Question

You are having a coffee chat in downtown Evanston with a friend who has just started working as a stock analyst and are talking about leverage and firm value. While working, your friend noticed that Apple (AAPL), Peet’s Coffee (PEET), and Urban Outfitter (URBN) are all unlevered even though they have enough profits to bene t from the interest tax shield. They are also very cash-rich; Apple, for example, has over $9.8 billion in cash on its balance sheet as of September 2011. She concludes that all these firms are clearly not maximizing shareholder value, because they are leaving money on the table. Do you agree with her statement? Explain your answer completely. Hint: There is no definite answer for this question, so think of it as an open debate. Support your argument with facts and evidence. A simple repetition of the answers to the first two questions will not earn you any credit.

Answer 1

To a certain extent, she is right. For debt-free companies, the shareholder value is maximized when the firm used moderate levels of debt as suggested by optimal capital structure and marginal cost of capital concept. As debt has tax shield associated with interest payments, it provides a cheaper way to finance operations than equity does. As the cost of capital is minimized using moderate level of debt, the shareholder value is maximized as the stock prices go higher. However, if the firm borrows a lot more than it could service especially during recession or cyclical downturn, it could also lead to lower shareholder value. Hence, many firms typically take conservative financing option and do not use leverage to finance operations.