2 - 2 Introduction to capital structure theory Aa Aa In his...

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Unformatted text preview: 2. Introduction to capital structure theory Aa Aa In his private office,just down the hall from his conference room, the Chief Financial Officer (CFO) of Caberto Chemicals is meeting with his newly hired assistant, Akiko. CFO Akiko CFO Akiko CFO Akiko CFO Before our next meeting with the bankers, let's take a second and make sure that we have a common understanding about the company's capital structure. Caberto can potentially have three different capital structures: its current, actual capital structure, a target capital structure, and an optimal capital structure. If we wanted to talk about the observed capital structure at which Caberto actually exhibits today or any other specific point in time, we’d be talking about which capital structure, Akiko? o o o We'd be talking about Caberto's actual V capital structure. This is the capital structure that Caberto is currently exhibiting, and it can differ from its ideal capital structure. 0 o 0 Very good. Now, if Caberto’s current capital structure consists of 37.5% debt and 62.5% common equity, then, Akiko, how would we know if we are operating with our optimal capital structure? 0 o 0 An optimal capital structure is characterized by two important attributes: First, it minimizes the firm's weighted average cost of capital“ , and second, it maximizes the value of the firm J , which should make our shareholders very happy. Again, that's great! Now, tell me, in general and without talking about Caberto in particular, why would a company ever be willing to operate with a capital structure that is not equal to its desired or target capital structure? Well, sir, there are several reasons that I can think of. Let's see. First, a firm may use debt and equity financing that differs from its targeted amounts if its business activities or its industry becomes more“ risky or more‘/ competitive, and, in general, these changes will allow a firm to increase its reliance on debt financing, everything else remaining constant. Second, the availability of unusually inexpensive sources of capital’/ may prompt a company to borrow or issue new shares and thereby deviate from its target capital structure. 0 o o Akiko, you've passed my first test with flying colors! With this understanding of the theory and some real-world experience, you'll be earning your bonus in no time. Explanation: Close A The term capital structure refers to the sources of long-term financing used by a business organization, including its borrowed capital, common stock, and preferred stock. Organizations usually have three relevant capital structures: a current, actual capital structure, a target capital structure, and an optimal capital structure. The actual structure is the capital structure exhibited by a firm at a specific point in time, whereas the target capital structure is the long-run capital structure at which the firm plans to operate ultimately. The optimal capital structure, in contrast, is the capital structure that minimizes the firm’s weighted average cost of capital and maximizes the value of the firm or its shareholders' wealth. A firm’s actual capital structure may differ from its target capital structure for several reasons. For example, as the riskiness of the firm’s business activities or the competitiveness of the firm’s industry increases, most firms will want to reduce their reliance on debt financing. In addition, the availability of unusually inexpensive sources of financial capital may prompt firms to capitalize on these opportunities and either borrow more or issue new shares of common or preferred shares. This could result in a firm’s actual capital structure deviating from its target capital structure. The use of a less-than-optimal level of debt financing provides the firm with an increased reserve borrowing capacity. This provides a firm and its managers with increased financial flexibility, an advantage in risky times and industries. ...
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