Debt Financing and Optimal Capital Structure
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1. What are 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 - see the first two articles in the required readings).
3. What is meant by "an optimal capital structure of the firm"? Be specific.
4. Now go to the main part of the Case:
Consider three companies: Krogers, Intercontinental Hotels Group, and Whirlpool. Reflect on the nature of the business of these three companies. You are recommended to also get to the web site of one company in each of these categories. You might also check what the beta of each of these companies is.
Based on the readings of the Module, and 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 you are not asked 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 (Do not quote the actual company's capital structure or their debt-to-equity ratios as per their balance sheet.)
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Solution Summary
This solution discusses the advantages and disadvantages of debt financing, the effect of debt financing on the rate of return, the optimal capital structure and a case study involving Krogers, Intercontinental Hotels, & Whirlpool.
Education
- MBA, Indian Institute of Finance
- Bsc, Madras University
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