Question

In: Finance

In a perfect world, if the firm value is $76 under the debt-laden capital structure (say...

In a perfect world, if the firm value is $76 under the debt-laden capital structure (say $70+$6), but the managers chose the $75 capital structure (say, all equity), what would you do?

Solutions

Expert Solution

Capital Structure is basically how a firm finances its overall operations and growth by using different source of funds. It is combination of both debt and equity in right balance, I say right balance not equally balance. It is the key of capital structure.

Debts can be comprised of:-

  • Bonds issued for long terms
  • Notes payable
  • long term bank loan
  • Short term debt as working capital loans

Equity can be comprised of:-

  • Common Stock
  • preferred stock
  • retailed earnings

Benefits for Issuing debt by the company:-

  • It allows company to retain its ownership
  • Interest payments are tax deductible
  • debt is abundant and easy to access
  • various tax advantages

Benefits for issuing equity by the company:-

  • Equity is more expensive than debt especially when interest rates are low
  • Equity need not to be paid back if earning declines.
  • Equity represents a claim on the future earnings of the company as part owners.
  • Ownership of the firm get diluted.

For the above case, I would suggest the firm to find a right balance of equity and debt for the capital structure. To be precise, I wold suggest 60% debt to reduce the tax burden of the company and to protect the ownership dilution. 40% equity for the capital structure is good enough.


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