Capital Structure, Financial Leverage, and Futures Contracts

This assignment solution delves into key concepts in finance, specifically capital structure and futures contracts. It addresses the importance of debt and equity within a company's capital structure, explaining how an optimal structure can add value through tax benefits and risk mitigation. The solution also discusses how leverage is measured and its potential impact on company value. Furthermore, it explores the use of futures contracts for hedging risk, including a scenario involving a wool grower and the factors influencing the futures price of commodities like coal. The document highlights the complexities of achieving a perfect hedge and the considerations involved in managing risk within futures markets. Desklib offers a wealth of similar resources, including past papers and solved assignments, to support students in their academic pursuits.

Running head: FINANCE
Finance
Name of the Student
Name of the University
Authors Note
Course ID

1FINANCE
Table of Contents
Answer to question 4:.................................................................................................................2
Answer to A:..........................................................................................................................2
Answer to B:..........................................................................................................................2
Answer to C:..........................................................................................................................2
Answer to question 5..................................................................................................................3
Answer to A:..........................................................................................................................3
Answer to B:..........................................................................................................................3
Answer to C:..........................................................................................................................3
Answer to D:..........................................................................................................................4

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Answer to question 4:
Answer to A:
The capital structure is regarded as the amount of debt and equity that is employed by
the firm to fund the operations and finance the assets. The debt and equity is regarded as the
important element of capital structure because they are used to fund the operations of
business, capital expenses, acquisition and other investments. There are trade-off firms that
have to decide whether to increase the debt or equity and managers would balance both in
order to find the optimal capital structure. The capital structure is the mix of company’s debt
and equity they are important because it costs the company the amount of money to borrow.
Answer to B:
Attaining the right structure of capital particularly the composition of debt and equity
which is used by the company to finance its operations and strategic investment has vexed the
practitioners. An appropriate capital structure helps in providing tax benefit because interest
expenditure is tax deductible. A right capital structure helps in maintaining the low leverage
and supports the greater level of leverage with collateral. The appropriate capital structure
helps in mitigating the refinancing of risk by matching the debt and asset maturity.
Answer to C:
Leverage is measured by the company’s debt and equity. The degree of financial
leverage measures the sensitivity of the company’s earnings per share with respect to its
fluctuations in the operating income as the outcome of changes in the capital structure. The
financial leverage varies between companies because companies relies on mixture of equity
and debt to finance their operations and understanding the amount of debt that is held by the
company in evaluating whether it can pay its debts. If the company does not have any
appropriate level of taxable income to protect or if the company’s operating profit is lower

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than the critical level, then the financial leverage would reduce the value of equity and hence
reduce the company value.
Answer to question 5
Answer to A:
Future contracts is treated as one of the most common derivatives that is used to
hedge risk. The ultimate goal of the investors using the future contract is to hedge and
perfectly offset the risk. The future contract is identical to options. The holder of future
contract has the right of purchasing the underlying security where both the party are obligated
to deliver based on the terms of contract if the settlement takes place. Buying a future
contract is useful for investors in restricting the exposure of risk that an investor usually has
in trade.
Answer to B:
Perfect hedges are real in theory, but they are rarely considered worthy for any time
period except during the most volatile markets. In this situation, perfect hedge is referred as
the safe haven for capital in the volatile markets. When the term perfect hedge is thrown in
the finance world which usually implies that the ideal hedge is determined by speaker’s own
tolerance risks. The most common example of perfect hedge would be the investors
employing the combination of stocks that are held and opposing the position of options to
self-insure against any loss that are held in the stock.
Answer to C:
Answer to I:
The wool grower should undertake the short position in the future market because the
future expectation is that the price would drop and the price at which she would be selling is
higher than the price she would buy later.

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Answer to II:
Short selling puts the investors in the position of limitless risks and limited reward.
The investor here should take into the account the risk as managing risk during the short run
is similar to purchasing stock.
Answer to D:
Due to the different types of coal in the market, different benchmarks has grown
relating to the price of numerous forms of coal. These price becomes a basis of future
contracts that are traded on the exchange across the world. There are demand side factors is
treated as the strongest factor that changes the price of coal. While the supply the supply side
factors does not bears much of the weight on the future coal price. However, much of the
supply in the end is bound to overweigh the coal demand that ultimately brings down price of
the coal.

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