Question

Until recently, state law left the Vermont Alcohol and Tobacco Company (“VAT”) with a near-monopoly on sales of these items in Vermont. (Mail order is prohibited.) The legislation has just been repealed, and soon competing retailers will be opening up stores in Vermont. As the CFO, you are deciding whether this should affect VAT’s target leverage ratio (currently 50%). If you want to improve shareholder value, you should

Group of answer choices

A. Raise the ratio. The repeal means that your firm needs to become more competitive, and higher debt payments will force management to run a tighter operation.

B. Raise the ratio. Your inventories make good collateral, and using a debt issue to fund a share repurchase will give shareholders a much-needed boost in stock price.

C. Lower the ratio. The repeal opens up all sorts of growth opportunities for your company, and debt payments would interfere with your ability to pursue these.

D. Lower the ratio. More competition means lower margins, increasing the chance that your firm will miss interest payments and enter financial distress.

Answer 1

D. Lower the ratio. More competition means lower margins, increasing the chance that your firm will miss interest payments and enter financial distress.

Shareholder's value is dependent on the ability of the firm to generate cash-flows and the ability of the firm to be able to service its debt comfortably. As the proportion of debt in the capital structure increases, the risk-ness of the firm increases as higher debt is associated with higher financing and interest costs, which results in a subsequent decline in net profits. As the earnings decrease, shareholders return decreases.

As the debt the leverage increases, the chances of the firm being comfortably able to service its debt decreases as the debt to service ratio decreases. In short, the operating profits to interest costs decrease. All these factors increase the riskiness of the firm.

Hence, lowering the ratio will improve shareholder's value, as the competition means that now the firm will have to work on lower margins owing to high competition.