Capital Structure
1. Debt financing has several advantages over equity financing. The first is that the cost of debt for most firms is lower than the cost of equity. The relative cost of debt or equity is weighed against other opportunities in the market. Given that debt is guaranteed, it is secure to the extent that the company can meet its obligations. The value of equity is less secure, and also bears more market risk. This contributes to the higher cost of equity and the lower cost of debt. Another advantage of debt financing is that the issuance of debt does not result in a dilution of control over the company. Equity typically comes with voting power embedded, thus giving the equity investor a voice in how the company is run. That does not occur with debt financing. A potential advantage of debt financing is that it increases the firm's leverage. The result of increased leverage is that as the firm's assets increase, equity increases at a faster rate. Thus, in a growing firm, debt can provide additional value to the ownership group.Increased leverage can also be a disadvantage, however. Leverage equates to risk, therefore increased leverage results in a sharper reduction in equity during times when the firm's assets are shrinki
With high competitive and market risk, a low debt ratio is ideal. The optimal capital structure can be viewed approximately as the point where the firm's weighted-average cost of capital is the lowest. High fixed costs also affect the amount of money available to meet debt obligations. Food is a staple product, for which there is a baseline demand with low price elasticity. Another major factor is the firm's cost structure. According to Proposition II of the Modigliani and Miller Theorem, the use of debt increases the rate of return that shareholders require for their investment. The grocery store retailer Kroger operates in a relatively stable industry. However, the company has lower fixed costs than, for example, a hotel group. The company is considered to be cyclical and has a beta of 1. Therefore, firms with cyclical revenue streams should generally not carry high debt levels, as they may be unable to meet their obligations should the market turn against them. Moreover, the product is not perishable. The International Hotel Group operates in a highly cyclical industry. This is because, as seen in M&M Proposition II, as debt increases the cost of equity increases. Therefore, Whirlpool's ideal capital structure is medium debt ratio.
Common topics in this essay:
International Hotel,
Proposition II,
,
Miller Theorem,
Modigliani Miller,
cost debt,
debt ratio,
capital structure,
cost equity,
optimal capital structure,
optimal capital,
risk default,
equity increases,
increased leverage,
debt financing,
fixed costs,
tough economic times,
debt optimal capital,
low debt ratio,
debt ratio ideal,
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