Question

1. Firm Value

Discuss any ways that you think a change in the capital structure of a firm can affect the stock price.

2. Tax Benefit of Leverage

Discuss how the tax code favors debt financing over equity.

Answer 1

1. Discuss any ways that you think a change in the capital structure of a firm can affect the stock price.

Stock price of a firm is inversely proportional to the cost of capital. By altering the capital structure of the firm we can either increase or decrease the firm's cost of capital. Equity financing or cost of equity is usually higher than cost of debt. Therefore, if we increase the equity component in the capital structure, the cost of capital would increase resulting in price decrease. However, if we increase the debt component of the capital structure, cost if capital would decrease leading to increase in stock prices. At the same time, there should be an optimal mix of debt and equity in the capital structure. Over leveraging can lead to worsening of credit metrics and reduce the stock price.

Thus, altering the component of equity or debt in the capital will result in change in stock price.

2. Interest to be paid on debt financing is tax deductible and hence tax lowers the effective cost of debt. This is because, interest in the income statement results in lower taxable income and therefore boost net income of the firm. This is known as the interest tax shield and is one of the reasons firms prefer to have some debt in the capital structure. Whereas, dividends paid to equity shareholders is not tax deductible and has no benefit to the cost of capital.