Question

XYZ plans to re-structure its capital due to the demand of some shareholders who would with draw their shares from company’s equities. To maintain a level of total assets, the company should either increase long-term debts or issue common shares to other shareholders (could be through private placement or initial public offering).Explain how does XYZ re-structure its capital ( Using 2 theories of capital structure)

Answer 1

Capital structure refers to the mix of debt and equity to finance the company. XYZ can use either of the theories to strike a balance between increasing long-term debts and issuing new shares.

Traditional theory approach of capital structure

In this theory, it is believed that optimal use of debt will increase the value of the firm and will ultimately reduce the cost of capital. The optimal point here is when the value of the firm is the highest, while at the same time, the cost of capital is at the lowest. Here, we have to maintain a level of total assets, hence the cost of capital must be at its lowest. The rationale behind this is that any leverage above the optimal debt-equity mix will decrease the market value and increase the cost of capital.

In the case of XYZ, it must raise its capital through debt up to a point where the cost of capital decreases due to adding more debt. The cost of equity too is more and less constant until this optimal point and will increase sharply if more debt or leverage is added beyond the optimal point. The leverage here is given by Debt/Equity in the capital structure of XYZ.

Miller-Modigliani theory

This theory advocates that the valuation of a firm should be based on the Net operating income of the company, XYZ in this case. According to this theory, leverage would not have an effect on the cost of capital of XYZ. This is because the advantage of low-cost debt is eliminated by the increase in equity. This theory advocates that firm's operating income as a major determinant of the firm's value.

Hence, XYZ's operating income is critical in accessing the capital structure. Also, corporate taxes are an important consideration as this theory believes that the cost of capital will decrease with the increased use of debt in financial due to the tax shield ie interest paid on the debt is tax-deductible. Hence, in XYZ's case, the company must access the tax structure the firm is in and compares the benefits and down-side of increasing debt in the capital structure v/s raising a public/private issue due to the corporate tax structure.