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.

                                             __________________________________________

                                                             Debt ratio                 kd                     ks

                                             __________________________________________

                                               

                                                             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

 

1. What is meant by capitalization? What is meant by a firm's capital structure? For financial planning purposes, explain why either book or market value should be used to determine the firm's capital structure. What is capital structure theory? 2. Discuss the following issues relating to business risk and financial risk. 3. a. What is the difference between business risk and financial risk? Explain some of the factors that contribute to each. Evaluate Moore Plumbing Supply's level of business risk. b. How do these risks relate to total risk? c. How does business risk affect capital structure decisions? 4. Discuss the following issues relating to Modigliani and Miller's (MM) 1958 capital structure model. a. What was the importance of the model? b. What are the basic assumptions of the model? 5. Discuss MM's later models (1963) in which they relaxed the no-tax assumption and added corporate taxes. Discuss Proposition I and II. Miller added personal taxes to the model in his 1976 Presidential Address to the American Finance Association. What happens to Miller's model, in general, if there are no corporate or personal taxes? What happens when only corporate taxes exist? 6. Briefly describe the asymmetric information theory of capital structure. What are its implications for financial managers? 7. Prepare a summary of the implications of capital structure theory that can be presented to Tom Moore. What insights can capital structure theory provide managers regarding the factors which influence their firm's optimal capital structures? 8. Finally, what recommendations would you make about the capital structure of Moore Plumbing Supply Company? Justify your answer.