Tom is interested in gaining additional insights into capital structure issues and has asked Walt to brief
Question:
Tom is interested in gaining additional insights into capital structure issues and has asked Walt to brief him in the area. He wants a basic review of the terminology but is particularly interested in the impact of different types of risk and in understanding of the better-known financial theorists. Walt knew that Tom could grasp complex issues quickly and felt that a thorough discussion of Modigliani and Miller’s work would be appropriate. He also felt that Miller’s addition of personal taxes to the earlier models would be good to cover, and he determined that a good approximation of personal tax rate on debt income was 28% and for stock income was 20%. He decided to add the more recent considerations of financial distress, agency costs and information asymmetry for a comprehensive overview. To help with this analysis, Walt developed the following estimates for cost of debt and cost of equity that included an increasing premium for financial distress and agency costs as the debt ratio increases.
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Debt ratio kd ks
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0% ---- 16.0%
10% 9.00% 17.0%
20% 9.25% 17.8%
30% 9.75% 19.0%
40% 10.50% 20.5%
50% 12.00% 22.0%
60% 15.00% 26.0%
70% 20.00% 30.0%
80% 30.00% 40.0%
90% 50.00% 60.0%
You have been assigned to help Walt develop the briefing and he has prepared the following questions to help direct your energies. He has also asked you to think about other relevant issues that Moore might bring up. Walt is aware of Tom’s keen intellect but is also aware of his reputation for “asking the right questions” and for having little tolerance for people who are not adequately prepared so he is concerned about covering the issues in an understandable manner.
Questions
Accounting concepts and applications
ISBN: 978-0538745482
11th Edition
Authors: Albrecht Stice, Stice Swain