Sample Case Study On Finance

The company intends to makes changes on the capital structure of the company. Currently, the company does not have any debt. However, there is intent to raise the debt level to 25 percent of the capital structure. There are advantages and disadvantages of incorporating debt in the capital structure. Some of the motivating factors are financial/monetary such as the cost of financing. However, some factors are non-financial such as the impact on management control. This memo addresses the financial impacts of incorporating debt in the company. In particular, the memo evaluates the impact of incorporating debt on the market value of stock and the company as well as the business risks.
Issue of debt lowers the value of a firm. An increase in debt increases business risks. Payment of debt and interest that arises is obligatory since it is bound by the contract between the company and debt providers. Failure to pay debt and interest results in bankruptcy. Therefore, the business faces a risk of being liquidated in case it is unable to pay arising debts. In addition, stockholders have a residual claim in case a business goes bankrupt. An increase in risk makes stockholders nervous thus existing shareholders supply their shares to the capital market to sell while demand from potential shareholders is limited. According to the market forces, the market value of the stock decline. Therefore, on aggregate the market value of the firm declines.
The stock price for a company with zero growth of dividends is determined by dividing the dividends per share by the rate of return. In this case, all earnings are paid out as dividends. Therefore, the dividends per share is the same as the earnings per share. Times interest earned ratio assesses the number of times the EBIT covers interest expenses. In other words, it assesses the ability of a company to pay interest expenses using available earnings. It is a measure of the bankruptcy risks of a company. The times earned interest ratio is computed for each value of the anticipated EBIT for each probability. The times earned interest ratio ranges from 0.78 to 4.77. EBIT below 1.0 implies that the company is not able to meet interest expenses form its earnings. Therefore, it has a high bankruptcy risk. In this case, if the probability event of 0.05 occurs and the EBIT is 1,000,000 then the company will have a high bankruptcy risk.
There are various implications of introducing debt into the capital structure as can be observed from the analysis provided. Firstly, debt increases bankruptcy and business risks. Secondly, debt lowers the market price of a company’s stock. Lastly, debt lowers the market value of a company. However, there are also advantages of introducing debt. Therefore, the pros of introducing debt should be weighed against the cons of introducing debt before making the decision of changing the capital structure. Debt should only be introduced if the benefits of doing so outweighs the cost of introducing debt.

References

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Peavler, R. (2014, December 16). Debt and Equity Financing The Advantages and Disadvantages of Debt and Equity Financing. Retrieved from http://bizfinance.about.com: http://bizfinance.about.com/od/generalinformatio1/a/debtequityfin.htm
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