Essay on "Corporate Capital Structure Decisions Are Difficult"

Quoted Instructions for "Corporate Capital Structure Decisions Are Difficult" Assignment:

Instructions

Each question is to be answered separately

Question 1

What important factors, in addition to quantitative factors, should a firm consider when it is making a capital structure decision? How do these factors play in the decision? Have you any examples from your own experience that you could share with others in the class?

The following statements need to be agreed with or disagreed with and reason why

Statement 1

Although there may seem that there are many factors a company should be considering, one that comes to mind is how recesion proof is the company at hand? Especially in the last few years, either some companies have strived or some have shut down doors because they are not able to withstand the competition. I believe that it maybe sad but my company actually does better when the economy is not doing so great. We are a drug and alcohol facility and when times are tight many clients go to other drugs of choice. When the economy is great, people are out spending money and going shopping and going on vacations. In the text book it talks about having either too much debt or too little. I think it is the companies responsiblity to find a happy medium you don*****'t want to have too much debt out there, because most likely there is interest that will have to be calculated in this tally and the less debt you have the more likely or easier it will be to pay it back when money is not coming in as greatly. Businesses as personal lives are similar as they say a consumr should not have to much debt, like a debt to income type scenario.

Statement 2

If you just listen to the news on any given day this week you will certainly realize some of the factors that companies need to carefully consider in deciding on how to manage their capital structure. It seems we are learning that debt obtained is necessary for companies to thrive and to maximize shareholders wealth. But could all this debt be just a facade for a measure of how well the company is doing?

In many instances, companies may need to sit back and make decisions out of the normal course of corporate acceptance. With such instable economic times around the world, it seems to me that financial managers would be left with their heads spinning trying to fiqure out which curency to invest in, which debt to obtain and whether or not they will be able to sustain the payments on that debt (just as our entire country is facing right now). It seems to be iresponsible for copanies to carry on with out adjusting their debt ratios before a crisis stricks. It is their responsibility to their shareholders to foresee a potential disaster. Financial managers need to be very carefully about manipulating data and reports in order to make the shareholders happy when the overall health of the company is in termoil.

Leverage is of course important. I am not totally agains companies using debt, that would be rediculous. I am, however, saying that companies need to carefully anticipate changes and potential issues before they occur. If revenues are going strong, but marketing research is suggesting a shift in the consumers interest in that companies product, changes may need to be anticipated. The company then would have to carefully decide if they needed to take on debt to produce a new product line or to scale back and cut expenses at that time.

A steady cash flow is necessary for any company to survive. There are numerous threats that could cause interuption to cash flow. Just as individual families should save for emergencies, how much more should large corporations. It is silly to think that it is ok for any company to just cover debt payments without having cash on hand for unforeseen issues.

Timing of decisions will also have an impact of capital structure. Managers need to consider interest rate to make good decisions. At times of low interest rates, it may make more sense to obtain debt rather than selling stock.

No decision regarding the capital structure can be made without taking multiple factors into consideration simultaniously. There is much to consider in order to understand which course of action is the best to take at any given time.

Statement 3

Financial managers must consider non-quantitative factors along with quantitative decisions in making capital structure decisions. Firms use leverage to affect potential risk and return. Higher leverage may bring higher returns but also has higher risk. Fixed costs and debts must be repaid regardless of the successes or failures of a firm. In making decisions on capital structure, legal constraints are important because of capital impairment restrictions to protect creditors. Firms also face contractual constraints, in which a firm must repay its financial obligations from loans. Growth prospects are also considered, where a firm must decide on the acquisition of assets, evaluate profitability and risk, and the ability to raise capital externally and the ease of obtaining financing. Owner considerations are also important. The purpose of an organization is to increase the wealth of its owners, and decisions need to be made regarding just that. There are also market considerations, in which the health of the market is taken into consideration to determine what capital structure decisions will be made.

Statement 4

After reading the article, there were interesting points that were made by Modigliani. *****"The first MM theorem states the conditions under which the choice between debt and equity to finance a given level of investment does not affect the value of a firm, implying that there is no optimal leverage ratio. The second MM theorem shows that under the same conditions also dividend policy does not affect a firm*****'s value, so that there is no optimal payout ratio.*****"(pg237).

*****"The theorem establishes that a company*****'s value - the market value of its shares and debt - equals the present discounted value of the company*****'s cash flow, gross of interest, where the discount rate is the required return for firms of the same *****'risk class*****'. Hence, the firm*****'s value is determined solely by this discount rate and its cash flows, that is, by its assets, and it is wholly independent from the composition of the liabilities used to finance those assets. The theorem implies also that the average cost of capital is independent of the volume and structure of debt, and it equals the return required by investors for firms of the same *****'risk class*****'. Even though debt may appear cheaper than equity, due to the absence of a risk premium, increasing leverage does not reduce the average cost of capital to the firm, because its effect would be precisely offset by the greater cost of equity capital. As a result, investment decisions can be totally decoupled from their financing: they should be guided only by the criterion of maximizing firm value, and the cost of capital to be used in rational investment decisions is its total cost, as measured by the required rate of return on fully equity-financed firms of the same *****'risk class*****'*****"(pg239).

From what I gather from reading this blurb is that eventhough expenses may appear less expensive in the long run, one should look at the whole picture and not just one area. For example, a company may have to take out a short term loan to acquire some assets, sometimes the short term loan rates are more expensive than taking out a loan on a long term period. The management trully has to look at the whole picture. One wrong decision could leave facing decisions such as a bankruptcy. Perhaps not getting a company into so much debt is probably a great idea, the less debt the better off you will be. Regardless if the economy is good or bad, the company will still have to repay their terms of their loans, so beforre taking out more debt they should look at some trends that in the past. Sometimes the manager will realize that pehaps at the time that they will be taking out the loan isn*****'t agod time at the moment. It doesn*****'t mean that they will never take out a loan but just at this time they are deciding to wait.

Another good point made in the reading was that if a company is able to take out a loan the interest that is paid is also deductable in their tax returns, which many companies will look at as a bonus. There are many times where the company shows a profit and ends up haivng to pay several dolalrs in taxes and perhaps doesn*****'t have any writeoffs, so any writeoffs that are given are always a bonus. Although the companies are able to claim the interest paid, they also have to weigh out their options. The interest that is paid that is claimed on their taxes is it more than the interest that paid on the monthly debt payment by the company. All these options should be weighed out so that decisions are made properly.

Marco Pagano. (2005). The Modigliani-Miller theorems: a cornerstone of finance*. Banca Nazionale del Lavoro Quarterly Review, 58(233/234), 237 247. Retrieved July 30, 2011, from ABI/INFORM Global. (Document ID: 999545531).

Statement 5

Some other important factors to consider in making capital structure decisions include, revenue stability, cash flow, contractual obligations, management external risk assessment and timing. With revenue stability, *****"firms that have stable and predictable revenue can more safely undertake highly leveraged capital structures than can firms with volatile patterns of sales revenue. Firms with growing sales tend to benefit from added debt; they can reap the positive benefits of financial leverage, which magnifies the effect of these increases*****" (Gitman & Zutter, 2009, p. 543).

When a firm is looking at implementing a new capital structure, it is important for them to focus on their ability to generate cash flow. Due to contractual obligations, a firm may have limitations on the types of funds they can raise. With management preferences there are times that a firm may impose internal constraints on the use of debt. The purpose of this is to limit the amount of risk the firm is exposed to (Gitman & Zutter, 2009, p. 543).

*****"A management group concerned about control may prefer to issue debt rather than (voting) common stock*****" (Gitman & Zutter, 2009, p. 544). Usually, only firms in jeopardy of takeover have control as a major concern. External risk assessment is just as it sounds. A firms ability to raise funds quickly and at favorable rates depends on the assessments performed by lenders and bond raters.Lastly, timing is another important factor that must be considered. When interest rates are low for instance, debt financing may be more appealing.