Question

1. What is the optimal D/V ratio that minimizes the WACC with and without financial distress costs?
2. Explain why the cost of debt and the cost of equity increase as debt is added to the capital structure?
3. Explain why our method of increasing the cost of debt is unrealistic and what could you do instead?

Answer 1

1.What is the optimal D/V ratio that minimizes the WACC with and without financial distress costs?

The optimal debt value ratio or capital structure is estimated by calculating the mix of debt and equity that minimizes the WACC while maximizing its market value .The lower the cost of capital, the greater the present value of the firm future cash flow. The objectives of every firm is to value maximization of the equity shareholder .Every company will have its own optimal capital structure mix to maximize the value of the firm which will vary depends on the economic ,social and political situation of the world . The optimal debt-to-equity (D/E) ratio will tend to vary widely by industry, but the general consensus is that it should not be above a level of 2.0. While some very large companies in fixed asset-heavy industries (such as mining or manufacturing) may have ratios higher than 2, these are the exception rather than the rule. The debt-to-equity ratio is associated with risk: a higher ratio suggests higher risk and that the company is financing its growth with debt.

2 .Explain why the cost of debt and the cost of equity increase as debt is added to the capital structure?

The interest on debt capital is always fixed ,the dividend on equity capital will vary depends on the company financial condition and use of optimal capital structure to increase the value of the firm .The cost of equity is typically higher than the cost of debt .So increase in equity financing usually increases WACC. If a firm raises funds through debt financing, there is a positive item in the financing section of the cash flow statement as well as an increase in liabilities on the balance sheet. Debt financing includes principal, which must be repaid to lenders or bondholders, and interest. While debt does not dilute ownership, interest payments on debt reduce net income and cash flow. This reduction in net income also represents a tax benefit through the lower taxable income. Increasing debt causes leverage ratios such as debt-to-equity and debt-to-total capital to rise. Debt financing often comes with covenants, meaning that a firm must meet certain interest coverage and debt-level requirements. In the event of a company's liquidation, debt holders are senior to equity holders.

3.Explain why our method of increasing the cost of debt is unrealistic and what could you do instead?

Before commit to the debt financing in your business you should know the cost of debt. In other words, you should know what the debt you’ll be taking on will help your business accomplish. Whether you want to launch a new product, open another storefront, or hire a new employee, the loan has to help your business grow and increase your company’s profits. Otherwise, the loan simply isn’t worth the cost. Of course, you’ll need to think about many other things, too the interest rate, the frequency and size of payments, the length of time to repay the lender, and how quickly you’ll get the funds but understanding cost of debt will help you know whether to pull the trigger.

The best way of raising fund for the business is issue of share while comparing with debt to reduces the risk of the above factor