Question

a. Suppose a firm wants to expand and will need to take on considerable debt to increase its operations. The firm is very concerned about the effect of financial distress costs on the value of the stock. Discuss options the firm can use to reduce these costs and their impact on the firm's value.

b. 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.

Answer 1

a) Considerable debt is perceived to be negative for equity shareholders. This is because higher debt is associated is higher risk, as the financing and interest costs of a firm go up. This, in turn, might impact the profitability of a company, thus impacting the stock price. The usage of the additional debt decides how the market would perceive the value of the firm. If the firm uses the debt to finance its operational activities it is perceived negative for the firm, as this signifies that the firm is not able to generate enough margins for the business to sustain smoothly. On the other hand, if the debt raised to expand the operations, investors in the stock perceive that the firm value would go up owing to the expansion plans, which may, in turn, lead to higher revenue and profits in the future. Hence, the debt must be used to expand the operations and the same should be communicated on a regular basis to the investors. Also, the debt to service coverage ratio (DSCR) must be sound enough to easily finance the interest costs associated with higher debt. Hence, maintaining the DSCR is critical. The costs can also be reduced by disinvesting in assets which are loss-making or less profitable. This improves the overall efficiency of the firm, which is seen positively by the equity investors.

b) The target capital structure for the firm is based on various factors and the same should be analyzed to determine the target debt-equity ratio.

Firm's financials - A firm's financial position and cash-flows generating capacity play an important role in determining the amount of debt. The same would be examined before suggesting a target debt-equity ratio. If the firm has higher operating cash-flows and has low earnings and revenue volatility, the firm can easily service its debt. Moreover, the firm can keep its Debt to service ratio under acceptable levels and vice-versa.

Industry sector - The sector in which the firm operates influences the amount of debt. Sectors that are less capital intensive and higher-cashflows may find it easier to get debt at a cheaper cost. Since equity is perceived to be expensive than debt, if the cost of debt is low, the firm can reduce its cost of capital. Also, sectors that are capital intensive and faces earnings volatility may find it difficult to arrange debt and may get debt at a higher cost.

Management outlook and strategy - This is a firm-specific factor and related to the type of management the firm has. If a firm has aggressive management, it may consider taking on higher debt, since raising capital through equity is perceived to be expensive. On the other hand, if the management is cautious and is highly risk-averse, they may consider lower debt or lower leverage.

Market outlook - Market outlook related to the interest rate regime and the overall market sentiment. If the firm needs immediate capital for expansion, and the market sentiment is very poor, a firm may not be able to raise enough equity. In such a case, a firm may consider raising capital through debt to meet its requirement. Also, if the market interest rates are low, debt may appear cheaper for a firm and the firm may be taken on additional debt to gain an advantage of the low-interest rate regime. As against, if the market interest rates are too high, a firm may abstain from taking higher debt due to the higher cost associated.

Accordingly, the target debt-equity ratio will be suggested.