When a firm’s debt-to- equity ratio maximizes its value and minimizes the firm’s weighted average cost of UAPITA (WAC), it is said to be at the “target” or “optimal capital structure”. Debt usually offers a lower cost of capital because of the ability to deduct tax from Interest, but the company’s risk Increases as debt Increases. Part b. (Business Risk) Business risk refers to the risk brought upon the firm by its operations. This can be influenced by many factors such as, cost of production, sales volume, unit price, competition, demand, government regulations, etc.
A company with higher business risk should operate with a capital structure that has a lower debt ration to safeguard TTS shareholders by guaranteeing that it can meet all of its financial obligations. A high business risk means a low debt ratio while a low business risk means that a firm might be able to operate with a high debt ratio. Part c. (Operation Leverage) A firm that makes few sales with sales providing a high gross margin is said to have high operation leverage. Operating leverage is dependent on a firm’s fixed and variable costs.
If a firm has a high proportion of fixed costs it has high operation leverage as opposed to a firm with low fixed costs and high variable casts which are unconsidered to have a low operation leverage. A high-end car dealership has high operating leverage while a grocery store has low operating leverage. In a high operating leverage firm or Industry, forecasting Is Incredibly Important. A small error in forecasting could greatly damage the firm’s BIT. The opposite can be said for a firm with a low operating leverage.
A small error in forecasting is accepted and expected. The error will have little effect on the firms BIT. A Company with high operation leverage should finance its operations with a low amount of debt to insure, n the case of a misconception, to protect Its Investors. Business risk and operation leverage often go hand In hand and are used to calculate the firms total risk on ROE. Part d. (Trade-Off Theory) The trade-off theory states that there are benefits to debt within a capital structure up until the optimal, or target, capital structure.
The theory takes into effect the “tax shield” created by interest payments. Interest payments on debt are tax deductible creating a tax benefit for debt financing. A firm reaches optimal capital structure when the marginal tax shield equals the marginal bankruptcy costs. Bankruptcy costs are ten Increased costs AT Talking Witt EOT Instead AT Witt equally which result in a higher probability of bankruptcy. Thus, there is a point where the marginal tax benefits equal the cost of financing with more debt. At this point, we see the firm’s optimal capital structure. Part e. Asymmetric Information and Signaling) Asymmetric information refers to the realization that managers have more and better information that outside investors do. Signaling is based upon a firms actions and how it is preserved by its investors. Optimist asymmetric information could lead oh firm suddenly taking on more debt or increasing their dividend policy. This would signal that the company is about to experience growth or is at a mature and stable state. Pessimist asymmetric information could lead a firm to issue more stock because they recognize an upcoming loss.
By issuing more stock, the loss could be spread over a larger number of stockholders resulting in a smaller loss per share. Investors know this however and are wary when a firm issues more stock. Because of signaling, when a firm tries to adjust their capital structure their investors behave in way directed by the signal given, whether that signal is accurate or not. Part f. (WAC) WAC or weighted average cost of capital is the firm’s cost of capital with each category of capital weighted proportionately.
The more debt that company uses, the higher the WAC. The higher the WAC, the higher the company’s risk. When using debt, the WAC begins to fall, but eventually, the costs of debt and equity will cause WAC to increase which will in turn cause the value of the company to drop. This brings us back to the optimal or target capital structure, where the debt to equity Asia maximizes the firm’s value. Part g. (Reserve Borrowing Capacity) Firms should however, use a lower debt to equity ratio than optimal capital structure suggests.
The reason being, that an opportunity may arise where more funds are needed. As previously discussed, the issue of more stock sends a negative signal whether the signal is accurate or not, but to issue more debt past the optimal capital structure ratio would decrease the firm’s value which would also send a negative signal. Therefore, a firm should have a reserve borrowing capacity in the case of such an opportunity. Part h. (Windows of Opportunity) A window of opportunity is a time period where a normally unreachable opening exists. An example is today’s interest rates.
The windows of opportunity theory suggest that because interest rates are so abnormally low, now is a good time for businesses to issue debt. On the contrary, when stock market prices are exceptionally high, firms should issue more equity. Part I. (Personal Application) It is of the utmost importance that managers know and understand their firm’s risk and how it breaks down into operation leverage and business risk. This might be eased solely off their particular firm or off their industry as a whole. Managers should also consider the benefit of deducting interest on debt to use as a tax shield.
Managers should take the asymmetric information theory and signaling into consideration. They should be aware of what certain actions signal and how they can avoid sending the wrong signal and use signaling to their advantage. The WAC should also be considered when determining the corporation’s debt to equity ratio. They should know that at a certain point, WAC will begin to increase as at this point ten Tall Is Klan on too much EOT IT a corporation wants to take advantage AT an opportunity but does not have the funds necessary, they should issue more debt to take benefit.
For this reason managers should have a reserve borrowing capacity and have a lower initial debt to equity ratio than the optimal capital structure suggests. Managers should also be watchful and aware of windows of opportunities in which they can maximize the corporation’s growth. As one can see, there are many aspects one needs to consider when determining a firm’s capital structure and this essay only slightly begins to scratch the surface of capital structure theory.