Question

Explain what will happen to the firm's optimal capital structure as a result of the following changes;

a) An increase in the firm's marginal tax rate

b) an increase in the firm's investment opportunities

c) The founding owner retires from day-to-day management of the firm and hires a professional manager as his replacement

d) a decline in business risk as the industry matures

e) an increase in R&D intensity and marketing expenditures

Answer 1

Below will be the impact on the optimal Capital structure of a firm in each scenario:

a) An increase in the firm's marginal tax rate - In this case, the tax liability will increase. The firm may need to increase the capital in the firm if the cashflow from operating or investing activites are expected to remain at the same level. The capital may be taken either in the form of equity or debt depending upon the cost of capital for equity and debt. If the debt interest rate (after tax) is lower than the expected return on investment for equity, additional capital should be taken in the form of debt, else additional should be taken in the form of equity. The acceptable level of financial leverage ratio should also be considered while deciding on the source of capital.

b) an increase in the firm's investment opportunities : In this case, the firm will need more capital for investing purpose. The capital may be taken either in the form of equity or debt depending upon the cost of capital for equity and debt. If the debt interest rate (after tax) is lower than the expected return on investment for equity, additional capital should be taken in the form of debt, else additional should be taken in the form of equity. The acceptable level of financial leverage ratio should also be considered while deciding on the source of capital.

c) The founding owner retires from day-to-day management of the firm and hires a professional manager as his replacement - Assuming that the founder owner does not withdraws his capital from the firm and only day to day management of the firm is handed over to a professional manager, it may not lead to immediate change in the capital requirements of the firm. The operating efficiency is expected to increase which will increase the profitability of the company. The equity portion in this case may increase in the overall optimal capital of the firm.

d) a decline in business risk as the industry matures - In this scenario, since the business risk has been redeuced, the expected ROI of the equity would also become lower and more cost effective. If additional equity is available at a lower cost of capital as compared to debt interest rate (after tax), the debt portion of the opitmal capital structure should be reduced and equity portion should be increased for achieving the optimal capital structure.  The acceptable level of financial leverage ratio should also be considered while deciding on the source of capital.

e) an increase in R&D intensity and marketing expenditures - In this scenario, additional capital is required. Depending upon other market factors, additional required capital may be taken either in the form of debt if the after tax interest cost is lower than the expected return on equity or in the form of equity if the rate of equity is lower than the interest rate for debt (after tax). The acceptable level of financial levarage ratio should also be considered while deciding on the source of capital.