Question

When does a firm’s choice of capital structure matter to stockholders? What factors drive the difference between the value of a levered firm and the value of an unlevered firm, if any? Given the equations for the value of a levered firm that we discussed in class, how much leverage should a manager choose in order to maximize firm value? According to the tradeoff theory of capital structure, how much debt should a firm issue?

Answer 1

The Capital Structure of the Firm/Company defines the ownership pattern. A wrong mix can lead to Bankruptcy as a worst case scenario. This mean complete loss of value for some shareholders. shareholders can be ordinary shareholders or preferred stock shareholders. In the both the cases, the company repays in the end after clearing its payment with debt holders. Therefore it is of a prime concern to stockholders when it comes to the firms choice of capital structure.

Factors that drive value of a Levered Firm and the value of Unlevered Firm.

In a gist, the firm which has a debt component in its balance sheet is called a levered firm whereas firm which does not have debt component is called unlevered company.

1. Define the need for additional capital - What could be the reason why the company wants go for additional capital. It is the basis on which firm can decide whether it should opt equity issue or debt. Is it a Buyout or an Acquisition.

2. The Cost of Capital - Debts entails interest payments in regular intervals. Failure in delivering towards debt holders can lead to Bankruptcy. However the cost of debt is lowered due to tax element. However in case of yield loans, the cost may rise. In case of Equity the dividends are paid. They may not be regular. It depends upon how much the firm wishes to payout and retain the rest. There has to be a optimal mix of both the cost to arrive at Weighted Average Cost Of Capital.

3. Risk - Risk factor varies for both equity and debt. The method of evaluating risks involving in borrowing or issuing capital can raise number of complications and legal requirements.

How much leverage should a manager choose to maximise firm value?

The Firm's Value is equal to Market value of equity and Market value of debt. the manager should choose an ideal mix in such a way that the cost of debt is lower. The Value of Firm is reduced due to repayment of debt. The manger should see that if the firm is levered at present, he/she should opt for a mix of equity and debt but if the firm is unlevered, the manager can choose to go for equity only. the above is stated as per Modigliani-Miller Theorem.

Generally, the ideal mix should not exceed 2:1. The mix of debt to equity of 0.30 is most sweetest spot for any firm. But it is subjective and varies with different industries. a very high content of debt may impair the ability of the firm to keep cash to repay its debt and a low amount of debt means that company is not profiting from it leverage positions.

As per Trade-off theory of capital structure, how much debt should a firm issue?

The Trade-off theory of Capital Structure gives the maximum value of the firm. This maximum value of firm is an output of value of unlevered firm (equity). in addition to this, it includes the difference between the Present value of tax shield and the Present Value of the cost of financial distress. it is the optimal Debt policy which is attained by taking the equity and the debt less the cost of financial distress. The proportion of equity to be issued should be more than the debt since it will reduce the obligation of repayment of interest and principal and even bigger, the risk of non repayment in case of adverse events due to business cycles.