Question

You have been hired as Financial advisor by Texas Corporation and the first task that is assigned to you is to help the company determine its optimal capital structure.

a) What factors will help you in determining the optimal structure for Texas Corporation.

b) From the financial statements of the company you have discovered that company has a very high operating leverage. How is it effecting the firm's profitability?

c) The company is in a higher tax bracket defined by the Federal Government. What are its implications for the capital structure of Texas Corporation?

Answer 1

1.A. Factors which will help in determining optimal capital structure of the organisation will be the rate of interest which is prevalent in to the economy, the inflation rate which is prevalent into the economy, risk exposure of the company along with past trends of capital structure.

1.B. if there is a very high level of operating leverage for the company, that will mean that the company is having a very high level of operating cost which will be fixed cost in nature and fixed cost will continuously reducing the profits of the company, So, operating leverage should be kept as low as possible in order to maximize the profit of the company.

It can also mean that the company is trying to go for capital expansion and it is having a high nature of fixed cost.

1.C.if the company is having a very high rate tax structure, it will mean by the company will be opting for more of the debt capital into its overall capital structure because tax payable will be higher for the company and interest cost is tax deductible for the company, so there would be a higher amount of tax deduction and it will help in incorporation of a large amount of debt capital into total capital structure for the company