Already have an account? Get multiple benefits of using own account!
Login in your account..!
Remember me
Don't have an account? Create your account in less than a minutes,
Forgot password? how can I recover my password now!
Enter right registered email to receive password!
Q. Observation of capital structure?
Droxfol Co has long-term funding provided by ordinary shares preference shares and loan notes. The rate of return necessary by each source of finance depends on its risk from an investor point of view with equity (ordinary shares) being seen as the most risky and debt (in this case loan notes) seen as the least risky. Disregard taxation the weighted average cost of capital (WACC) would therefore be expected to decrease as equity is replaced by debt since debt is cheaper than equity that is the cost of debt is less than the cost of equity.
Nevertheless financial risk increases as equity is replaced by debt and so the cost of equity will increase as a company gears up offsetting the effect of cheaper debt. At low as well as moderate levels of gearing the before-tax cost of debt will be constant but it will increase at high levels of gearing due to the possibility of bankruptcy. At elevated levels of gearing the cost of equity will increase to reflect bankruptcy risk in addition to financial risk.
In the traditional observation of capital structure ordinary shareholders are relatively indifferent to the addition of small amounts of debt in terms of increasing financial risk and so the WACC falls as a company gears up. As gearing up persists the cost of equity increases to include a financial risk premium and the WACC reaches a minimum value. Further than this minimum point the WACC increases due to the effect of increasing financial risk on the cost of equity and at higher levels of gearing because of the effect of increasing bankruptcy risk on both the cost of equity and the cost of debt. On this traditional view thus Droxfol Co can gear up using debt and reduce its WACC to a minimum at which point its market value (the present value of future corporate cash flows) will be maximised.
In contrast to the traditional outlook continuing to ignore taxation but assuming a perfect capital market Miller and Modigliani demonstrated that the WACC remained constant as a company geared up with the increase in the cost of equity due to financial risk exactly balancing the decrease in the WACC caused by the lower before-tax cost of debt. Since in a prefect capital market the chance of bankruptcy risk doesn't arise the WACC is constant at all gearing levels and the market value of the company is also constant. Miller and Modigliani showed thus that the market value of a company depends on its business risk alone and not on its financial risk. On this view so Droxfol Co cannot reduce its WACC to a minimum.
When corporate tax was put into the analysis of Miller and Modigliani a different picture emerged. The interest payments on debt decreases tax liability which meant that the WACC fell as gearing increased due to the tax shield given to profits. On this observation Droxfol Co could reduce its WACC to a minimum by taking on as much debt as possible.
Nevertheless a perfect capital market is not available in the real world and at high levels of gearing the tax shield offered by interest payments is more than offset by the effects of bankruptcy risk as well as other costs associated with the need to service large amounts of debt. Droxfol Co should thus be able to reduce its WACC by gearing up although it may be difficult to determine whether it has reached a capital structure giving a minimum WACC.
Assume you are a professional financial analyst working for a wealthy investor. Your client has $2.6 million to invest and wants to sink it into a single stock (diversification is
How could we project exchange rates in order to be able to forecast exchange differences? If someone knew how to predict exchange rates, they would be a millionaire and would n
Illustrate the term quality of benefits It is clear from Table that total returns associated with two alternatives are identical in a normal situation but range of variati
The holder of a corporate debt instrument is preferred to equity shareholders in the bankruptcy proceedings. However, secured/senior creditors are preferred to no
Define the concept of a real option. Discuss some real options a firm can be confronted with when investing in real projects. A positive APV project is accepted under the supposi
Extent of Financing Required It is clear that sales are unsure with low, high and medium estimates of demand. This of itself gives a few uncertainty but the reliability and pr
How do tax considerations affect the cost of debt and the cost of equity? As interest on debt is tax deductible to the issuing firm, as much higher the tax rate the lower the aft
Discuss the different ways political events in a host country may affect local operations of an MNC. Answer: The answer can be organized based on the three types of political ri
FORMS OF DIVIDEND Cash Dividend Many Companies pay dividend in cash. Often cash dividend may be supplemented by a bonus issue (stock dividend). When the company chooses
Features of Treasury Bills Treasury Bills are short-term, rupee denominations issued by the Reserve Bank of India (RBI) on behalf of the Government of India. T-bills are issued
Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!
whatsapp: +1-415-670-9521
Phone: +1-415-670-9521
Email: [email protected]
All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd