Question

Tom is interested in gaining additional insights into capital structure issues and has asked Walt to brief him in the area. He wants a basic review of the terminology but is particularly interested in the impact of different types of risk and in understanding of the better-known financial theorists. Walt knew that Tom could grasp complex issues quickly and felt that a thorough discussion of Modigliani and Miller’s work would be appropriate. He also felt that Miller’s addition of personal taxes to the earlier models would be good to cover, and he determined that a good approximation of personal tax rate on debt income was 28% and for stock income was 20%. He decided to add the more recent considerations of financial distress, agency costs and information asymmetry for a comprehensive overview. To help with this analysis, Walt developed the following estimates for cost of debt and cost of equity that included an increasing premium for financial distress and agency costs as the debt ratio increases.

__________________________________________

    Debt ratio                 kd ks

__________________________________________

                                               

                                                            0%                               ---- 16.0%

                                                            10%                             9.00%             17.0%

                                                            20%                             9.25%             17.8%

                                                            30%                             9.75%             19.0%

                                                            40%                             10.50%            20.5%

                                                            50%                             12.00%            22.0%

                                                            60%                             15.00%            26.0%

                                                            70%                             20.00%            30.0%

                                                            80%                             30.00%            40.0%

                                                            90%                             50.00%            60.0%

You have been assigned to help Walt develop the briefing and he has prepared the following questions to help direct your energies. He has also asked you to think about other relevant issues that Moore might bring up. Walt is aware of Tom’s keen intellect but is also aware of his reputation for “asking the right questions” and for having little tolerance for people who are not adequately prepared so he is concerned about covering the issues in an understandable manner.

Questions

1. What is meant by capitalization? What is meant by a firm’s capital structure? For financial planning purposes, explain why either book or market value should be used to determine the firm’s capital structure. What is capital structure theory?
2. Discuss the following issues relating to business risk and financial risk.
3. 1. What is the difference between business risk and financial risk? Explain some of the factors that contribute to each. Evaluate Moore Plumbing Supply’s level of business risk.
   2. How do these risks relate to total risk?
   3. How does business risk affect capital structure decisions?
4. Discuss the following issues relating to Modigliani and Miller’s (MM) 1958 capital structure model.
   1. What was the importance of the model?
   2. What are the basic assumptions of the model?
5. Discuss MM’s later models (1963) in which they relaxed the no-tax assumption and added corporate taxes. Discuss Proposition I and II. Miller added personal taxes to the model in his 1976 Presidential Address to the American Finance Association. What happens to Miller’s model, in general, if there are no corporate or personal taxes? What happens when only corporate taxes exist?
6. Briefly describe the asymmetric information theory of capital structure. What are its implications for financial managers?
7. Prepare a summary of the implications of capital structure theory that can be presented to Tom Moore. What insights can capital structure theory provide managers regarding the factors which influence their firm’s optimal capital structures?
8. Finally, what recommendations would you make about the capital structure of Moore Plumbing Supply Company? Justify your answer.

Answer 1

1) Capitalization is an accounting method in which a cost is included in the value of an asset and expensed over the useful life of that asset, rather than being expensed in the period the cost was originally incurred.

The capital structure is the particular combination of debt and equity used by a company to finance its overall operations and growth. Debt comes in the form of bond issues or loans, while equity may come in the form of common stock, preferred stock, or retained earnings.

Book value is the value of an asset reported in the balance sheet of the firm. Market Value is the current valuation of the firm or assets (the ongoing price of the share) in the market on which it can be bought or sold.
Book value gives us the actual worth of the assets owned by the company whereas Market value is the projected value of the firms or the assets worth in the market.
Book value is equal to the value of the firm’s equity while market value indicates the current market value of any firm or any asset.
An investor can calculate the book value of an asset when the company reports its earnings on a quarterly basis whereas market value changes every single moment.
Book value shows the actual cost or acquisition cost of the asset whereas the other indicates the current market trends.
Book value is the accounting value of an asset and is less relevant at times when a company is actually planning to sell that asset in the market; in comparison market value reflects the more accurate valuation of an asset during buying and selling of that asset.
Book value of an asset is accounted in the balance sheet based on historical cost, amortized cost or fair value. Market value reflects the fair value or market value of an asset.

The capital structure theories explore the relationship between your company's use of debt and equity financing and the value of the firm.

2 a) Financial risk and business risk are two different types of warning signs that investors must investigate when considering making an investment. Financial risk refers to a company's ability to manage its debt and financial leverage, while business risk refers to the company's ability to generate sufficient revenue to cover its operational expenses.

Some of the factors that may affect a company's financial risk are interest rate changes and the overall percentage of its debt financing. Companies with greater amounts of equity financing are in a better position to handle their debt burden. One of the primary financial risk ratios that analysts and investors consider to determine a company's financial soundness is the debt/equity ratio, which measures the relative percentage of debt and equity financing.

The level of a company's business risk is influenced by factors such as the cost of goods, profit margins, competition, and the overall level of demand for the products or services that it sells.

b) Total risk is the Sum of Financial and Business risk, as we have seen from the above explanation both of them together contribute to risk at an entity level.

c) Companies structure their financing around two sources of capital: debt and equity. The right mix of the two varies according to your circumstances. In a stable or flourishing economy, there are advantages to financing a new or growing company with debt, but it becomes riskier if your industry is volatile or the economy enters recession.

Borrowed money has definite advantages as a source of capital. Interest on business debt is tax deductible, which lowers the cost of raising funds. Your lenders receive a fixed rate of return, so if a small business takes off, owners don't have to share the extra profits. Unlike equity investors, creditors don't get a vote in how you run your business, so you retain more control. These features make debt more attractive than equity -- unless you're at risk for defaulting on your debt.

If you operate in a speculative industry or business risk has increased, what otherwise would be a safe amount of debt becomes more dangerous. The level of business risk is shaped not only by your decisions but by what's happening to your industry, the economy, your ability to borrow more money and government regulation and social trends. In some situations -- for instance, your company is facing new competitors or new technology is shrinking your industry -- the risk may be high enough that equity financing is safer than debt.

If you believe your circumstances have changed so that your level of debt is no longer safe, one solution is to deleverage, which means change your capital structure by reducing your debt level. If you have cash, consider paying off some of your debts early to avoid default. Alternative approaches are to offer a share of equity or some of your assets in return for wiping out debt at a discounted price. The Wall Street Journal reports that many companies did this during the 1970s recession in order to avoid default.

If you can't reshape your capital structure, another alternative is to reduce to the level of risk. In agribusiness, for example, crop insurance protects companies against a sudden loss of their product from drought or flooding. If you secure contracts guaranteeing you a steady income, this lowers the chance that your cash flow won't cover your debts; diversifying into new fields may lower your risk if your current industry is floundering. The safer your company becomes, the less of a threat your debt level is.

There is no sufficient information to discuss business risks of Moore.

b)