the economy is booming. Using an average spread for each level might not be appropriate if you have the estimated credit spread available, if that is not available and not reliable then the average spread should be used.