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Debt financing / Optimal Capital Structure

Part I -

1. Please explain the advantages and disadvantages of debt financing.

2. How does the use of debt financing affect the rate of return that shareholders require on their investment in the firm's shares. How does the cost of equity (i.e., the rate of return investors require on their investment in the firm's shares) change when the firm increases its use of debt. (This is 'Proposition II" of Modigliani and Miller for the Tax Case that I was working.

3. What is meant by an optimal capital structure of the firm?

Part II -

Consider three companies: Krogers, Intercontinental Hotels Group, and Whirlpool. Reflect on the nature of the business of these three companies. You are recommended to check what the beta of each of these companies is.

Based upon reviewing the nature of the operations of the companies including the nature of their customers and products, what would you recommend should the capital structure (total liabilities or debt and equity proportions) be for each of the three companies? You should relate your answers to what you wrote in your response to question (3) above. Note that I am not asking you to provide specific numbers, just 'low debt ratio', 'medium debt ratio' or 'high debt ratio'. (Do not quote the actual company's capital structure or their debt-to-equity ratios as per their balance sheet.)

Be sure to include a reference list.

Solution Preview

Part I -
1. Please explain the advantages and disadvantages of debt financing.

The advantages of debt are
a. The interest payment are tax deductible reducing the effect cost of debt.
b. The interest to be paid is certain and so there is no uncertainty in cash flows.
c. Under inflation, the debt would be repaid using cheaper dollars.
d. Since the cost of debt is lower than the cost of equity, using debt up to a level would reduce the overall cost of capital and so increase the value of the firm.
e. It can be raised at short notice and can be secured or unsecured.

The disadvantages are
a. Interest and principal are to be repaid without regard to the situation of the firm, else the firm may be forced into liquidation.
b. Bond indentures may place some restrictions on the firm.
c. Use of debt increases the financial risk of the firm and beyond a level may result in a decrease in stock price.
d. Secured debt ties up the assets of the firm and so reduces flexibility.

2. How does the use of debt financing affect the rate of return that shareholders require on their investment in the firm's shares? How does the cost of equity (i.e., the rate of return investors require on their investment in the firm's shares) change when the firm increases its use of debt. (This is 'Proposition II" of Modigliani and Miller for the Tax Case that I was working.

The use of debt financing increases the return that the shareholders require. The reason is that the use of debt exposes the shareholders to the additional financial risk - risk that the firm may go bankrupt - and to counter this ...

Solution Summary

The solution explains the effects of debt financing and about optimal capital structure

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