Question

1. Explain why the following statement is true: "All else the same, firms with relatively stable sales are able to carry relatively high debt/asset ratios."

and the explain how a firm might shift its capital structure so as to change its weighted average cost of capital (WACC). What would be the impact on the value of the firm?

Answer 1

"All else the same, firms with relatively stable sales are able to carry relatively high debt/asset ratios."

As the name itself indicates, the Debt/Asset Ratio is an indicator of financial leverage. It indicates that portion of an entity's assets financed by the creditors. In other words,

Debt/Asset Ratio =Total Liabilities / Total Assets.

Liabilities here include all the outside liabilities

An entity that has a stable level of sales can forecast and plan its future strategies in an efficient manner. This is because they have an idea about the cash flows and profits and receivables. This way the inflows and outflows can be easily determined. Since the sales are stable, the risk of default is very low which in turn means they may be able to access and service a higher amount of debt comparatively. This is a huge advantage over entities with an unstable income, as even the creditors are unwilling to take upon themselves, risk beyond a certain limit.  

Impact on the value of the firm when it shifts its capital structure so as to change its weighted average cost of capital.

Every entity is unique in some way or the other. So each entity decides on its funding options depending on its needs. Any changes made in the funding or the capital structure can affect its Profits, WACC, risk profile etc.WACC usually consists of the cost of debt and cost of equity.  

Cost of equity:

Equity is raised by selling new shares of stock. Even though a new issue may not change the profits in the company it may result in dilution. Equity does not create any obligation on the profits of the entity, unlike debt. Increase in equity may increase the WACC.

Cost of debt :

Raising debt results an increase in the liability and creates a fixed obligation that has to be fulfilled whether or not the entity makes any profit. Increasing the debt may increase the risk of default. On the other hand, it also results in tax savings. Usually, the cost of debt is lower than the cost of equity. So an increase in equity may increase the WACC.

So suiting to the entity's needs, it can choose the optimal mix of equity and debt to form its capital structure.