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Determining the Debt-Equity Mix

Can someone eloborate and, if necessary, correct my responses to the questions below?

A) Why is debt a comparatively cheaper form of finance than equity?

The repayments on the debt component are deductible from income of a business and the WACC calculations reflect this savings as well. Because debt is a fixed amount that can be repaid, with the owners of the business retaining full ownership after repayment. Equity makes one an owner of a (presumably growing business and therefore of potentially huge value and an indeterminate loss to the original owners.

B) If debt is cheaper than equity, why do companies approach the equity markets?

Companies appear to go public not to finance future investments and growth, but to rebalance their accounts after high investment and growth.

C) Can one minimize WACC when there is a constraint on rising debt? If so, how?

Yes, one area where focusing management attention could yield substantial value is the frequently neglected accounts receivable function. A company can liquidate assets as needed to lower WACC. In El Café' the owner swaps some debt for equity, renegotiated the interest and sold some assets.

D) What are the effects of a corporate tax on the WACC of a business?

First, the company cost of capital is a weighted average of the returns demanded by debt and equity investors. The weighted average is the expected rate of return investors would demand on a portfolio of all the firm's outstanding securities. Taxes are important because interest payments are deducted from income before tax is calculated. Therefore, the cost to the company of an interest payment is reduced by the amount of this tax saving.

E) Is minimizing WACC by having a largely debt-based capital structure a high-risk strategy, given the threat of bankruptcy in an overleveraged business? Explain your answer.

Yes, you're already overleveraged and teetering on bankruptcy, and yet you want to load up more on debt against equity. In the simulation, we tried to alleviate some of the leverage by swapping some debt for equity with real estate and renegotiated our loan.

F) What are the extraneous factors which impact the ability of a business to radically alter its debt-equity mix?

Taxation, would bias the financing choice towards debt if, for example, corporate income is taxed but interest payments are tax deductible. Informational asymmetries lead to different perceptions of risk. If investors perceive the risk to be higher than managers then cost of external finance via debt in higher than that of internal finance via retained earnings. Third, if firms accumulate more debt, say via the differential taxation mechanism described, then, their ability to meet interest payments from current earnings diminishes. This increases the probability of bankruptcy and as a result, the cost of both debt and equity. (Hart 2001)

Solution Preview

Debt is cheaper for equity because of two reasons. First, because debtors have a prior claim if the company goes bankrupt, debt is safer than equity and therefore warrants investors a lower return; for the company, this translates into an interest rate that is lower than the expected total shareholder return on equity. Second, interest paid is tax deductible to the company; and a lower tax bill effectively creates cash. Because the cost of equity is not explicitly displayed on the income statement whereas the cost of debt (interest expense) is ...

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