The Andersen Corporation is considering the use of debt to increase its rate of return to common stockholders. The firm presently has no debt and 100,000 share of common stock outstanding for a total capitalization of $1,000,000. The firm has no current liabilities so total assets also equal $1,000,000.
It has been suggested by the Chief Financial Officer that the firm borrow $500,000 at 10% and retire 50,000 of it common shares. The shares are selling at $10 in the secondary market.
If the firm expects EBIT of $100,000 in the future, would this be a good idea? Why or why not? Assume a 50% tax rate and show your explicit quantitative reasoning. Be sure to consider such things at EPS, Debt Ratio, Risk, Degree of Financial Leverage, and the Rate of Return on Stockholders Equity.
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This solution explains how to determine capital structure for The Andersen Corporation.
Capital Structure Decision and Cost of Capital
In simple words, the capital structure is the combination of debt and equity used to finance a company. The background readings of this Module provide plenty of information regarding both the issue of the capital structure decision and the concept of the weighted average cost of capital.
1) For the Module, please lookup the following three companies' data:
eBay (NasdaqGS: EBAY),
The Clorox Company (NYS: CLX), and
Alaska Air Group, Inc. (NYS: ALK)
Write a 5 page report by responding to the following:
1) Based on the readings, please include the information together with other information that you think is necessary to below questions:
a. The nature of the business in brief (all three companies)
b. Total current assets and long-term assets of all three companies
c. Total current liabilities and long-term liabilities of all three companies
d. Revenue of each company
e. Total debt/equity ratios of all three companies
f. Profit margin, return on assets, and return on equity ratios of all three companies
g. Betas of all three companies
h. The riskiness of all three companies in brief (e.g., the higher the beta, the higher the risk)
i. The advantages and disadvantages of debt over equity financing.
2) What do you perceive you have learnt in the Module? Which of the following learning objectives mastered?
-Explain and demonstrate the use of bonds and other debt instruments in financing the firm's capital plans
-Discuss the advantages and disadvantages of debt financing and of equity financing
-Identify and discuss the concept of optimal capital structure
Note: Describe the purpose of the report and conclusion.
Alaska Air Group, Inc. (2012). Investor relations. Retrieved May, 2012, from http://phx.corporate-ir.net/phoenix.zhtml?c=109361&p=irol-IRHome
To access company background information, ratios analysis (e.g., debt/equity ratio, profitability ratios, etc.), and other information (e.g., company beta), please use the following websites: http://ca.finance.yahoo.com/q?s=ALK&ql=1; http://ca.finance.yahoo.com/q/ks?s=ALK.
The Clorox Company (2012). Investors. Retrieved May, 2012, from http://investors.thecloroxcompany.com/
Crfonline.org (n.d.). Ratios and formulas in customer financial analysis. Retrieved November 19,
2012, from http://www.crfonline.org/orc/cro/cro-16.html
Damodaran, A. (2005). Finding the right financing mix: The capital structure decision. Retrieved
November 20, 2012, from
Ebay Inc. (2012). Investor relations. Retrieved May, 2012, from http://investor.ebay.com
Peavler, R. (2012). Debt and equity financing. Retrieved November 20, 2012, from
Welsh, I., (1996). A premier on capital structure. The John E. Anderson Graduate School of
Management, University of California, Los Angeles. Retrieved November 20, 2012, from