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 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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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 ...
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