Question

Problem 2 - Capital Structure Mix

(Show real insight to the answer)

Moody Blues Inc. is considering an expansion of Manufacturing Capacity. This expansion is the first for the company and will slightly more than double plant capacity. The reason for the expansion is that Moody Blues believes that it can sell it’s product line on a national basis instead of the smaller regional basis that it has been selling to for 5 years. The firm’s sales last year were $5,000,000 (with expansion this is forecasted to grow to $9,000,000) with an Earnings Before Interest and Taxes (EBIT) ratio of 10% and a Net Income to Sales ratio of 5%. The tax rate for the firm is 30%. The new financing will total $3,000,000 (total assets prior to expansion equal $5,000,000) and will primarily be used to acquire new specialized manufacturing equipment. Effectively discuss primary factors that the firm should consider when choosing a capital structure mix that includes debt, preferred stock, and common stock. Be sure to identify the pros and cons of each of your suggested choices.     Given what you know about the firm, be as specific as you can related to the appropriateness of each of the elements to Moody Blues project financing. I do not want a generalized discussion of general points. Show that you have true reflective insight on the issues that should be considered. No specific calculations are involved but the values presented should influence your comments. The answer to this problem is much more than a couple of sentences.

Answer 1

The primary factors that should be considered while adding debt to capital structure with how much of debt how much additional value is created and at what level of debt the tax benefit of debt in the capital structure is overweight by the financial distress cost associated with that. The firm last year sales were $5 Million and after expansion it is expected to go to $9 Million, the things here to consider is the change total value of the firm or with addition of debt how much value is created for the shareholders. The cost of equity is higher than the cost of preferred stock and debt, the cost of preferred stock is higher than the cost of debt so by adding debt and preferred stock to the capital structure the WACC of the firm should be reduced, at the same time the value from the project for the firm should be increased. The capital structure ratio should be such that the WACC is least as well as financial distress cots is low and benefits is high. The disadvantage of having debt and preferred stock in the capital structure is that you have to make payment. The company can skip the dividend payment to equity holders as long as it wants but it can not skip its obligation on the debt payment. Similarly, the dividend on preferred stock has to be paid, if not in this year then they might be cumulative.