The capital structure decision and the cost of capital
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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: Adobe, T-Mobile, and Fed-Ex. 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.
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'. (Show references and do not quote the actual company's capital structure or their debt-to-equity ratios as per their balance sheet.)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 is comprised of detailed explanation about the advantages and disadvantages of debt financing, how the use of debt financing affect the rate of return the shareholders require in thier investment in the firm's shares, and the changes of cost of equity when the firm increases it use of debt. This solution also provides clear explanation of the meaning of an optimal capital structure of the firm and a recommendation of either low debt, medium debt, or high debt ratio to three companies, Adobe, T-mobile, and FedEx. A list of references is also provided.
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