Question

1. a) If a firm has $25 million of debt and $75 million of equity, what fraction of the firm’s value was financed with debt?

b) Corporate control is a factor that the firm’s decision makers use but it doesn’t necessarily work out well for firm value. Acme Inc., was founded by the Acme family and its members own the majority of its stock. Not wishing to lose control of the company, Acme has done all new borrowing with debt and it now has the highest Debt/Equity in its industry. How might this hurt the value of Acme Inc. eventually?

c) If a firm changes its capital structure by decreasing its ratio of debt to equity, does it increase or decrease the percent of the company finance with equity?

Answer 1

a: % financed with debt = Debt/ (Debt + equity)

=25/(25+75)

=25%

b: A very high debt equity ratio implies high debt.This brings a question on the sustainability of the company.There is high burden on the profits due to high interest payments and lesser money for retaining for long term growth of the business. This may finally lead to bankruptcy due to extremely high risk involved.

c: If ratio of debt to equity decreases, the percentage financed with equity increases. This is because the % financed with debt has decreases.