Discussion questions format and application

Finance

1a) Capital structure can have a significant impact upon the company in a number of ways. The degree of debt that the company has reflects the amount of risk that the company has. Risk in terms of capital structure is related to the debt obligations of the firm, so the more debt that a firm has, the riskier it is. Cash flows generated from operations must be directed toward servicing that debt, rather than making investments into the business. Thus, the more debt a firm has, the more its ability to reinvest is stymied and the less likely the firm is to have money left over for the equity investors once the debt has been paid down.

The risk of a firm is reflected in its cost of capital. The cost of debt increases with the risk level of the debt. The more debt that a company has, the worse its ability to pay off that debt will be. As a result, the company's cost of debt will increase. However, the total cost of capital reflects the cost of debt and the cost of equity. The latter is typically higher, because the equity shareholders have less of a claim to the firm's cash flows. Therefore, the higher the equity component of the capital structure, the higher the cost of capital for the firm. Thus, most firms attempt to strike a balance between the cost of capital and the risk associated with higher debt levels.

1b) Business risk is the risk associated with a firm's business model. This is firm-specific risk, related to what the firm does and is not related to the risk associated with broader macroeconomic factors such as the overall economy or industry climate. With respect to corporate finance, business risk is the risk associated with the firm's cash flows -- for example the risk to shareholders than is associated with the firm's debt level.

1c) Operating leverage is the degree of debt that a firm has. This leverage, if high, allows the firm to have better returns on its equity. However, if the degree of leverage is low, the firm's equity does not typically return as well.

1d) to earn $150,000, the firm would need to generate earnings as follows:

$150,000 = (((2.5)(5) -- (5)) * x) - 50,000

$150,000 = 7.5x -- 50,000

200,000 / 7.5 = 26,6667 units

1e) the ROE for the first scenario is 140,000 / (0.85*350,000) = 47%

the ROE for the second scenario is 140,000 / (0.65*350,000) = 61.5%

The difference is 61.5 -- 47 = 14.5%

1f) the dividend payout structure is going to be as follows. The taxable income will be as follows:

($200,000 * .35) = $70,000 of debt. The interest will be (70,000)(.105) = $7,350

So taxable income will be $200,000 -- 7350 = $192,650

Tax at 30% is $57,795

Thus, net income is $192,650 - $57,795 = $134,855

The equity needed for the capital budget is (.65)(150,000) = $97,500

The dividends are therefore calculated as $134,855 - $97,500 = $37,355

The payout is therefore $37,355 / $134,855 = 27.7%

2. a) the company faces some risks if it tightens the credit policy. It will reduce its accounts receivable if it does this, and the result will be that its liquidity ratios will decrease. The company will convert more money to cash more quickly, but in doing so it will put itself in a position of having fewer current assets with which to deal -- it must invest its cash well if it tightens its credit policy.

2b) Depreciation should not affect the working capital analysis. Depreciation should only affect capital assets, which are not included in the current assets, the part of the assets that are included in the working capital.

2c) Using short-term debt financing as a source of financing is has advantages and disadvantages. Short-term debt is easy to use, and carries with it a lower cost because of the short time frame. Banks are willing to lend in the short-term as well. In addition, the firm can affect short-term credit financing even without banks, for example by stretching payables. The main disadvantage, however, is that this technique restricts the firm's working capital. More of its near-term income is dedicated to debt service, increasing the firm's overall risk level.