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Debt and Equity MIX

1. The debt and equity mix is an example of a financial ratio and indicates the extent to which borrowed funds are used to finance assets. What are the main factors that go into determing the right mix of equity and debt? IF debt is always cheaper than equity ,why have equity?

2.Financial Lease option

You are the owner of a start -up company that is small, but growing fast. TO support your growth, you need to purchase some long-term fixed assets. You are considering whether to buy or lease. Why might a financial lease be especially attractive for your situation.

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The debt and equity mix is an example of a financial ratio and indicates the extent to which borrowed funds are used to finance assets. What are the main factors that go into determing the right mix of equity and debt? IF debt is always cheaper than equity ,why have equity?

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. A firm's optimal capital structure is that mixture of debt and equity than minimizes its weighted average cost of capital (WACC). Since the after-tax cost of debt is lower than equity for many corporations, why not use debt only or mostly? It turns out that, while debt reduces a company's tax liability because interest payments are deductible expenses, increasing amounts of debt raise both the cost of equity capital and the interest rate on debt because of the increasing probability of bankruptcy. In other words, higher amounts of debt raise the financial risk of a company, and this risk is reflected on the cost of all the types of capital the company uses. As such, the relationship between financial leverage and WACC is not a straight line, but more of a U-shaped curve, with a minimum WACC between the extremes of debt utilization.
Thus the objective of the capital structure management is that mixture of debt and equity than minimizes its weighted average cost of capital (WACC).

Factors which go in determining right mix:

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 terms of the agency costs of debt, Jensen and Meckling (1976) suggest that the potential conflict between equity and debt claimants is presented primarily in terms of wealth expropriation and risk shifting.

Shareholders may capture wealth from bondholders by investing in new projects that are riskier than those presently held in the firm's portfolio. If the projects perform well, shareholders capture most of the gains, while bondholders bear most of the cost ...

Solution Summary

The solution explains debt and equity. Financial lease options are discussed.

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