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Debt and Capital Structure

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Should a company be financed entirely with debt? Why or why not? How does debt impact the optimal capital structure?

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A firm's long-term success depends upon the firm's investments earning a sufficient rate of return. This sufficient or minimum rate of return necessary for a firm to succeed is called the cost of capital. The cost of capital can also be viewed as the minimum rate of return required keeping investors satisfied.

Thus the objective of the capital structure management is that mixture of debt and equity than minimizes its weighted average cost of capital (WACC). It has to optimally utilize the sources of finances which broadly are equity and Debt. The advantages of each are described below:

Issue of Equity Shares
Equity can be raised either by private placement or by public. Intel has got strong track record; thus it can use this route to raise money. It has following features:
Claim on Income and Assets:
Shareholders have the claim on income and assets of the firm.
Right to Control
Voting Rights
Pre-Emptive Rights
Limited Liability
Advantages of raising shares
Permanent Capital: It need not be paid back
Borrowing Base: It can be used to trade on equity
Dividend Payment Discretion: The payment of dividend is in the hands of management

Cost: It is more costly than debt
Earnings Dilution: It involves reduction in EPS.
Ownership Dilution: It involve sharing of ...

Solution Summary

The solution discusses the relationship between debt and capital structure for a firm.

Similar Posting

Evaluated TMV Industries' Capital Structure

Capital Structure
Need help figuring this out. Please provide a DETAILED solution with calculations and formulas where needed. The answers should be pretty simple.

a.Read the following case located in the text.
CASE STUDY: Evaluated TMV Industries' Capital Structure.
b.Prepare a 350-700 word memo to the President of TMV Industries that responds to the questions posed by the case. In your memo, be sure to explain how cost of debt, cost of equity, and weighted average cost of capital are determined.

TMV Industries, an established producer of printing equipment, expects its sales to remain flat for the next 3 to 5 years
because of both a weak economic outlook and an expectation of little new printing technology development over that period.
On the basis of this scenario, the firm's management has been instructed by its board to institute programs that will allow
it to operate more efficiently, earn higher profits, and, most important, maximize share value.
In this regard, the firm's chief financial officer (CFO), Ron Lewis, has been charged with evaluating the firm's capital
structure. Lewis believes that the current capital structure, which contains 10% debt and 90% equity, may lack adequate
financial leverage. To evaluate the firm's capital structure, Lewis has gathered the data summarized in the following table
on the current capital structure (10% debt ratio) and two alternative capital structures ---A ( 30% debt ratio) and B ( 50%
Debt ratio) ----that he would like to consider.

Capital Structure
Current A B
Source of capital (10% debt) (30% debt) (50% debt)

Long-term debt $1,000,000 $3,000,000 $5,000,000

Coupon interest rate (b) 9% 10% 12%

Common stock 100,000 shares 70,000 shares 40,000 shares

Required return on equity, k 12% 13% 18%

(a) These structures are base on maintaining the firm's current level of $10,000,000 of total financing.
(b) Interest rate applicable to all debt.
( c) Market-base return for the given level of risk.

Lewis expects the firm's earnings before interest and taxes (EBIT) to remain at its current level of $1,200,000. The firm
has a 40% tax rate.

a. Use the current level of EBIT to calculate the times interest earned ratio for each capital structure. Evaluate the
current and two alternative capital structures using the times interest earned and debt ratios.

b. Prepare a single EBIT--EPS graph showing the current and two alternative capital structures.

c. On the basis of the graph in the part b, which capital structure will maximize TMV's earnings per share (EPS) at
its expected level of EBIT of $1,200,000? Why might this not be the best capital structure?

d. Using the zero-growth valuation model given in Equation 11.12, find the market value of TMV's equity under each
of the three capital structures at the $1,200,000 level of expected EBIT.

Equation (11.12) Po= EPS
k = required returns k
s s

e On the basis of your findings in parts c and d, which capital structure would you recommend? Why?

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