Capital Structure Policy: Risk of Debt, Cost of Capital, Agency Theory, Pecking Order Theory

This article discusses various aspects of capital structure policy including risk of debt, cost of capital, agency theory, and pecking order theory. It also includes computations and practical considerations related to capital structure.

CAPITAL STRUCTURE POLICY
SECTION A
16.2
The above statements holds true as the risk of debt is generally lower to equity on account of
securitisation against the assets of the company. Further, the debt holders has a higher tranche
in repayment in case of liquidation of the company. In addition, the debt holders are ensured
that they shall receive their interest irrespective of company making profit or loss. Thus, the
return from such security is always lower than that of equity at max can be equal and can
never exceed the same based on above deliberations. Further, the cost of debt is reduced by
tax rate prevailing tax rate in the country. Hence, the stated proposition holds true.
16.4
The computation has been presented here-in-below:
Sl No Particulars Amount Amount
1 Expected Cash flow 200
2 Cost of Equity 20%
3 value of the company today 1000
4 Buyback of shares 100
5 Cost of Debt 10%
6 Overall Cost of company 20%
7 Revised Cost of Equity 30%
8 Value of the company 1000.00
9 Value of debt 100.00
10 Value of Equity 900.00
On perusal of the above, it shall be seen that value of the company stands at $ 1000. Further,
the value of the claims on asset of the company after the share buyback stands at $900
(Assuming no current liability exists). The rate of return on ordinary shares post buyback
shall be 30% on the basis of MM Proposition 1.
16.5
The computation has been presented here-in-below:
Sl No Particulars Percentage Amount
Current Structure
1 Cost of Capital- Equity 100% 15%
Proposed Structure
1 Debt 50% 10%
2 Equity 50%
3 Cost of Capital 100% 15%
Cost of Equity 20%

On perusal of the above, it may be seen that the revised cost of equity shall stand at 15% on
the basis of proposition laid down under MM 1.
16.7
The computation has been presented here-in-below:
Sl No Particulars Percentage Amount
1 Weighted Average Cost of Capital 100% 10%
2 Cost of debt 80% 8%
3 Cost of Equity 20% 18%
On perusal of the above, it may be seen that cost of equity of the company on the basis of
assumption stands at 18%.
16.8
In terms of Static Trade-Off theory when the debt exceeds the optimal structure of the
company, increase in debt does not reduce the WACC of the company on account of financial
distress that occur on account of additional borrowing by the company. This causes cost of
equity of the company to rise leading to rise in WACC post a certain point which is optimum
capital structure. (Ebrary.net, 2018)
16.11
The computation has been presented here-in-below:
Sl. No Particulars Percentage Amount
Current Structure
1 Cost of Equity 100% 15%
Proposed Structure
2 Debt 50% 7%
3 Cost of Capital 100% 15%
4 Cost of Equity 50% 23%
On perusal of the above, it may be seen that cost of equity stands at 23% based on
computation that tax shield on debt has been considered.
16.12
The practical considerations have been detailed here-in-below:
(a) Business Risk is the risk of operations of the company. The higher the risk of business
the lower will be the debt optimal ratio;
(b) Exposure of company to tax and the impact of such tax on the capital structure of the
company. For instance, interest of debt is tax deductible.
(c) Financial Flexibility: It is analysed to understand the capability of company to raise
capital from the financial market under bad and good conditions;
(d) Cash flows from the project: Before undertaking a project, management shall take into
consideration the proposed cash flows from the project, the weighted average cost of

capital of the company, the net present value of the project, ranking of different
projects, capital rationing etc;
16.28
The computation has been presented here-in-below:
Sl No Particulars Interest Tax Shield Discounting Factor Present Value
1 Debt 27.5 8.25 0.869565217 7.173913043
2 Debt 27.5 8.25 0.756143667 6.238185255
3 Debt 27.5 8.25 0.657516232 5.424508918
4 Debt 27.5 8.25 0.571753246 4.716964276
5 Debt 27.5 8.25 0.497176735 4.101708066
6 Present Value 27.65527956
Assuming WACC of 15%
On the basis of above, it may be understood that present value of tax savings of the company
stands at 27.65 AUD.
16.29
Under the Modigliani Miller Approach, the valuation of the company is dependent on the
value of tax savings on account of debt. If the value of debt is removed from the capital
structure accordingly the value of company shall fall by 300*30% i.e. 90 Million and the
value of the company post repayment of debt shall stand at 810 Million.
SECTION B
16.7
In term of agency theory, the use of debt resources under the capital structure helps managers
to be disciplined in regard to how they spend capital resources of the company as they have
less free cash flow in their hand to use for their own benefit. Thus, in terms of agency theory,
the higher the financial leverage the lower the agency cost. Thus the optimal structure is 90-
99% debt in terms of agency theory provided financial distress is maintained.
16.9
Financial distress is a situation in which the company cannot meet the expectations and face
difficulty in paying off its creditors due to its high fixed cost and the assets which are
generally illiquid in nature. Costs which company has to bear under financial distress such as
heavy costs related to financing cost of next best alternative and low efficiency of employees.
Distressed firm employees have very low productivity and high stress due to risk of
bankruptcy of the company which could force them to join another organisation.
16.20

If the company have just begun the financial difficulty like creswell shoes, some of the ways
the company should opt for
a) The company should go for a restructuring process, by analysing the weakness of the
company one will be able to reduce them and concentrate on strength of the business.
b) The company should properly manage the cash flows, understand the total debt of the
company, manage the inventory, and organise the total cash inflow of the company so
that the outflow of cash can be met.
c) The company should make a list of payment to be made to outside people according
to urgency .Every organisation bear expenses which are not necessary but the moment
the company is in financial problem those should be avoided. Another alternative is to
find cheap raw material and go for a better negotiation. (Anon., 2018)
In the situation of financial distress the company should not quit but it should take few steps to
overcome it.
16.21
Yes, the managers of Ellison Group should chose the project as the Net Value of the project
is positive and it shall provide resources to the company to pay off the liabilities. Further, the
company can take a debt restructuring scheme to prevent itself from becoming insolvent and
can use the fund to acquire other positive projects and hence the said project be accepted.
The cost that the company shall bear on account of declining the project includes:
(a) Cost of Debt;
(b) Payroll cost;
(c) Feasibility study cost of project;
(d) Cost of insolvency;
(e) Cost ancillary to project discussed.
16.24
The order of financial sources for managers who subscribe to pecking order theory has been
detailed here-in-below:
(a) Internal Funds: This means from profits generated within the company accumulated over
the years. The cost of raising is Nil;
(b) Debt: This means raising funds from the market by issue of a fixed rate of interest
instrument and these instrument does not have any voting rights and no role in decision
making of the company. The cost of raising money through bank is low and through
secondary market is high;
(c) Equity: This instruments are last resort and used when all other aforesaid measures are
invaluable and generally results in dilution of ownership. The cost of raising funds
through market is high.

References:
Anon., 2018. CAN YOUR COMPANY DEAL WITH FINANCIAL DIFFICULTIES?. [Online]
Available at: https://blog.apruve.com/how-can-your-company-deal-with-financial-problems-and-
difficulties
[Accessed 30 September 2018].
Ebrary.net, 2018. The Trade-off theory of capital structure. [Online]
Available at: https://ebrary.net/735/business_finance/trade-off_theory_capital_structure
[Accessed 30 September 2018].