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Optimal or target capital structure

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Because of the difficulty in determining a firm's optimal or target capital structure, financial managers depend on both quantitative analysis and judgment in practice. Some things that are considered are:

Cash Flow
Market Conditions
Profitability and Stability
Management Preferences
Financial Flexibility
Business risk.

Can you think of any others? What factors might be important with respect to the issues listed above.

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(source: http://www.ssc.uwo.ca/bacs/courses/310/peters/LEVERAGE%20AND%20CAPITAL%20STRUCTURE.htm)

Capital structure is a mix of debt and equity. Debt has tax benefits, so firms should use some debt. However financial distress and agency costs limit debt usage. Distress costs are higher for firms with intangible assets. Because of the presence of asymmetric information, firms will follow pecking order in the capital structure. (Pecking order: Internally generated funds are the most preferred, followed by new debt, and debt-equity hybrids. Finally, new equity is at the least preferred source.) Because of asymmetric information, firms should also maintain reserve for borrowing.

The optimal, or target capital structure is the structure with the lowest possible WACC. The Interest Tax Shield (deductibility of interest as expense ) is critical here, because it effectively lowers the cost of debt. Therefore for many firms, the use of financial leverage (debt financing) can lower WACC and increase profitability. However there is a warning: choice between debt & equity can not be based on interest rates, etc. alone. Risk must be considered as well. The systematic risk (which cannot be diversified ) consists of two factors which must be considered: Business risk which is the risk inherent in firm's operations and Financial risk which is the risk inherent in using debt financing. We must remember that debt is a magnifier: it can magnify returns if returns > cost of debt, but it can also magnify losses, or returns < cost of debt.
Optimal capital structure is achieved by finding the point at which the tax benefit of an extra dollar of debt = potential ...

Solution Summary

The solution discusses the factors that might be important in determining a firm's optimal or target capital structure.

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Optimal Capital Structure

A firm has determined its optimal capital structure that is composed of the following sources and target market value proportions:

Source of Capital Target market proportions

Long-term debt 20%
Preferred debt 10%
Common stock equity 70%

Debt: The firm can sell a 12-year, $1,000 par value, 7% bond for $960. A flotation cost of 2% of the face value would be required in addition to the discount of $40.

Preferred Stock: The firm has determined it can issue preferred stock at $75 per share par value. The stock will pay a $10 annual dividend. The cost of issuing and selling the stock is $3 per share.

Common Stock: A firm's common stock is currently selling for $18 per share. The dividend expected to be paid at the end of the coming year is $1.74. Its dividend payments have been growing at a constant rate for the last four years. Four years ago, the dividend was $1.50. It is expected that to sell, a new common stock issue must be underpriced $1 per share in floatation costs. Additionally, the firm's marginal tax rate is 40 %.

1) The firm's before-tax cost of debt is _________

7.7 %, 10.6 %, 11.2 %, or 12.7 %

2) The firm's after-tax cost of debt is ____________

3.25 %, 4.6 %, 8 %, or 8.13 %

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