Question

The large, consistently profitable firm you work for is considering a small project. Your firm is financed by 60% equity and 40% debt. Its cost of equity is 10%. Its cost of debt is 5%. The risk free rate is 5%. Corporate taxes are 40%. The expected rate of return on the market is 11%. Assume CAPM is correct and the project is just as risky as your firm. Recall equation 18-5:

BETA(unlevered firm) = (Equity / ((Equity) + (1 - tax rate)*(DEBT))) * BETA(levered firm)

The project will cost $1000 at time 0, and is expected to produce $1250 at time 1, and no other cashflows. The firm is considering $600 debt at 6% and $400 equity to finance it.

d) Why might it matter that the firm is large and consistently profitable?

Answer 1

A company has a responsibility to protect and maximize its shareholders wealth. In order to achieve this objective, the company needs to make appropriate capital structure and investment decisions. The company should ensure that it has sufficient funds all the time to pay for its interest expenses (on the debt capital) and provide appropriate returns to shareholders (either in the form of dividends or capital appreciation). A large company with consistent profits will be able to achieve both of these objectives without facing any financial crunch. It will be in a better position to allocate its funds (excess capital) to new projects and borrow money from outside sources as and when required which in turn is likely to improve investor confidence in the company's management and its decision making processes.

Consistent profits are also essential to ensure that the company has sufficient capital to repay its debt obligation (s) as and when they become due. Large companies with constant profits are better able to manage its loan repayments and invest in new projects at the same time. Such companies may also be able undertake riskier projects which can provide substantial returns and improve shareholders wealth within a short period of time.