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Optimal capital structure

You have been hired as a financial consultant by two firms, Alright Industries (Firm A), and Zelda Ltd. (Firm Z). Firm A is in the fast-growing microcomputer retail sales industry, while Firm Z manufactures office equipment such as pencil sharpeners, staplers, and tape dispensers. Your job is to recommend the optimal capital structure for these 2 firms. Discuss the factors that would influence your decision, and specifically how each of the factors applies to each firm.
Additional information about the 2 firms:

a. Firm A generally leases it stores, while Firm Z purchases its plants.
b. Firm A's stock is widely held, while the family of Firm Z's founder holds 40% of its stock.
c. Firm Z has a significant amount of accelerated depreciation expense each year, while Firm A has almost none.
d. Firm A has demonstrated high growth and profitability over the last few years. On the other hand, Firm Z's growth has averaged a modest 5% per year, and its profit margins and Return On Equity (ROE) have been unspectacular.

Be thorough in your discussion.

taxes, information assymetry, non interest tax shelters, depreciation, Uniqueness of assets

Solution Preview

Factors that influence capital structure:

1 Taxes :
Taxes are the main reason for capital structure optimization. Interest payments are deductible as an expense. Total income increases by interest payment times the tax rate. The optimal strategy is therefore to acquire a maximum of leverage. The greater the amount of debt, the greater the tax shield and the greater the value of the firm. But to derive the benefit of tax shield there should not be any uncertainty of the tax shields. The possibility of using tax shields effectively depends on net income or profitability.

Firm A therefore can make use of the tax shields effectively as it has demonstrated high growth and profitability over the last few years. In contrast Firm Z's growth has averaged a modest 5% per year, and its profit margins and Return On Equity (ROE) have been unspectacular. Therefore it would not be able to use tax shields from interest payments ...

Solution Summary

The solution discusses the factors that influence capital structure and recommends capital structure for two firms.

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