Pound Industries Ltd Finance Assignment Sample

• Subject Name : Accounting and Finance

Theories of Capital Structure - Part A

iii) In that case XYZ limited doesn’t need to pay any tax; hence the company won’t have sufficient taxable income. On the other side financial leverage could increase the profits of the company. Thus if the company has sufficient taxable income due to the presence of corporate tax, the increasing financial leverage could increase the equity value through which the value of the company in this situation could also be increased.

ii) The structure of optimal capital of certain firm is estimated to be the most effective mix of debt and equity financing with maximizing the market value of the company along with minimizing the cost of capital. Thus, based on MM theory, if there is no tax rate, and if the financial leverage would increase, then debt financing of XYZ Ltd would offer lowest cost of capital because of the tax deductibility. On the other hand, however, higher debt margin might increases financial risk of XYZ’s shareholders alongside with the return on equity whichthey is most likely to require. Hence, XYZ Ltd is required to find optimal point based on which company's marginal debt benefits would be equals to marginal cost. Thus, as a whole, it can be said that in a world of MM approach with no taxes, minimization of weighted average cost of capital (WACC) would happen and also would be the one way for optimizing towards lowest financing costs mix if financial leverage tends to increase.

Theories of Capital Structure - Part B

Theories of Capital Structure - Question 1

I) In MM world that depicts no tax rates, the cost of debt would fundamentally be lower compared to the cost of equity. Hence, it is assumed that firm would borrow by taking the advantage at lower rate. Moreover, based on MM approach with having no tax rate assumptions, if borrowing rate is increased in order to receive the cheaper rate then the payable amount on equity would also needed to be increased. As a result, these two would practically offset by leaving the overall WACC to be same. Thus, having no debt, with market value of 200 million USD and cost of equity of 12% rate, if the financial leverage of the firm XYZ Ltd increases the value of the firm would also increase.

According to the M&M theorem, the cost of capital is considered as the part of the capital structure in this situation. It can be stated that at a definite rate of debt/equity ratio, the cost of capital become minimum and the firm value could be at its maximum stage. But due to this pandemic situation the financial distress has increased and it costs the decrease in the firm’s value. In this way this can be stated that if the operations of the firm could be closed or stopped during this situation of Covid-19, the firm wouldn’t be able to pay its debt and its debt/equity ratio will be decreased, which also reduce the value of the firm as well.

II) As the alternative payout policy device in order to cut dividends or to conserve cash, companies would consider the approach of Debt Signalling. Specifically to say, cost of equity is always tended to be more than the cost of debt. Hence, within financial distress, if companies are most likely to struggle with the payments of dividends to the shareholders then the cost of equity would be further high at margin. Thus, other sources of debt financing would complement the payment costs.

Theories of Capital Structure - Question 2

Based on the signalling theory firms use the equity financing for the investment and after that if the firm has no chance to raise the equity, they could use debt financing in this situation. However for the company, named, Adairs (ADH), generally they have low growth opportunities and volatile earnings, hence this company wouldn’t be able to perform easily within the market during the situation of Covid-19 in this situation. As the company has decided to cut the dividends, they now could depend on the debt financing in this situation. As per the debt signalling theory company could raise their capital through debt financing as the equity costs could be high compared to debt. Hence in accordance with this situation of Covid-19, if ADH raise their capital through debt financing according to debt signalling theory, they have to incur less costs as the equity costs always greater than the debt costs and hence company doesn’t have to pay the equity or dividend to their shareholders which could place the company in a safe position within the company.

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