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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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Solution Summary

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

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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

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

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