One of the more interesting decisions that a financial manager must make is how to finance a firm’s collection of assets. Specifically, a financial manager must determine if assets (i.e., the left side of the balance sheet) should be financed with debt, equity, or some combination. The ratio of the market value of debt to the market value of equity is referred to as the firm’s capital structure.
The ultimate goal of a financial manager is to maximize the wealth of a company’s shareholders. Although much of finance focuses on how to effectively and efficiently manage a firm’s assets in order to achieve this goal, this week you explored the possibility that a firm’s market value, and thus shareholder wealth, may be affected by the company’s debt ratio. Thus, it may be possible, all else constant, that a firm has an optimal capital structure (i.e., debt to asset ratio). If so, discovering and maintaining the proper debt ratio is an additional important point of focus for a financial manager.
Assume a firm sells all of its real assets to its investors as a package of securities. One possibility is for this package to be comprised of equity only. Another package may include many different types of debt and equity securities. Still another may contain only debt securities. The financial manager must attempt to find the specific package that represents that greatest value.
Unfortunately, changes in value are not guaranteed. Modigilani and Miller’s (MM) debt irrelevance proposition (Higgins, 2015, pp. 225-229) infers that a company’s value is independent of its capital structure. Thus, the proportions of debt and equity used to finance a firm’s assets do not matter. More specifically, the increase in expected return to shareholders as leverage increases is perfectly offset by increased risk.
Of course, MM’s proposition relies on a set of very stringent and highly simplifying assumptions. For example, the argument depends on assuming perfect capital markets, complete information for all participants, no taxes (corporate or personal), and zero costs of financial distress. Obviously, none of these are strictly correct. Nonetheless, MM’s proposition is very important. It illustrates a misperception held by many business executives that debt is “cheaper” than equity. Indeed, for any single company, the explicit cost of debt will be less than the explicit cost of equity. However, debt also comes with an implicit cost. Increased borrowing (i.e., a higher debt ratio) leads to greater risk for equity holders, which raises the cost of equity capital. Thus, when both the implicit and explicit costs of debt are considered, debt is not less expensive than equity. MM proves that in a world where interest is not subsidized by lower taxes, a company’s weighted average cost of capital (WACC) is independent of the amount of debt used to finance the firm. For this assignment, you must create a report on the financing decision that a publicly traded corporation faces. Your report must address each of the following:
Evaluate the leverage implications of using different levels of debt to finance a firm. Be sure to include a discussion of the impact of an increasing debt ratio on ROE and on risk. Incorporating graphs into your analysis will most likely make your discussion more meaningful and interesting.
Assess the tradeoff theory capital structure theory (Kraus & Litzenberger, 1973) by explaining the conditions with and without taxes, as well as the implications of bankruptcy costs. There should be the development of graphical illustrations of these arguments.
Explain and discuss the importance of the following in the capital structure debate: signaling theory, the constraining managers’ theory, the pecking order hypotheses, and the windows of opportunity theory.
Compare and contrast the actual debt choices that firms tend to make, including how the choices seem to adjust across industries.
Offer your opinion on why firms in some industries tend to use significant amounts of debt, while others use little.
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