Case 1: E. I. du Pont de Nemours and Company (1983)
1.) Why should a firm have a capital structure policy, i.e., a target debt ratio? With this, explain what you believe are the benefits of maintaining a target debt ratio and discuss what the negatives are with having too much or too little debt. Also, how does a firm know if it has too much or too little debt?
Capital structure is a way for a firm to finance its assets through a combination of equity and debt. This includes short-term debt, long-term debt, preferred stockholders’ equity, and common stockholders’ equity. Having a capital structure policy allows a firm to have financial flexibility. This financial flexibility allows a firm to finance projects in whatever way is best for the firm. Financial flexibility permits a firm to curb financial distress in the occurrence of negative shocks as well as fund investments at low costs when opportunities arise.
Many people might think that debt free financing is the best choice for a firm, just like du Pont did in the late 60s. Because of the low debt policy, du Pont was able to maximize its financial flexibility and insulate its’ operations from financing constraints. But in the real business world, debt free financing might not be a wise capital structure decision for the firm. For example, if you can borrow money at 7% for 30 years in a world of 3% inflation and reinvest it in core operations at 15%, you would be wise to consider financing with at least 40% to 50% debt capital in your overall capital structure.
An ideal level of debt for a firm occurs when the marginal benefits of taxes, resulting from tax shields, equals the marginal cost of debt.
There are four main benefits to using debt in capital structure; cost reduction, profit retention, financial leverage, and tax savings. Debt requires lower financing costs than equity. It allows debt holders to make interest payments giving them less risk because there is has no back up for failed companies using equity. Profits become retained because more money is kept in the firm rather than shared between shareholders with equity. The interest is only paid out of the firm’s profits. This is compared to using equity; the more profits the firm makes, the more it has to share with the investors. Using debt also has a positive effect on financial leverage. Investors are able to keep extra profits generated by debt capital after interest is paid. The last benefit to using debt in capital structure is tax savings. Debt lowers taxes because of interest deductions. It lowers taxable income which, in the long run, saves the amount of taxes paid. These are the four main reasons to use debt in capital structure.
On the other hand, there are some negatives if a firm were to have too much or too little debt. If a firm carries too much debt they will become overleveraged and not be able to sustain the high interest payments. This occurs when the firm has a slight drop in profits. A high level of debt can lead a firm into bankruptcy and can even hinder the growth of a firm. Too much debt can also increase the cost of equity because stockholders will begin to demand a higher return due to the increased risk the firm is taking.
A firm desires financial flexibility; it knows it has too much debt if the threat of a sudden negative occurrence would have great effects throughout the firm. A firm knows that it has too little debt if it can't properly finance profitable opportunities when they arise.
2.) What impact does leverage have on (1) WACC (and, therefore, value of the firm…explain the connection between WACC and value of the firm) and (2) performance of a company?
Increased leverage decreases the weighted average cost of capital therefore increasing the value of the firm until exceeding the optimal debt level. The use of leverage has value due to the interest tax shield that is provided by...
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