Question

Question 1
It has been suggested that in a world with only corporate taxation the value of the firm = the
value of all equity financed + the present value of tax shield on debt finance
a. If the above equation applied, what would be the most appropriate capital structure for
the company?
How far do existing capital structures of companies compare with the most appropriate
structure according to the equation?
b. Discuss how and why the existence of personal taxation might alter the choice of capital
structure suggested in part (a) above.
c. If a finance manager agrees with the implications for the choice of capital structure that
you have suggested in part (b) above, what problems might arise in applying them within
his company?
d. (i) Give examples of possible costs associated with a high level of gearing.
(ii) Discuss how such costs might influence the capital structure of the following.
(1) A medium sized electronic company entering the home computer market and
(2) An established company owning and managing a chain of hotels (5 mark)

(TOTAL MARKS 30)

Answer 1

1. The most appropriate caoital structure for a company is an optimum mix betwen debt and equity.

The companies ususally employ more debt due to advantages such as allowance of expense deduction in income tax and tax sheild on interest paid. However, it is important to find an optimum mix between debt and equity to avoid debt leveraging

2. Increase in debt, provide tax sheild to the company due to the deductible interest expense. However, in the other hand, dividend paid t equity SH is not tax deductible, Hence, more debt= Higher tax saving

3. problems due to increase in debt-

a. Debt leveraging

b. Preferntial creditors in the event of winding up

c. Reduction of control of Shareholders

4.Possible costs associated with high level of gathering are-

A low gearing ratio may not necessarily mean that the business’ capital structure is healthy. Capital intensive firms and firms that are highly cyclical may not be able to finance their operations from shareholder equity only. At some point, they will need to obtain financing from other sources in order to continue operations. Without debt financing, the business may be unable to fund most of its operations and pay internal costs.

A business that does not use debt capital misses out on cheaper forms of capital, increased profits, and more investor interest. For example, companies in the agricultural industry are affected by seasonal demands for their products. They, therefore, often need to borrow funds on at least a short-term basis.

A high gearing ratio shows a high proportion of debt to equity, while a low gearing ratio shows the opposite. Capital that comes from creditors is riskier than the money that comes from the company's owners since creditors still have to be paid back regardless of whether the business is generating income. Both lenders and investors scrutinize a company's gearing ratios because they reflect the levels of risk involved with the company. A company with too much debt might be at risk of default or bankruptcy especially if the loans have variable interest rates and there's a sudden jump in rates.

Changes in case of two diffrent scenarios-

First, a medium sized electronic company entering the home computer market-

Incerease in levearge would prove financial beneficial to a new entract as it enables companies to incur tax dedutible expense and also an established means of funds. However, excess of gearing can be risky and hence it would be ideal to go for an optimum risk capital structure.

Seciond, an established company owning and managing a chain of hotels -

It would be easier and beneficial for an established company to raise funds throuh equity as it helps in cutting financial risk. Alaso, since dividend payment is discretionary to Companies, it does not poses a fixed burden. However, sice dividend is not tax deductible, it does not provide tax benefit.