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The optimal debt ratio for a firm balances the influences of risk and return, leading to a maximization of share price. As such, the optimal debt ratio serves as a target level of debt financing for the value-maximizing firm. A debt ratio of 1.0 would be possible only if one hundred percent of the firm were financed with debt, eliminating equity ownership. Such a scenario is impossible.
A firm’s capital structure affects:
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A firm’s capital structure affects both its return on equity and its risk of default.
The firm's target capital structure is consistent with which of the following?
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At the optimal capital structure the firm will minimize the WACC, maximize the share price of the stock and maximize the value of the firm.
Jayco, Inc. currently has a D/A ratio of 33.33% but feels its optimal D/A ratio should be 16.67%. Sales are currently $750,000, and the total assets turnover (Sales / Assets) is 7.5. If Jayco needs to raise $100,000 to expand, how should the expansion be financed so as to produce the desired debt ratio? Finance it with:
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Sales / Assets = 7.5 = 750,000 / A, so A = $100,000, D / 100,000 = 33.33. Therefore, D must be 33,333. You want to change D/A to 16.67, so must double A so the 100,000 must be all equity.
Zoltan DeJainus is the Chief Financial Officer of Hilliard Veterinary Products (HVP). In a discussion with HVP’s management team about the firm’s capital structure, DeJainus makes the following comments:
Comment 1: HVP’s target capital structure is the same as its optimal capital structure.
Comment 2: If market value fluctuations cause the firm’s actual capital structure to vary from the target capital structure, HVP should buy or sell its own stock or bonds as necessary to make sure that the capital structure remains at its optimal level.
Should the members of HVP’s management team agree or disagree with each of DeJainus’ comments?
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The management team should agree with DeJainus’ first comment. For managers trying to maximize the value of the firm, the target capital structure will be the same as the optimal capital structure. The management team should disagree with the second comment. In practice, a firm’s actual capital structure will float around its target. One of the reasons for floating around the target is market value fluctuations. The target capital structure serves as a guide for making decisions about how to raise additional capital, but unless there is an extreme circumstance, there is no need for a firm to make transactions to keep the capital structure exactly on target.
Katherine Epler, a self-employed corporate finance consultant, is conducting a seminar for executive management teams regarding issues related to a company’s capital structure. In the morning session of the seminar, Epler makes the following two statements:
Statement 1: Management teams will have a target capital structure for their firm because of an awareness of how competing firms finance their operations and a desire to keep their financial ratios close to industry averages.
Statement 2: In order to reap the benefits that come with having a target capital structure, management must always raise capital in the exact proportions called for by the target.
With respect to Epler's statements:
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Both of Epler’s statements are incorrect. Management teams will have a target capital structure because they are aware that their firm as an optimal capital structure that will maximize the value of the firm. It is the desire to keep the capital structure close to the optimal structure that leads to a target capital structure, not a desire to keep financial ratios close to industry averages. The second statement is also incorrect. The target capital structure is more of a floating range, and the firm may deviate slightly from the target when raising capital to exploit short-term opportunities in a particular financing source.
Which of the following is least likely to be a reason why a firm’s actual capital structure may vary from the target capital structure?
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A firm should always finance a project based on the firm’s weighted average cost of capital, although when evaluating a project, the firm may apply a risk factor to adjust the risk of the project. A corporate manager generally cannot deem some projects as being financed by debt and some by equity as all projects are effectively financed proportionately based on the firm’s capital structure. In practice, a firm’s actual capital structure will float around its target. For a firm that does have a target capital structure, the actual structure may vary from the target due to market value fluctuations, or management’s desire to exploit an opportunity in a particular financing source.
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