1. Explain the concept of capital structure and how a corporation attempts to maximize shareholder value through its capital structure choice.

Capital Structure, as the name suggests, is the structure or composition of the debt and equity (common stock and preference shares) of an organization which is used to fund its assets. Say for example, if an organization has 40% of the long term capital as Equity and the balance 60% as Debt, then the organization can be said to have a Debt - Equity ratio of 60:40, i.e., 1.5:1.

In the real world, the cost of equity is generally higher than the cost of debt to the organization. This is owing to the fact that equity is riskier; interest on debt is tax-deductible, presence of taxes, etc. This difference in cost of equity and cost of debt makes the Capital Structure very important today where the organizations seek to maximize the shareholders’ wealth as they would like to have a optimum capital structure, i.e., a capital structure with the lowest Weighted Average Cost of Capital (WACC) which is determined as under:

WACC = Kd( D )  +  Ke( E )                                                                                                                               (D+E)       (D+E)

Where, Kd = Cost of Debt

            Ke = Cost of Cost of Equity, (Harold Bierman)

            D = Debt of the Organization

            E = Equity of the Organization

2. Describe the effects of taxes and threat of bankruptcy with the capital budgeting decision.

Effect of Taxes –

The interest on debt is tax deductible whereas Dividends on Equity are not which, other things remaining the same, makes the cost of debt lower than the cost of equity. Thus, in the presence of taxes, the value of a leveraged organization would be more than the value of a comparatively less leveraged organization. Thus, the presence of taxes allows the organization to opt for leveraging itself in order to maximize the shareholders’ wealth.

Threat of Bankruptcy –

If there were no threats or costs associate with bankruptcy (like legal and administrative expenses, liquidation of assets at distress value, etc), all the organizations would have been highly leveraged today. The higher is the proportion of debt in an organization; higher are the risks / threats of bankruptcy. This leads us to the point that with leveraging beyond a certain extent, the organization / business gets riskier and hence the Cost of Equity for the organization increases. 

To conclude, the effect of taxes (or tax shield) and threats of bankruptcy would affect the Value of a firm which can be stated as under:

Value of Firm = Value of Unlevered Firm + Net Value of Tax Savings on Interest + Present Value of Bankruptcy Costs

3. Calculate an EBIT-EPS analysis.

EBIT-EPS analysis is an approach which helps in designing the optimum capital structure for the organization in order to maximize the EBT given the various levels of EBIT.

Let us assume that the organization is currently financed entirely with 20, 000 outstanding common stock and has no debt / preferred stock and that it pays no dividend on the common stock as all the earnings are retained and reinvested. Further, the organization needs to raise 50,000 for the business which can be raised from the following alternatives:

  1. Issue of New Common stock at the prevalent market price, say $5 per share, i.e., issue of 10,000 new shares.
  2. Issue of Preferred stock - The dividend yield on preferred stock will be, say, 5% and the preferred can be sold for $400 per share.
  3. Raising of debt at an interest rate of 4% per year. 

Case 1 - Common Stock

Case 2 - Preferred Stock

Case 3- Debt

Common Stock

100000

100000

100000

Additional Funds

50000

50000

50000

Total Funds

150000

150000

150000

Existing No. of Common Stock

20000

20000

20000

EBIT

20000

20000

20000

Interest @ 4%

0

0

2000

EBT

20000

20000

18000

Taxes (50%)

10000

10000

9000

PAT

10000

10000

9000

Pref. Div.

0

2500

0

Earnings Available to Common Stock Holders

10000

7500

9000

New No. of Common Stock

30000

20000

20000

EPS

0.33

0.38

0.45

We see that the EPS would be maximized when Debt is issued in Case 3, followed by Case 2 (Preferred Stock) and Case 1 (Common Stock issue).

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