Question

at AAB Chapter Review 9-8h Cases Case 9-1 Analysis of financing corporate growth Assume that the president of Elkhead Brewery made the following statement in the Annual Report to Shareholders: "The founding family and majority shareholders of the company do not believe in using debt to finance future growth. The founding family learned from hard experience during Prohibition and the Great Depression that debt can cause loss of flexibility and eventual loss of corporate control. The company will not place itself at such risk. As such, all future growth will be financed either by stock sales to the public or by internally generated resources." As a public shareholder of this company, how would you respond to this policy? Case 9-2 Receivables and inventory turnover Thornby Inc, completed its fiscal year on December 31. The auditor, Kim Holmes, has approached the CFO, Brad

Answer 1

Case 9-1

An optimal capital structure for a company must be a balance between equity and debt. Debt allows the company to have flexibility over repayment as well interest paid on debt has tax benefits. This reduces the overall cost of capital for the firm. Also, having only equity will lead to conflict of interest and can lead to issues of sharing profits among the shareholders. Also, having only equity is that all shareholders might not agree on all the decisions and in that case having debt capital enables the firm to make independent decisions. Debt also helps in growth of the firm and create value to the shareholders. Having only equity increases the cost of capital for the firm by a huge margin. Hence, the right policy must include a optimal balance between debt and equity.