Discuss in details what influences capital structure decisions. In particular, 1

Question

Discuss in details what influences capital structure decisions. In particular,

1. Explain the trade-offs that firms must consider when they determine their target capital structure
2.Explain the effects that debt financing has on the firm’s risk and cost of capital
3.Summarize capital structure theory
4.Explain why firms in different industries have different capital structure.
5.Explain why some investors like the firm to pay more dividends while other investors
prefer reinvestment and the resulting capital gains.
6.Discuss the various trade-offs that companies face when trying to establish their
optimal dividend policy.
7.Differentiate between stock splits and stock dividends.
8. List the advantages and disadvantages of stock repurchases vis-à-vis dividends from
both investor’s and companies’ perspectives.

Explanation / Answer

1. As a trade of between equity and debt , the firm must chhose the structure that offers the lowest WACC and the highest market value of the firm. It depends on a lot of factors like the expected cash flow generation, the interest coverage the firm can produce, the dividend expectation and capital appreciation expectation of the shareholders and the future requirement of firm and the current leverage utilized by firm etc. So the firm needs to consider all these factors while determining the debt equity ratio of the company.

2. Debt financing defintely increases the risk of the firm as there is fixed interest and maturity payment associated with the firm. If surplus cash is not generated, the dividend payment to shareholders become uncertain and the cost of equity goes up.

3. The Capital structure theory explain that the objective of the firm by minimizing the weighted average cost of capital used and maximizing the market value of the firm. A judicious mix of debt and equity is needed to achieve the goal , however this mix will be dynamic as the business scenarion changes.

As per the traditional capital structure theory , cost of capital initially decreases with increased amount of debt in capital structure upto a certain extent and thereafter , the cost of Capital increases with increase in debt component.

However, MM Hypothesis and Net Opearting Income approach argue that in the absence of Taxes , the firm's market value remain indifferent to the Capital structure. However , this theory suffers from the limitation that it assumes a perfect capital market , there is no coporate income tax and firms can be classified into homogeneous risk classes.

4. Different Industries have different capital structure depending on the capital needs of the company. Most of the companies in the capital intensive sectors and technology driven secotors need high investment in Capital Assets and they approach Banks or capital market for debt Financing. Depending on the Fixed asset and working capital needs or the industry and the company , the debt component also vary. As a thumb rule , companies with higher fixed asset requirements and longer working capital cycles need more long term debt than other companies.

5. Some investore like dividends over capital appreciation as they prefer quicker return in dividends than the long term riskier return inthe form of capital appreciation. However , other group wants to reap the benefit of long term capital appreciation which given generally more return and has a lower tax incidence than dividend income.

6. The optimal dividend policy depends on a lot of factors , like the ploughback required to internally fund the capital investments in coming years , the dividend expectations of the shareholders and the availability of cash for paying dividends , the history of dividend payout ratio so far ,etc. All these factors need to be weighed before deciding the optimal dividend policy.Dividend payout also affects the capital appreciation and therefore the long term appreciation of stock also to be considered for dividend policy.

7. Stock split is reducing or increasing the par value of shares , thereby changing the par value and no of outstanding shares . The total value of the shares do not change.

Similarly stock dividend is issuing additional no (based on % of existing nos) of shares to the sharholders without and cash caonsideration. In stock dividend also the total value of shares remain same as the stock holder's equity total remain unchanged.

8. Stock repurchase the done to reduce no of outstanding shares to resist takeover attempt or to imprive EPS and P/E raio. It involevs outflow of cash and dividend payment per share also improves due to this action. The total stock holder's equity is reduced by share repurchase.

From invetor's point , the EPS, dividend yield and P/E ratio improves after stock repurchase .

Dividend payout reduces the Retained earning and cash balance of the company and shareholder's equity is reduced. For investor it is earning in cash but the capital appreciation is reduced due to dividend payment.

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