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.


Related Solutions

(10) This is a world with NO TAXES (perfect capital markets). The firm is a no...
(10) This is a world with NO TAXES (perfect capital markets). The firm is a no growth firm and pays out all of its earnings as dividends. It is originally all equity financed (unlevered). The firm decides to issue $500,000 in debt to repurchase stock. The cost of debt is 4%. Fill in ALL the missing values in the table. Unlevered Levered EBIT 200,000 200,000 INTEREST Earnings (Net Income) #Shares 20,000 Ru 8% 8% RE EPS Price Value of the...
Please describe how changes in capital structure affect the value of the firm in a world...
Please describe how changes in capital structure affect the value of the firm in a world with taxes and including the possible costs of financial distress. Is there an optimal capital structure for a firm? Please discuss. Electric utilities have an average 60% debt/total capitalization ratio whereas software firms have debt ratios close to zero. Why? Please explain the dividend policy that you would advise for a tech company to adopt that has very high business risk. How do you...
Please describe how changes in capital structure affect the value of the firm in a world...
Please describe how changes in capital structure affect the value of the firm in a world with taxes and including the possible costs of financial distress. Is there an optimal capital structure for a firm? Please discuss. Electric utilities have an average 60% debt/total capitalization ratio whereas software firms have debt ratios close to zero. Why? Please explain the dividend policy that you would advise for a tech company to adopt that has very high business risk. How do you...
‏6. What does it mean to say that: “A firm operating under perfect competition conditions is...
‏6. What does it mean to say that: “A firm operating under perfect competition conditions is a price taker"? ‏Why Can't this firm set any price it chooses? What if it operates in a monopolistically competitive market, would it be able to set the price? Why? Give some real life examples to support your answe
Debt-free, Inc., an unlevered firm, is planning to use debt in its capital structure. The firm...
Debt-free, Inc., an unlevered firm, is planning to use debt in its capital structure. The firm currently has 5,000 shares outstanding trading at $60 per share. The firm plans to sell 150 6% annual-coupon, 10-year bonds at their face values of $1,000 each and use the proceeds to repurchase some of its shares. When the bonds mature, Debt-free, Inc. plans to reissue new bonds to pay off the principal and to “roll over” its debt this way indefinitely. Assume the...
Under the M&M world with perfect capital markets, the cost of equity is independent of its...
Under the M&M world with perfect capital markets, the cost of equity is independent of its capital structure. True False Under the M&M world with perfect capital markets, a firm’s value should rise with increased leverage because debt is cheaper than equity. True False Under the M&M world with perfect capital markets, a firm’s average cost of capital (i.e. pre-tax WACC) falls for increases in debt as long as the firm avoids truly excessive leverage. True False
[Q1-5] The debt-to-equity ratio of your firm is currently 1/2. Under this capital structure, the cost...
[Q1-5] The debt-to-equity ratio of your firm is currently 1/2. Under this capital structure, the cost of equity is 12%. You are planning to change your firm’s capital structure so that the new debt-to-equity ratio becomes 2. The change in the debt-to-equity ratio is expected to be permanent. Assume that regardless of the firm’s capital structure, the cost of debt is 6% and the corporate tax rate is 40%. What is the WACC under the current capital structure? A. 10%...
Question 1: [Q1-5] The debt-to-equity ratio of your firm is currently 1/2. Under this capital structure,...
Question 1: [Q1-5] The debt-to-equity ratio of your firm is currently 1/2. Under this capital structure, the cost of equity is 12%. You are planning to change your firm’s capital structure so that the new debt-to-equity ratio becomes 2. The change in the debt-to-equity ratio is expected to be permanent. Assume that regardless of the firm’s capital structure, the cost of debt is 6% and the corporate tax rate is 40%. What is the WACC under the current capital structure?...
True/False: In the context of perfect capital markets, suppose a firm increases the proportion of debt...
True/False: In the context of perfect capital markets, suppose a firm increases the proportion of debt in its capital structure, but leaves all other aspects of its business unchanged. Taken together, the Modigliani-Miller Propositions tell us that the firm’s increased reliance on the relatively cheap debt financing is perfectly offset by a rise in the required return paid to shareholders (as well as a potential rise in the required return paid to debt holders), such that the value of the...
Using debt and preferred stock in the capital structure of a firm will _____. decrease business...
Using debt and preferred stock in the capital structure of a firm will _____. decrease business risk increase the book value of common stock increase the tax payable by the firm. increase financial risk decrease operating leverage
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT