Capital Structure of a Firm

Introduction

Capital structure is a term used to refer to the fraction of debt and equity that make up a firm’s total capital. The cost of debt is the amount above the borrowed amount that lenders demand from the firm in form of interest.

There are benefits associated with each financing criteria. For instance, using debt to finance a project qualifies a firm for an interest tax shield. This means that, interest paid for debt is deducted from taxable income which serves to reduce the cost of financing as opposed to equity financing. The expenses incurred in issuing debt are fewer and the managers are pressured to allocate the funds to more profitable projects in a bid to protect their careers. However, using debt has a disadvantage of pushing the firm into financial distress by incurring extra costs to service the debt when the firm is experiencing tough financial times (Parrino, R. & Kidwell, D. S., 2009).

28 a). Assuming that the share price of IST will remain $13.50 after issuing equity and that:

i) The managers know the correct value of the shares is $12.50,

The firm needs $500 million to finance the project. If equity is issued to obtain the funds, then 37 million shares must be issued:

$500 million / $13.50 = 37 m.

However, the share price of $13.50 is inclusive of a $1 premium, therefore the total benefit to the firm due to share premium is 37m x $1 = $37 m. This is equivalent to $ 0.27 per share. This can be shown as,

12.50 x 100 + 500 = 12.77

100 + (500 /13.50)

The par value is $ 12.50, 12.77 – 12.50 = 0.27, which is the premium per share.

The borrowing cost is $20 m and the firm will compare the $20m borrowing cost with the $37 m benefit accruing from share issue at a premium.

The best choice is to ...

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...a benefit and managers would prefer it to debt financing. If the cost of borrowing is zero, and the shares can only be issued at a discount, managers will issue debt to evade the extra equity financing cost. However, investors seek to maximize their money value by buying at the least possible share price that the firm is willing to offer. With no benefit accruable from equity financing, the managers will use debt issue since it has no cost (Berk & Demarzo 2011).

References

Berk & Demarzo, 2011. P. 213-214. Financial distress, managerial incentives, and information...

Pearson Education, Inc publishing.

Ricardo N. Bebczuk, 2003. P. 37-52

Asymmetric information in financial markets: introduction and applications. Cambridge university press.

Xin Chang et al, 2011. P. 7. Capital Structure

http://www.bm.ust.hk/fina/staff/Dasgupta/Chang_Dasgupta_Hilary.pdf)