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    A Firm's Capital Structure, Incremental IPO, and Debt Financing

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    How does using more debt impact a firm's capital structure? Discuss the trade-offs between incremental IPO proceeds and debt financing. How would a company's balance sheet be impacted by debt financing rather than using cash? How would the company's return on equity be impacted by utilizing more debt? Can you provide reference sites for further research?

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    Solution Preview

    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.

    Use of debt
    Debt
    It entails payment of interest on a specified date.
    Advantages
    Less Costly
    No ownership Dilution
    Fixed payment of interest
    Reduced real obligation

    Disadvantages
    Obligatory Payment
    Financial Risk
    Cash outflows
    Restricted Covenants

    The Nature of Agency Cost of Debt

    The agency cost of debt is associated with monitoring, enforcing, credibly promising, and constraining decisions, and result from the general situation in which the optimization problem for one constituency is suboptimal for another constituency. In ...

    Solution Summary

    This solution provides detailed explanations for how debt would impact a firm's capital structure, the differences between incremental IPO proceeds and debt financing,and the impact of debt financing.

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